Special Report on Investment Trusts: Vintage year puts focus on value: The narrowing of discounts has been vital to the sector's success. Paul Durman looks at the implications

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The Independent Online
BY ANY standards, investment trusts had a remarkable year in 1993.

The value of the assets owned by investment trusts grew by an average of more than 34 per cent, while the average share price in the sector rose by 43.6 per cent. They outperformed every other sector of the stock market - not bad for an investment vehicle that was supposedly dying on its feet a few years ago.

New investment trusts are finding it almost embarrassingly easy to raise money from institutions and private investors. Last month Mercury Asset Management pulled in pounds 426m for its World Mining Trust, making it the biggest ever launch. The record is already under threat: Kleinwort Benson has raised pounds 320m for its European privatisation investment trust and may near pounds 500m by the time the public offer closes on Wednesday.

One of the most important contributors to this success has been the narrowing of the discounts at which investment trust shares traditionally trade to the value of their underlying net assets. According to the Association of Investment Trust Companies, the average discount in the sector was down to under 5 per cent by the end of 1993, having fallen sharply from 12.7 per cent one year earlier.

In theory, it is always better to buy an investment trust at a discount - to pay, for example, 90p for every pounds 1 of assets. Conversely, investors should always be wary of having to buy at a premium, when they must pay (say) 105p for each pounds 1 of assets. When discounts fall, investors receive a share price benefit on top of that which they receive from the growth in the underlying assets of the trust. (Of course, one needs to find a good fund manager that can deliver the capital growth in the first place.)

Discounts have narrowed steadily from about 30 per cent at the start of the 1980s. For the last 10 years, this process has been supported by the rising tide of money coming in every month from investment trust savings plans.

More recently, low interest rates have prompted renewed enthusiasm for the sector from institutional investors - hence the huge amounts being raised by Mercury, Kleinwort Benson and others.

The narrowing of discounts has made finding good value investments that much harder. Even the grand-daddy of the sector, Foreign & Colonial Investment Trust, has edged to a share price premium. F & C's size, international spread and impeccable track record have long made it the obvious starting point for new investment trust investors.

Mark Fiander, manager of the investment trust selection service at Capel-Cure Myers, believes this status may be under threat. 'We're having to say that (investors) have got to bide their time - that now may not be the time to go into Foreign & Colonial, which was previously the banker.'

The extent to which discounts have narrowed can be overstated by the sectoral average. The trust sector has become increasingly fragmented as fund managers have wooed the institutions with specialist investments that they could not make themselves.

Many of the sharpest falls in discounts have been experienced by the venture capital trusts, as they have recovered from the problems they suffered during the recession. The enormous enthusiasm for emerging markets has seen trusts investing in these areas move to premia. But many of the trusts popular with private investors, the generalists with a UK bias, remain at respectable discounts.

Colin McLean, the fund manager of Scottish Value Trust, which invests its money in trusts it believes to be under-valued, points out that published net asset values often understate the true position, making discounts appear smaller than they are. Professional investors are able to unlock this hidden value by careful analysis of the trusts' underlying portfolios.

Investors can also benefit by choosing trusts managed by fund managers that are not well-known, or out of favour for one reason or another. Jupiter Tyndall and Ivory & Sime are two examples. Ivory's Selective Assets is trading at a discount of about 15 per cent, about twice that of comparable trusts. Since Selective Assets has a creditable recent performance record, its discount might be expected to narrow relatively quickly as market sentiment towards it improves.

Mr Fiander suggested that private investors looking for an international general trust should consider Scottish Mortgage, managed by Baillie Gifford and trading at a discount of about 7 per cent. Investors looking for a trust more heavily invested in the UK might choose Edinburgh Investment Trust, also on a 7 per cent discount.

Scottish Mortgage was also mentioned by Edwin Lilley, in charge of the investment trust management service at Bell Lawrie White, and by Richard Green, investment analyst at the rival stockbroking firm of Allied Provincial. Mr Lilley also likes Monks, Baring Tribune and Anglo & Overseas: 'The discounts look reasonable and they're all doing a very good job for their shareholders.' Mr Green favours Govett Strategic and Witan.

Many professionals expect to see further modest falls in discounts this year, as low interest rates continue to push more money into the stock market. But it is dangerous to assume that this can carry on indefinitely.

For one thing, said John Szymanowski, investment trust analyst at SG Warburg Securities, 'trusts constantly running at premia have an incorrigible urge to issue more shares', thus easing upwards pressure on their share price. Fundamentally, the discount is the by-product of the interplay between the demand for and supply of investment trust shares. It would be wrong to conclude that with discounts generally small, demand and supply have reached some long-term stable equilibrium.

Mr Green says that institutions are now expanding the market, with a flood of new issues coming forward. But a rise in interest rates would dramatically alter the focus of institutional investment; a stock market crash would deter many private investor. Any loss of interest in investment trusts could easily see discounts widen once more.