When it is worth paying a premium for an investment trust

Jennifer Hill details scenarios when investors should not be put off buying an investment trust at a premium.

Positive news on Covid-19 vaccines led to investment trusts re-rating considerably during 2020. The average discount among equity investment trusts narrowed from 4.6% to 2.5% – the tightest level on record – according to Numis Securities.

Discounts widened slightly to 5% during January but remain significantly narrower than a 10-year average of 7.8%.

Looking across asset classes, a growing number of investment trusts – 108 of the 463 UK-listed trusts on Morningstar’s database – are trading at a premium. Five years ago, that was the case for 87 out of 383 trusts.

“Although there are more trusts at a premium today, it isn’t that different in percentage terms,” says Canaccord Genuity investment analyst Kamal Warraich. “The key difference is that the sectors trading at premiums have changed over time and the level of the premiums are higher in some areas.”

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Many recent investment trust launches have focused on alternative assets and the provision of a strong and reliable income stream. Their popularity among hard-pressed income-seekers means they have consistently traded at premiums.

Most of the 39 trusts that have traded at an average premium of 5% or more over the past year have specialist or alternative mandates.

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How much is too much?

Paying more for something than it is technically worth is not a great investment strategy. Equally, just because something is trading at a discount does not make it a bargain.

When it comes to premiums, how much is too much? The answer is subjective. “You really have to look sector by sector and consider each trust in the context of history,” says David Liddell, a director of IpsoFacto Investor. For equity investment trusts, he would be wary of a premium of more than 3%.

William Heathcoat Amory, a founding partner of Kepler Partners, agrees. “A premium of up to 3% is acceptable, but anything over that is getting dangerous. A 5% premium seems excessive for a listed equity strategy.

“For unlisted or alternative assets, it’s a bit more nuanced and could be more to do with the way the net asset value (NAV) is calculated.”

In broad terms, trusts trade at premiums because there is excess demand for the shares – more buyers than sellers. While this should help to continue to support the share price, many investment trusts have discount control mechanisms which sees them issue shares to limit premiums or buy them back to narrow discounts.

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Premiums and discounts are susceptible to shifts in investor sentiment, too. Property trusts are a good example. Shares in GCP Student Living (LSE:DIGS) have swung from a premium of almost 23% to a discount of more than 44% over the past year after the coronavirus pandemic decimated demand for student accommodation.

“Sentiment can be fickle,” says James Carthew, head of research at QuotedData. “When fashion changes and premiums fall, share price returns can look quite poor and this can trigger more selling. There’s a danger of heightened volatility.”

John Newlands, founder of Newlands Fund Research, says this is particularly true of “sectors of the moment, such as mining or commodities funds, where a premium can plunge to a wide discount in the blink of an eye”.

Trusts that invest in less liquid areas, such as property, private equity and infrastructure, revalue their investments infrequently, and shares trading at a premium or discount can reflect optimism or pessimism about the most recent valuation.

“Many of them adopt a conservative approach to valuation, as evidenced by managers being able to consistently sell investments at a significant premium to their last valuation,” says Carthew.

A rising premium can indicate that investors are anticipating an uplift in the net asset value (NAV), whereas a widening discount can reflect uncertainty over valuations due to a change in the investment environment. The outlook for certain property trusts has deteriorated significantly against the backdrop of social distancing and working-from-home trends.

Hunt for income

Some trusts trade at premiums because investors are primarily attracted to the yield and are prepared to pay up for this, such as the case with infrastructure and healthcare property trusts.

The general infrastructure sector has an average yield of 4.8% (as at 1 February, the date used for all other premium figures) and is trading at an average premium of 15.2%, higher than a 12-month average of 13.3%. The renewable energy sector yields 3.7% and is trading at an average premium of 11% versus a 12-month average of 9.7%.

Target Healthcare (LSE:THRL) and Impact Healthcare (LSE:IHR), which own and operate care homes, yield 5.8% and 5.5% respectively, and are trading at premiums of 8.4% and 7%.

As the population ages and nations take steps to become carbon neutral, demand for these areas should continue to climb and strengthen the reliability of underlying revenues. They also benefit from inflation linkage and government backing (for infrastructure).

When assessing value, Peel Hunt suggests considering the ‘risk-adjusted yield’ – the margin of yield over near risk-free gilts. Benchmark 10-year gilts yield 0.3%, giving listed infrastructure trusts an ‘attractive spread’ of around four percentage points despite them typically trading at double-digit premiums, says Anthony Leatham, its head of investment companies research.

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Ewan Lovett-Turner, head of investment companies research at Numis, likes Bluefield Solar (LSE:BSIF) and its 5.9% yield despite its 20% premium.

Music royalties is a relatively new area but one that is capturing investor interest thanks to the rise of streaming and income generated. “Not for the first time, the investment trust industry seems to be ahead of the game, having the perfect structure to hold these investments for the long term,” says Heathcoat Amory at Kepler.

He highlights Hipgnosis Songs (LSE:SONG) fund, which yields 4.3% and is trading at a 1.4% premium. “The NAV doesn’t account for the value of having assembled the portfolio. The manager has also highlighted that the valuer is likely to reduce the discount rate applied,” he adds.

In the traditional equity income sector, Chris Salih, an investment trust research analyst at FundCalibre, rates City of London (LSE:CTY), which is trading at a small premium. “At a time when dividends are scarce, income investors might be willing to pay a bit more for its 54 years of consecutive dividend increases,” he says.

Growth trajectories

Private equity share prices can chalk up a meaningful premium to the published NAV, particularly where the underlying companies are relatively early stage or maturing and benefit from high growth trajectories.

“Where a listed investment company portfolio includes private equity, it is important to remember that historic valuations used to calculate the NAV will often not fully reflect – if at all – anticipated growth or capital markets activity, such as an upcoming IPO that is expected to result in a meaningful uplift to the investment’s carrying value,” says Leatham.

Notable examples include Augmentum Fintech (LSE:AUGM) and Chrysalis Investments (LSE:MERI), which trade at premiums to published NAVs of 14% and 22%, respectively.

“It’s important to consider a sum-of-the-parts analysis alongside the top-down considerations of the fund and strategy as a whole,” adds Leatham. “In both cases, we believe there are plenty of reasons to be optimistic on the future pathway for the NAV, which would justify the premium rating placed on the shares by the market.”

While property trusts focused on offices and student accommodation have fallen firmly out of favour, the opposite is true of those that invest in warehouses. Hopes that future moves in NAV will more than justify the share price are behind rising premiums at Warehouse REIT (LSE:WHR) (6.1%), Aberdeen Standard European Logistics Income (LSE:ASLI) (12.7%) and Tritax Big Box (LSE:BBOX) (25.2%).

“There is evidence that values of warehouses are climbing and development activity at Tritax is also driving NAV uplifts,” says Carthew.

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Within equity markets, Canaccord Genuity rates the growth potential of global smaller companies. Its ‘buys’ in the sector, Edinburgh Worldwide (LSE:EWI) and Smithson (LSE:SSON), are trading on small premiums.

Lastly, while not aiming to shoot the lights out, Newlands believes it is worth paying a modest premium for “trusty nuggets” that have strong track records and stable management and aim for an element of capital preservation. Capital Gearing (LSE:CGT) and Personal Assets (LSE:PNL) fit the bill for him despite trading on small premiums. Both Capital Gearing and Personal Assets proactively adopt discount/premium control policies.