How to work out if an investment trust at a discount is really a bargain: THE INVESTING ANALYST

Many investment trusts trade a discount. This means that canny investors can buy into the basket of investments at less than the cost of the assets themselves.

A discount could be a sign of that the market has missed a trick and negative sentiment means it is undervaluing an opportunity, but it could be a warning sign for those investments, or a sign of deeper issues at the heart of a trust.

So how do you work out what's a bargain and what's a red flag? In this column, at Thomas McMahon, investment trust research analyst at Kepler Partners, explains how investors can establish whether a discount is a buying opportunity.

Unfortunately, you can't put an investment trust between your teeth and bite down on it, which is how the cartoons of my childhood suggested you could test the value of something purporting to be money. So investors need to find a different strategy for assessing the attractiveness of a discount.

In this context, a discount means the difference between the value of the assets an investment trust owns (the portfolio, measured as NAV per share) and the share price.

Trusts often trade on discounts, meaning that 100p of assets can be bought for 98p, or 90p, or even less.

One of the major attractions of the investment trust sector is the opportunity to take advantage of these situations, but this can only be done if there is scope for getting that 100p, or something close to it, back.

Wide discounts are common – although they have been narrowing this year – but investors need to judge whether they signal opportunity or a value trap.

Investment trusts are what is known as closed-ended funds, listed on the stock market with a limited number of shares.

One of the key, and often underestimated, advantages of closed-ended funds is that managers have a fixed pool of capital.

This is different to open-ended funds, which face daily redemptions and must hold cash or sell investments to meet them. Similarly, open-ended funds must invest any fresh inflows. Some 'cash drag' is inevitable, and this hampers returns in a rising market – it's another factor an active manager needs to overcome to add alpha (the return they deliver above the market), on top of fees.

Closed-ended funds avoid this, but when sentiment weakens, selling drives discounts.

There are two key points here: first that discounts are a natural consequence of the structure, and not always indicative of a problem with the trust or the manager, and second that sentiment towards an asset class, style of investment or simply to investing at all is often the reason for a discount moving.

Given these are all usually cyclical, this is where the opportunity lies: being brave while others are fearful, and taking advantage of poor sentiment to buy something on the cheap.

But persistent wide discounts can also indicate deeper issues, such as corporate governance. When a manager has a large shareholding, implying a high degree of influence over the board, a wide discount may be the market's way of demanding a price cut to compensate for lack of control over the strategy.

Pershing Square Holdings, for example, trades at a stubborn 20–30 per cent discount, despite strong performance, likely reflecting concerns over complicated governance. Manager and hedge fund star Bill Ackman has a major personal shareholding of over 20 per cent.

Also, for opaque reasons there is a controlling shareholder with 50.1 per cent of the votes, with limited information in the annual report.

It seems likely that the discount reflects the complicated corporate governance, and so perhaps it is unlikely to narrow anytime soon.

Some of today's widest investment trust discounts involve doubt over valuations.

For trusts investing in private equity or real assets like property or infrastructure, investment values are estimated – albeit using widely accepted methodologies – and discounts may mean the market simply disagrees with these estimates, as they are less transparent than public market valuations.

This partially explains the dramatic widening out of discounts on private equity trusts in 2022 and 2023. When public markets fell as rates soared, some investors thought private equity trusts should have marked down their holdings more.

But global public equity markets are now around 40 per cent higher than they were entering 2022, and the NAVs of private equity trusts aren't (with one exception).

Private equity discounts now look particularly interesting. Despite suspicions about portfolio values, most trusts do indeed use listed company comparables in their valuation methodologies, so valuations should have adjusted, even if slowly, for major changes in the public markets.

And importantly, trusts have to sell their investments to realise the value and ultimately prove the NAV is justified.

While realisations have been relatively slow in the past few years, there are some positive signs of the market picking up.

CT Private Equity reported a decent number of realisations in its interim results a few weeks ago, and good returns from most of these investments, while it flagged that it expected an acceleration of activity later this year as the uncertainty around tariff policy subsided. It trades on a discount of almost 30 per cent.

One thing to watch is the gearing. It is relatively conservative at the moment, at just 17 per cent, but if realisations don't pick up the figure will have to rise, as the trust has commitments to make to existing investments – private equity investments typically involve agreeing to commit tranches of capital at different times to foster a company's growth.

Nevertheless, with commitments of £177m compared to realisations of £100m over 2024, the situation doesn't seem alarming, and the board and manager is confident enough to commit to a significant dividend payout of 7p per share, meaning it yields 5.9 per cent.

The discount may reflect some wariness about the gearing and the realisation outlook, and so if realisations pick up in the coming months the discount could well narrow.

However, it also likely reflects in part today's generally poor sentiment to investing, which can be seen in very high demand for cash accounts and for bonds, but this is a cyclical trend which will surely reverse.

It's always worth bearing in mind that there is no free lunch in investing, and there are always risks when trying to take advantage of a discount, but in this case a 30 per cent discount provides significant compensation.

Some of the widest discounts in the sector involve situations where doubt has been raised about valuations.

In particular, a rushed sale of a portfolio can lead to poor prices being achieved, and this appears to have been the case with Digital 9 Infrastructure, which has sold some assets well below carrying value.

