A deep dive into discounts
How much do they matter for investors?
Discounts (and premiums) are a fact of life when investing in investment trusts.
They can be best understood as the gap between the share price and the value of assets held by the investment trust. So if an investment trust has 100p of assets per share and a share price of 95p, it’s trading at a 5% discount.
Most investment trusts trade at discounts most of the time. At the moment the average discount is 14%, which is pretty wide by historical standards. But some investment trusts trade at discounts of 50% or even greater, while others trade at premiums.
Why does this matter? Well, it can affect the return you get as a shareholder.
Let’s say you invest in a trust where the underlying portfolio – the investments the trust holds – go up in value by 10%. This is also called the net asset value return or NAV return.
Let’s also imagine that you invest in this trust on a 10% discount, and sell it when the discount has narrowed to 5%. The effect of this can be seen in the table below.
Purchase investment trust | Sell investment trust | |
|---|---|---|
| Net asset value (NAV) per share | 100p | 110p |
| Discount | 10% | 5% |
| Share price | 90p | 104.5p |
| NAV return |
| 10% |
| Share price return |
| 16.1% |
So, you invested at a share price of 90p, but sold your shares at 104.5p. The narrowing of the discount has transformed a 10% NAV return (the underlying return of the trust’s portfolio) to a 16.1% share price return (the return you actually get). Nice!
Of course, this can work the other way round. Let’s say you bought on a 5% discount but sold on a 10% discount.
Purchase investment trust | Sell investment trust | |
|---|---|---|
| Net asset value (NAV) per share | 100p | 110p |
| Discount | 5% | 10% |
| Share price | 95p | 99p |
| NAV return |
| 10% |
| Share price return |
| 4.2% |
This time, the discount has widened, and your return (the share price return) is only 4.2%, less than the NAV (underlying portfolio) return of 10%. Not quite so nice.
So, discounts are pretty important right? Well, it depends.
If a discount doesn’t change during the time you hold an investment trust, it makes no difference. If I buy at a discount of 37% and sell at a discount of 37%, my return will be the same as the NAV return. The same is true for any other level of discount (or premium).
There’s one little wrinkle though. If the investment trust pays an income, then buying at a discount gets you a better return, even if the discount doesn’t change. That’s because your yield will be higher. Say an investment trust has an NAV per share of 100p, and that 100p of assets generates an income of 3p. Buy that investment trust on a discount of zero, and you’ll get a yield of 3%, but buy it on a 20% discount, and your yield will be 3.75%.
Are you in this for the long term?
So far, we’ve only looked at single-period returns. But how much discounts matter really depends on your time horizon.
Short-term investors, such as arbitrageurs and other traders, will play the discount game. They’ll invest at deep discounts and hope they narrow quickly (they may even be activists, trying to force change at board level to narrow those discounts).
Longer-term investors, such as someone saving for their children or for a pension, tend to be less fixated on discounts.
The chart below shows why. It looks at a hypothetical investment trust where the NAV return is a steady 7% a year (pretty unrealistic I know, but bear with me.)
From the chart you can see what your annualised share price return would be in three different scenarios: a narrowing of the discount from 20% to 10%, a widening of the discount from 10% to 20%, and no change in the discount.
Source: AIC. Assumes 7% NAV growth
If there’s no change in the discount, not surprisingly, the share price return works out exactly the same as the NAV return: a steady 7% a year.
If the discount narrows from 20% to 10%, the share price return is better than the NAV return; if it widens, it’s worse. Also unsurprising. But look at the difference between the time periods.
Over a one-year investment horizon, the share price return is dominated by what’s happened to the discount. In fact, the discount movement matters more than the steady-eddie 7% return in the underlying portfolio.
But over longer periods, you can see the annual returns getting closer to the steady-eddie 7% return whatever happens to the discount. The chart below takes the discount-narrowing scenario and breaks down how much of the return is due to the discount, and how much to the change in the underlying portfolio over each time period. After 20 years, less than a tenth of the return is due to the change in the discount.
Source: AIC. Assumes 7% NAV growth and discount narrowing from 20% to 10%
What about regular investors?
It’s not just your time horizon that makes a difference, it’s how you invest. Generally speaking, the regular saver should be a lot less worried about discounts than the lump sum investor.
To make things easy, let’s stick with our fictional investment trust where the NAV return is 7% a year, and we’ll keep the same three scenarios (discount narrowing, discount stable, discount widening).
But this time, let’s look at what happens if you invest a £10,000 lump sum then wait ten years, compared to investing £1,000 a year over a ten-year period.
Source: AIC. Assumes 7% NAV growth and straight-line discount movement over period.
As you’d expect, the lump sum investor does better than the regular investor, because more of their money is in the market for longer. You’ve heard it all before – it’s time in the market that counts, not timing the market (especially when we assume a constant 7% NAV return!)
But what’s interesting from a discount perspective is that for the regular saver, the change in the discount – widening or narrowing – makes much less difference than it does to the lump sum investor.
Be discount-aware
So, are we telling you not to worry about the discount? Not exactly. It’s good to be discount-aware, if not discount-obsessed.
That’s because discounts can signal a good time to buy. At the moment, for example, the average discount is 14%, well into the double digits. Historically, this has been a great time to buy investment trusts.
The chart below looks a bit scary but it shows you the strong correlation between the level of discount at which you invest, and the return over the next five years. It’s based on historical data going back to 2008 (which, for those who are really interested, is when we tweaked the way we calculate discounts).
The message is clear: investing at deeper discounts tends to lead to better returns, over the medium term anyway.
Source: theaic.co.uk / Morningstar. Based on 139 overlapping five-year periods starting in June 2008 (beginning of cum fair discount history)
But remember, this is for the average investment trust. And you won’t be investing in the average investment trust, but in a specific trust or trusts. Always do your research.
And always, always worry more about what’s in the portfolio than what the discount is.
Nick Britton
Nick is the AIC’s Research and Content Director. He is in charge of research projects at the AIC, working closely with journalists, financial advisers and wealth managers. Nick is a CFA charterholder, holds the Investment Management Certificate and is a member of the Chartered Institute for Securities and Investment (CISI).
Email: [email protected]
