By Simon Elliott, client director, JP Morgan Asset Management
While not a day passes in the investment trust sector without share buybacks, there are those who still question their usefulness.
Superficially, the doubters would seem to have a point. Despite £3.9bn being returned to shareholders through buybacks in 2023, according to data from Winterflood Securities, discounts have widened to record levels over the past 18 months on the back of rising interest rates and market volatility.
This represented a 44% year-on-year increase from the record set in 2022 (£2.7bn) and marked the highest annual level since buybacks became tax efficient in the late 1990s.
However, while it can be argued that buybacks have failed to stem de-ratings, many would suggest that this is simply reflective of market conditions. The advantages of buyback programmes are numerous and include limiting discount volatility, ie holding discounts around a prescribed level; being NAV accretive; improving liquidity in the secondary market and narrowing spreads; protecting the quality of the shareholder register; and meeting the wishes of shareholders.
Managing discount volatility
It is perhaps an obvious error to assume that buybacks, alone, can be effective in ‘marching in’ discount levels.
There is no evidence that this is the case, however, there is data to suggest that an active programme can ensure that discounts remain around a prescribed level, such as a discount target, either publicly stated or effectively adopted. This is important to investors in investment companies, as it can provide a safety net and limit the downside risk from discount volatility.
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To illustrate this in numbers, an investment trust that saw its NAV fall by 20% and its rating widen from par to a 10% discount would deliver a share price decline of 28%. Not great, but better than a 36% decline if that de-rating was to a 20% discount.
Driving value for existing shareholders
Buybacks can be beneficial for existing shareholders too. When a company buys its shares at a discount to NAV, it increases the value of the remaining shares that other shareholders own.
For instance, if a company buys back 5% of its share capital at an average discount of 10%, this generates an uplift of 0.5% to NAV – so the underlying value of the trust increases. If the discount is even bigger, say 20%, the boost to each remaining share is even greater, around 1.1%.
Discerning whether this is the most appropriate use of shareholders’ capital really comes down to the levels of returns you could make from investing it rather than buying back.
Improving liquidity
The ability of buybacks to improve liquidity in the secondary market and lead to tighter spreads was explored in a research paper produced last year by Numis. They looked at investment companies invested in equities and showed that, typically, the spreads – such as the difference between the bid and offer prices – were narrower for those pursuing buybacks than those that do not.
Managing the shareholder register
Using buybacks to ensure that discount levels do not widen to levels that might attract activist investors has become more topical. A cynic might observe that buyback activity across the sector in 2023 seemed to step up as the year went on when it became clear that activists, were being attracted by wide discounts. Certainly, boards appreciate the quality of their shareholder registers and seek to look after the interests of long-term holders.
Considering all investor concerns
Despite numerous advantages there are some boards and indeed, long-term investors, who remain uncomfortable with the principle of buybacks. At a time when there is an increasing focus on the size and cost base of investment trusts, shrinking through buybacks may appear counter-intuitive.
In addition, there are those that would argue that pursuing a buyback programme obscures the real issue, ie why is the investment trust trading on a discount in the first place? Does the mandate and strategy remain relevant? Other voices argue that returning capital to shareholders via buybacks negates one of the key advantages of the investment trust structure, ie that it provides a captive pool of capital in a listed closed-ended fund.
My view is that while there is some validity to a number of these points, the overwhelming majority of shareholders welcome buyback activity, particularly if that means providing a floor under the level of discount.
While discount volatility provides value-orientated investors with investment opportunities, it is to the detriment of long-term shareholders. In contrast, investment companies that take measures to address this risk are inherently more attractive prospects to potential investors.
Given the cyclical nature of the investment trust sector, I believe it makes sense for those trusts – that have the means at their disposal – to use buybacks to provide their shareholders with some respite from discount volatility.
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