How to spot cheap, out-of-favour trusts

frog-with-crown

It is party time for much of the investment trust sector. Sales are up, performance is good and trusts are now readily available on most of the mainstream investment platforms.

But amid the jollity, there are a few trusts sitting in the corner with no one asking them to dance. However, these wallflowers may yet hold some riches for the right investor.

The beauty of an unloved trust is that an investor can enjoy the investment nirvana of the trust's narrowing share price discount relative to its net asset value (NAV) plus a rise in the price of the underlying assets.

11 unloved trusts worth a closer look

FINE LINE

For example, over the past three months to late March, investors in the JPMorgan Emerging Markets Income investment trust saw not only a 5 per cent recovery in the NAV but also a near 7 per cent narrowing of the discount, giving them a 12 per cent return.

Admittedly, this was from very depressed levels, but it shows how an unloved trust can suddenly look rather more attractive.

However, the line between an unloved trust and a bad trust may be a fine one. Managers can change, lose their spark, attract too much extra capital from new investors or be put under unwelcome constraints by the board, all of which can permanently dent shareholder returns.

It can be difficult to differentiate between a trust subject to that type of change and one that is poised for a return to the limelight.

Read our latest investment trust bargain hunter article

With that in mind, no single indicator can reveal a trust likely to do well; but taken in combination, various factors will help investors build a picture. Perhaps the first place to start is the discount.

A discount doesn't tell an investor much in itself. A trust's shares may be trading at a 10 per cent discount to NAV, which may look like a bargain - but it could quite easily remain at that level and investors could never see the chunky double-digit profits they are after.

David Liddell, director at investment trust advisory firm IpsoFacto Investor, says: 'A trust could be trading at a discount because it's had rotten performance, or because it's out of fashion, but it is important to understand why it is cheap and out of fashion.

Is it because its sector is performing badly, or does it take a contrarian approach, at a time when it has been tough for value-oriented investors generally? Or has the fund manager simply made the wrong call?'

Investors need to assess how the discount looks relative to historic averages, and whether it will change. Many of the investment platforms now show historic premium/discount information for investment trusts.

Hargreaves Lansdown, for example, has premium/discount data going back five years and provides a 12-month rolling average.

Morningstar, Financial Express and Citywire also hold this data. Our own data pages in this magazine include current discount/premium data, plus the high and low over one year and any percentage point change over the previous quarter.

'Z SCORE'

A second option is to look at the 'z-score' of a trust, again featured on many web-based platforms. This is another way to compare a trust's current discount or premium to its historic level.

A positive z-score shows the current value is higher than the mean, while a negative value indicates the opposite.

This has some advantages in that it can also help even out differences between sectors.

For example, the share prices of UK equity income trusts have historically traded at or near NAV, while smaller companies or emerging market trusts may trade at an average 10 per cent discount. The z-score evens this out.

Both discounts and z-scores may not trade in line with historic norms for various reasons, and these must be taken into consideration too. For example, a board may introduce a share buyback or other discount management policy.

It is also worth looking at whether a trust's style is out of favour. Good managers don't suddenly become bad, but they can have periods of poor performance, which are often the best time to buy.

In deciding whether a manager is just having a bad patch or whether there are broader problems at work, it is worth comparing the manager to peers with a similar style, or to other trusts specialising in, for example, resources or financials.

It is also worth looking at whether something might have changed for the manager: are they running a lot of assets? Have they lost key team members? Has there been a change of senior management at the company itself?

WHAT THE EXPERTS SUGGEST

With this in mind, Stephen Peters, analyst at stockbroker Charles Stanley, says any trust with a 'value' tilt has been out of favour in the past two to three years.

This would include any trust that looks to invest in companies that have become unfashionable, believing that ultimately prices will revert to the mean.

In a climate of sparse economic growth, investors have preferred greater predictability: companies with 'safe' earnings and dividends. Equally, value-oriented investors have often been fishing in areas such as commodities, which have fallen and continued to fall.

This has spelt bad news for a number of previously popular managers. Alistair Mundy, for example, at the Temple Bar investment trust has had a very difficult run.

The trusts run by Edinburgh Partners, EP Global Opportunities and the European Investment Trust, have also been very out of favour.

Peters also believes there may be value in areas of emerging markets. He says: 'Emerging market income funds have done really badly in the past three years.

'It is also notable that Templeton Emerging Markets has started to pick up after a very weak run. The weaker dollar might be very good for more cyclical sectors.'

