Geared up for better long-term performance
Saturday 04 April 1998
"Gearing", which is simply a technical term for borrowing, is one way of enhancing the performance of the underlying assets of a trust. The funds can take out loans to buy more assets in the expectation that these will rise in value.
The loan has to be repaid at a later date but the more total assets rise in value the greater the proportional benefit to shareholders, because the value of the loan remains fixed. Effective gearing relies on the expertise of the manager. In rising markets, it enhances shareholders' returns but in falling markets it has a correspondingly negative effect. Good underlying performance is the most important factor in driving up the price of a trust's shares, so investors benefit from successful gearing.
Investment trust shares are valued in the stock market according to supply and demand. Most trade at a price that is lower than the underlying net asset value per share (NAV). This is called "trading at a discount".
The discount is the difference between the NAV of the assets held in the trust and its share price, calculated as a percentage of the NAV. For example, if the share price is 90p and the NAV is 100p, the discount is 10 per cent. If the share price rises above the NAV, it is trading at a premium. This is rare but it can occur when there is particularly high demand for the shares of a trust.
The investment trust industry's average discount currently stands at around 12 per cent. But in the 1970s, discounts of well over 30 per cent were common. They narrowed significantly after the late 1980s, when the tax regime became more favourable and low-cost investment trust savings schemes and PEPs were launched. As a result, demand for the shares increased.
The narrowing of discounts to single figures in the early 1990s, however, encouraged new launches. This inevitably led to over-supply. Investment trust companies have a fixed number of shares in issue which they cannot readily reduce or increase in the way unit trusts can. When supply outstrips demand, discounts widen.
Investment trusts have no control over the discount but their boards of directors have a duty to shareholders to address poor performance, and they can do this in a number of ways. Savings schemes and PEPs, for example, have encouraged demand and enable investors to buy investment trust shares on a regular monthly basis or with an occasional lump sum at favourable rates.
Investment trusts can buy back some of their shares to reduce supply, although their ability to do this is limited. The Association of Investment Trust Companies is exploring ways of making buy-backs easier for investment trusts.
If asset performance is poor, the board may change the manager. If share price performance is poor, the board could wind up the company to enable shareholders to realise their investment nearer to the NAV. Alternatively, they could unitise, changing to a unit trust; restructure, possibly into a split capital trust; or maybe change the investment policy.
Action may be forced on a board. An investment trust on a wide discount, with an attractive portfolio of investments, may find itself the subject of a takeover bid. While a takeovers may enable shareholders to realise investment at a value close to the NAV, the costs of the liquidation will reduce their return. So shareholders must weigh up the pros and cons of a possible quick profit today compared with the potentially greater, but longer-term, benefits of continuing to hold the investment.
Such corporate activity does not signify that the investment trust industry is coming to an end, as some critics have predicted. It's just the market's way of restoring balance when supply and demand are out of line.
So are discounts automatically a bad thing, as is often assumed? If you can buy a good quality product for lower than the retail price, you don't hesitate, and the same principle applies to investment trusts. If the investment trust has good underlying asset performance, it meets your investment criteria and is trading at a discount, consider it a buying opportunity.
Over the long-term, the discount pales into little significance where performance is concerned. And, historically, investment trusts have delivered excellent performance.
- Annabel Brodie Smith
Free information on investment trusts, including a factsheet on Investment Trust Discounts, is available from the AITC on 0171-531 5222.
n Annabel Brodie Smith works for the Association of Investment Trust Companies.
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