By Simon Elliott, client director at JP Morgan Asset Management
The investment companies sector is enduring another tough year. For the second year running, IPOs have proven virtually non-existent, while the sector average discount has widened to levels last seen in the aftermath of the global financial crisis. What a difference a few years can make. Cast your mind back to 2020, when the sector was one of the best performers in the UK market, with strong returns against a backdrop of a buoyant issuance market. This begs the question: are those days firmly behind us or are there reasons to be cheerful?
There is a case that we have been here before. As Mark Twain is reputed to have observed, history doesn’t repeat itself but it often rhymes. In the sector’s 155-year history there have been periods of growth and times of contraction and we are in certainly in the latter camp at present. There are currently nearly 200 investment companies that are trading on discounts of 10% or more, with almost 100 on discounts of 20% or more.
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One possible explanation for this is that the market is not fully convinced by current valuations, or net asset values, particularly for those trusts that cannot regularly mark-to-market their investments. The market may have a point and there have been several recent examples of investment companies making disposals at significant discounts to carrying values across asset classes.
My view is that current discount levels reflect both investor caution against a backdrop of market uncertainty and the impact of rising interest rates. However, both factors, in my opinion, offer investors an attractive opportunity. In the case of the former, investment trusts have always suited contrarian investors prepared to take a view on an out-of-favour, conventional asset class that is invariably trading on a wide discount. UK small-cap trusts are a live example of this, with an average discount of 12% according to the AIC, while other subsectors on wide discounts include global smaller companies (15%) and Asia Pacific (10%).
As and when these asset classes come back into favour, the double whammy impact of narrowing discounts and NAV appreciation, invariably assisted by modest gearing, has the potential to be a formidable combination. To use a very simple example, an investment trust that sees its NAV increase by 15% at the same time as its discount narrows from a 15% to a 5% discount will generate a share price return of 29%, offering a significant kicker to performance. This approach is well-trodden ground for a number of professional, value-orientated investors and a real source of long-term alpha.
The de-rating of investment companies investing in alternative asset classes is a more involved story. The unprecedented rise in interest rates since 2021 – in terms of speed – has had a dramatic effect on the entire investment industry. Investment companies generating yields from alternative assets had previously benefited from the demand for bond proxies. However, with the repricing of bonds, these vehicles arguably no longer offer the same attraction regardless of the merits of their respective asset class. In my opinion, this offers a considerable opportunity for investors willing to do their homework. We have already seen bids come for whole portfolios at significant premiums to share prices, while a wave of managed wind-downs has also been announced.
After 155 years, predictions of the sector’s imminent demise are arguably overstated. That said, there is a cyclical element to the sector’s fortunes that of course reflect the realities of the day. Looking three years down the track, I believe the investment companies sector will look markedly different. Assuming more benign market conditions, I suspect discounts will be narrower in aggregate as a function of the consolidation and retrenchment process that has already started.
A number of managed wind-downs will take some years to complete, and many will still be with us in three years’ time. However, there will be fewer investment companies overall, particularly in sectors where there is an oversupply. By extension, I would expect to see far fewer funds providing access to more specialist sectors and a reduction in the number of investment companies with assets of £200 million or less.
Investment trusts continue to have an important role to play in the retirement provision of UK investors. And despite the challenges the sector currently faces, there remains a huge opportunity for well-informed investors to take advantage of attractive valuation levels.