He suggests JPMorgan Global Emerging Markets Income might be a good trust with which to target a reversal in emerging market fortunes.

He suggests that Asia could be the source of some out-of-favour ideas. He adds: 'There are some good names in the sector, such as Schroders and Aberdeen. The Fidelity Asian Values trust run by Nitin Bajaj could also be one to watch.'

INCOME-GENERATIVE TRUSTS

Within income-generative trusts there have been precious few bargains, as investors have rapaciously sought out income.

However, Peters points out that the average discount to NAV for the UK equity income sector has moved to around 3 per cent, which is wide compared to recent history.

Simon Moore, head of research and senior analyst at Bestinvest, looks at some former investment trust 'darlings'.

'Artemis Alpha, for example, helped seed the wider Artemis fund management business,' he says, 'but people have moved on and now it's just sitting there, completely unloved, but still run by John Dodd.'

He also recommends looking at sectors that have been out of favour. Financials, for example, have spent a long time in the investment doghouse in the wake of the financial crisis.

Some of the specialist financials trusts, therefore, now appear to be on relatively attractive valuations. He suggests looking at Blue Planet, an investment trust slanted to global financial securities, which has an admittedly chequered track record dating back to 1999.

Liddell agrees, suggesting investors delve around in some unloved sectors - notably in financials and commodities.

He likes Polar Capital Global Financials trust, which is on a 12 per cent discount and is currently paying an income of around 3.5 per cent.

'If you believe the global economy is on a slow path to normality, this is the sector to back.' He believes that a real contrarian might look at the resources sector, but warns that this remains a difficult area.

POOR MARKETING

It is controversial to suggest it, but some trusts may be bargains simply because they have historically been relatively poor at marketing themselves. Moore puts International Biotechnology, managed by SV Life Sciences, into this category.

He says: 'Rival Orbimed [which manages two healthcare and biotechnology trusts] tends to get all the press coverage and its trusts have seen a narrowing discount, but this is a good trust.'

Herald, the small technology company specialist, has seen similar problems. It has been managed by Katie Potts since 1994, long before dotcoms hit the scene.

Moore says: 'The trust invests in a lot of UK-based software companies, which are often bought out by the big technology giants, but the discount is huge.'

However, he admits that the problem with this type of trust is that the value may not be recognised in the short term and any change may require a catalyst. Recently the board agreed a wider remit to invest in small, US-based companies.

Gavin Haynes, managing director of Whitechurch Securities, highlights BlackRock World Mining, but admits it would be a brave choice: 'The outlook for the mining and commodities sector remains relatively opaque, but we have seen a sharp bounce-back from low levels in the last couple of weeks.

'Commodity prices are stabilising at their current level. BlackRock is a major player in this area and this trust provides exposure to the larger mining companies. It is high risk, but it may yet come good.'

SMALLER COMPANIES

He also highlights Aberforth Smaller Companies. One of the sector stalwarts, the trust has been run by the specialist smaller companies group since 1990.

It is the largest trust in the sector and has had a difficult run of performance. Again, its value tilt has not suited market conditions, but the long-term performance remains very good, ahead of its sector and index.

The shares currently trade at a discount of around 14 per cent to NAV, against a 12-month average of 10 per cent, and the discount is significantly above its average over the past three years.

Haynes says: 'Over the longer term, value investing in smaller companies has proved to be a successful strategy, but there has been a long-run bounce in favour of growth-oriented trusts.'

In common with Peters, Liddell likes Temple Bar, pointing to the chunky dividend yield: 'Investors can put up with a bit of pain, if they are being paid a yield of 4-5 per cent to wait for the capital performance to turn around.'

He also highlights Bruce Stout's Murray International trust. He adds: 'To some extent, Stout and Mundy have both made a similar call: they are both worried about the effects of quantitative easing.

'Stout sought to invest away from those countries that were affected and they turned out to be the best performers.'

Stout's performance has been dented by being overweight in emerging markets, but Liddell believes that investors need to look to their strong longer-term records.

Liddell also likes Lowland, managed by James Henderson. He says: 'He's mixed large and smaller companies very successfully, and I like the way his portfolio is positioned at the moment with some reasonable industrial exposure. The trust is on a discount that is wider than its historic average.'

He reckons that it is a good time to be buying all investment trusts. The recent volatility has seen discounts widen out, notably in some of the income-oriented trusts that were previously looking very expensive. It may be that amid the recovery, there are a few wallflowers about to bloom.


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