This article was taken from the summer issue of the 1875. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
Investment trusts are trading at their widest discounts since 2008 at the time of publication. In theory, we now have the ability to go out and buy a quality basket of assets for substantially less than they are worth, but we have to be careful. These discounts have shown no real signs of narrowing, and there is still the potential for further pain in the short-term. Before we dive into what makes these investment companies appealing from a long-term perspective, it is worth highlighting some of their key features.
Investment trusts invest in a range of companies and infrastructure projects and can have a variety of different objectives that often determine specifically what they buy. For example, an investment trust that focuses on UK equity and aims to generate income will look very different from one that wants to achieve long-term capital growth. Unlike unit trusts, they can borrow money and take on debt in order to invest additional capital. This has the effect of juicing up returns in bull markets but can also provide a serious drag to performance in down markets.
Investment trusts are listed vehicles, which is why they can trade at discounts if market sentiment turns on them and people are willing to sell them for less than the value of the underlying assets – the Net Asset Value (NAV). First, we should examine the debt, or gearing, that many investment trusts have used to provide enhanced returns over the last decade. This is of particular interest, as interest rates are still rising and the cost of refinancing this debt is becoming extortionate, when compared to the price it was issued at.
For most of the last decade, the effective use of gearing has seriously benefited many investment trusts. Eurobox, a retail investment trust that specialises in large warehouses in Europe, is over 60% geared and this is part of the reason it was able to return over 23% in 2021. At the time of publication, the trust is trading at a discount of around 36% and has had a rough couple of years as interest rates have risen and the return available on near risk-free government bonds has risen in tandem. This increase often forces the value of other income-generating investments down as investors must be compensated for taking the additional risk associated with the investment, as the price of these trusts drops, the yield you can get from investing in them rises. Many commentators believe we are nearing the top of the rate-hiking cycle and, as such, the long-term returns available on property and infrastructure may start to look appealing again.
So, Eurobox’s high-level of debt is by no means the only reason it has struggled and given the emergence of e-commerce and the importance of delivery infrastructure to the sector, you could be tempted to take advantage of that large discount and see this as a buying opportunity. However, the trust has €500m worth of debt that is due in 2026 and interest rates now seem unlikely to have turned a significant corner by then. Should they remain at current levels, this will put the trust in a situation where it will either have to sell assets in order to pay off its debt, which will significantly reduce its NAV, or refinance the debt on much less favourable terms. Currently it pays 0.95% annually on this debt and, while it is difficult to predict what the payments would be if it chooses to refinance, the figure would be undoubtedly higher. A significant increase in the cost of borrowing could force the sustainability of the trust’s dividend payments to be called into question as it would decrease the trust’s free cash flow. Fears surrounding these eventualities are undoubtedly one of the reasons that the trust is trading at such a large discount. While the debt helped the trust establish itself as a key player in the sector, it is now causing serious headaches for its management team.
Some of the investment trusts that are trading on the largest discounts are those that operate in the private equity market. These trusts are popular as they provide retail investors with access to markets that have traditionally only been accessible to large institutional investors or those with a high net worth. HarbourVest Global Private Equity (HVPE), a sort of private equity fund of funds, is trading at a discount of over 44% at the time of publication. One of the main reasons for this is that private equity assets are notoriously difficult to value. They do not have the same reporting requirements as publicly traded companies and as such it is only really possible to get accurate valuations when companies fund raise or the holdings are traded on secondary markets. As a result of this, these valuations are often outdated. As the investment trust is exchange traded, investors often try to price in these future write-downs, which is very difficult.
Uncertainties regarding valuations can cause discounts to widen, which appears to be the case here. This can create buying opportunities for investors who know where to look but, as ever, there are many other factors that bear considering. For example, while private equity provided excellent returns in the lead-up to the pandemic, it is currently unclear how much of this was dependent on cheap debt and low interest rates.
What these two cases highlight is that while discounts can be enticing, the overall picture is often more complicated. They can offer excellent buying opportunities and provide investors with the opportunity to gain access to quality assets at cheap prices. However, in certain circumstances, it is possible for the discount to tighten as the NAV of the trust moves down towards the share price. It is therefore important that investors have a solid understanding of what is going on under the hood of any trust they are invested in.
From interest rates and debt to valuations and investor confidence, there are a variety of reasons that investment companies can trade at a discount. Those who bought investment trusts at big discounts in 2008 will have made excellent returns, but trying to catch a falling knife is often a dangerous game.
Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.