A buy signal for investment companies?

For financial advisers looking for affordable Christmas presents for their clients – or a suitable New Year pep-me-up – the investment companies sector is looking more attractive than ever. Data published recently by AJ Bell lays bare some of the potential bargains in the sector – the stockbroker’s head of investment analysis describes investment company pricing as “bizarre” and “extreme”, so cheap has it become.

That conclusion reflects AJ Bell’s analysis of “Z scores” in the sector, which offer a guide to the potential value available from investment companies.

For the uninitiated, a Z score is calculated by looking at the discount at which an investment company currently trades relative to the value of its underlying assets, and the extent to which that discount varies from the average discount over the past five years.

Broadly speaking, a Z score between 0 and -1 suggests the investment company’s shares are affordable; with a Z score between -1 and -2, the investment company looks cheap; and any Z score below -2 signals that the fund currently looks much cheaper than usual.

AJ Bell’s analysis focused on investment company sector averages rather than individual funds, but its findings are striking. Of 16 sectors studied, 11 of them have a current Z score of -1 or lower.

At the extreme, the average renewable energy investment company has a Z score of -2.8, AJ Bell reports, with infrastructure having a Z score of -2.0. Investment company sectors including Asia Pacific, Global Equity Income and Flexible Investment all offer attractively low Z scores too, the analysis shows. And just one sector – Japan – has a Z score above zero.

These numbers tell us that many investment company discounts are out of whack with what has been the norm, at least over the past five years. It’s not just that discounts are wide right now, but also that they’re atypically wide. These funds, on average, are far cheaper than anything we’ve seen in the recent past.

Z scores are an invitation to investigate whether funds might be worth considering, rather than the final verdict. In some cases, there will be good reasons why individual investment companies in a sector have slipped to such wide discounts; but in others, it may simply be market sentiment that has pushed them in this direction.

There is also the question of when the negative trends seen across much of the investment companies sector will reverse. Funds’ Z scores may be unusually negative right now, but that doesn’t mean they won’t deteriorate even further before they improve. Investors may have to be patient, even if they’re getting into these funds on the cheap.

Overall, however, the message of AJ Bell’s research is clear. Investment company valuations have reached a level where genuine bargains may be available. For savvy advisers prepared to do their homework, this festive season could prove very rewarding.