It's sensible for investors to be wary of situations where valuations have been proven wrong. Real asset trusts in wind-up are fraught with such risks. The portfolio value must be considered, and any sniff of a fire sale or a distressed seller can be dangerous.

There are also various other costs of paying back debt and paying fees that have to be deducted from the NAV.

One way to deal with this is to invest in MIGO Opportunities, which is a small trust run by the team at AVI.

AVI specialises in spotting and unlocking value in complicated company structures, including investment trusts. MIGO focusses purely on investment companies and is currently overhauling its strategy to focus exclusively on alternative assets.

The idea is to build a concentrated portfolio of alternative asset companies trading on wide discounts and agitate for the return of value to shareholders.

Investing via an activist investor like AVI means investing in situations where there are professionals on the share register trying to make sure the wind-up process – or whatever corporate action is proposed – is managed well and in the interests of shareholders.

In general, assets are being sold close to market in many alternative sectors which means the problem is largely to do with the investor base. The people who want to own a lot of these assets would rather hold them in something that wasn't an investment trust.

For investors looking to take advantage of this and pick through the situation, MIGO might be a better option than trying to do it yourself.

Compared to alternative assets trusts – where evaluating discount drivers can be complicated – equity trusts benefit from simpler structures, easier-to-understand assets, and lower gearing, although there are still nuances to consider.

Some of the widest discounts amongst equity trusts are those with some unlisted equity in their portfolios, which may reflect wariness about valuations.

The concentration of a portfolio is another factor that has to be borne in mind, particularly if the largest positions are in less liquid small caps.

The very widest discounts are on those that lack those features, such as Syncona (SYNC), for example, trades on a discount of 45 per cent and recently announced plans to wind up its portfolio.

This process, which involves selling private, early-stage biotech companies, is expected to take years.

The discount has also been exacerbated by uncertainty surrounding the idea of some investors rolling over into a new, unlisted fund, which would continue to own some of SYNC's existing assets.

An additional complication is the highly concentrated nature of the portfolio, with 17 per cent in Spur, a gene therapy company whose products have produced good data but not yet completed the formal trial process.

Baker Steel Resources also has a highly concentrated portfolio, with 54 per cent of it in two companies. These are listed mining companies, but small caps, so with limited liquidity.

Performance has been unimpressive over the long run, but over the past 12 months, the NAV is up 37 per cent and the share price 26 per cent (both in total return terms). Yet it still trades on a discount of 39 per cent.

Exposure to coal and cement will put it outside of some investors' remit due to ESG concerns, and it is likely to be sensitive to economic growth, which may be one reason for the wide discount, alongside a very concentrated shareholder register which reduces liquidity.

It may be that concerns about liquidity, concentration and gearing explain why Golden Prospect Precious Metals trades on a discount of just under 10 per cent. But the trust has enjoyed an incredible rally of c. 95 per cent in NAV terms, with the discount closing slightly to give shareholders a total return of c.113 per cent.

The outlook for gold and gold miners continues to look attractive, with emerging market central banks buying hand over fist to reduce reliance on the dollar, and inflation and government debt two major risks which are leading professional and retail investors to look for alternatives to bonds and cash. It could be then that this discount narrows further.

The shares have traded at or even above par in past periods when gold was in favour.

Another very clean discount situation seems to be Aberforth Smaller Companies, in the UK smaller companies sector. Aberforth is a value specialist, and the portfolio is made up of UK businesses trading at cheap valuations.

The strategy is to buy out-of-favour companies and profit when good operational performance and changing sentiment sees their valuations revert to fairer levels – just as the typical discount player seeks to operate in the investment trust sector.

The UK is one of the most unloved major markets in the world right now, and this has contributed to the trust trading on a 9 per cent discount. Gearing is modest, at around 4 per cent, and the portfolio well-diversified.

While it is a smaller companies portfolio, there are no liquidity concerns, and certainly no issues with governance. It has all the hallmarks of a cyclical situation. The problem is predicting when and why poor sentiment towards the UK will reverse.

There is plenty of bearish sentiment about the UK economy with no obvious catalyst on the horizon to change this. However, often deeply discounted valuations can themselves spark a reversion to a trend.

A good example of a discount closing rapidly and unexpectedly is Invesco Global Equity Income Trust (IGET). It started its 2025 financial year on a discount of almost 9 per cent and ended it on a small premium. The move happened quickly in February.

The trust went through a restructuring which saw it absorb the assets of two other share classes, and there was a tender offer which saw some investors then exit. A larger trust is arguably a more attractive prospect, but the reason for the discount reversing seems to be a rapid change in sentiment and the market environment.

The trust seems to have been a major beneficiary of the sudden decision by investors in the first quarter of 2025 to rotate their portfolios away from the US.

The trust has always been underweight the US thanks to its value-sensitive approach, and it seems to have been a key beneficiary of investors looking for a portfolio which was light on the US but had delivered good performance.

A change in the dividend policy must have helped, with the yield jumping from around 2 per cent to around 4 per cent, but the shift in the discount happened well after this had been brought into effect.

In this instance, an investor who had bought into IGET at the start of the year when it was trading on a discount of 9 per cent would have made a total shareholder return of 25 per cent to date, compared to NAV returns of just 11 per cent.

This demonstrates how closing discounts can help deliver excellent returns for investors willing to pick through them to find those that represent an opportunity.