A price worth paying

If you were looking for evidence to demonstrate the growth of interest in investment companies over the past couple of decades, a key exhibit would have to be the emergence of the ‘persistent premium’. But what is that, and what does it mean for investors?

Historically, shares in most investment companies would generally trade at a discount to the value of the underlying assets they owned. If the discount then reduced, investors benefited from that additional boost to the share price; but received wisdom said shares that moved to a premium to net asset value (NAV) were unsustainable and heading for a correction, and should be avoided.

However, in the last 10 or 15 years that’s changed, and share price premiums to NAV – in some cases across entire sectors – have become a much more prevalent feature. In other words, even canny investors have become increasingly willing to pay ‘over the odds’ for certain investment companies.

To put that into context: Simon Elliott, head of investment trust research at broker Winterflood, reports that of the 320 or so funds in the firm’s universe, around 100 are now trading at around NAV (‘par’) or on a premium. Among the sectors where average share prices have sat almost exclusively at a premium over the past year are Biotechnology and Healthcare, Infrastructure, and Renewable Energy Infrastructure, though others, including Environmental and Technology, have also traded above par for lengthy periods.

 So why have persistent premiums become so much more commonplace, and how should private investors approach them?

There are several reasons for this shift. In part it reflects changes in the investor base. This was formerly heavily dominated by big institutional investors looking for good value and wealth managers playing a shorter-term discount and premium game, but the last decade or so has seen considerable growth in retail investors saving into SIPPs and ISAs – often regular savers thinking about the very long term.

“Long-term retail investors are less discount or premium-sensitive and will buy if they like a company, even if it’s trading on a premium,” explains Elliott.

He gives the example of the former Witan Pacific trust. Prior to the market crash in February/March this year, it was trading on a fairly consistent 8-9% discount, but in September management passed to Baillie Gifford – a firm that has a large retail presence and whose star has been firmly in the ascendant. The renamed Baillie Gifford China Growth trust shot to a massive 34% premium, though it has since come back to around 12%.

Another factor in the emergence of premiums is the growth in funds invested in alternative assets. According to Ewan Lovett-Turner, head of investment companies research at broker Numis, alternatives have accounted for around 75% of the new investment company shares issued in the last six or seven years, and “have changed the dynamic” of the closed-ended landscape.

Alternatives investment companies – unlike conventional investment companies focused on listed equities – hold illiquid assets such as infrastructure, property and private equity. Valuations are more subjective and less frequent, and in some cases focused on historical cost rather than prospective earnings. In other words, net asset values may be based on pretty conservative valuations, and investors paying a share price premium in such cases are aware of that chronic undervaluation.

Importantly, certain alternatives sectors also offer a dependable yield, typically of 4-6% and in many cases substantially government-backed, which many people are prepared to pay for in these days of near-zero interest rates. The Infrastructure sector, for instance, currently has an average weighted yield of 4.6% and trades on a premium averaging around 17%.

“I know of value-oriented investors buying these alternative funds on premiums, sometimes quite substantial ones. When you have harder-to-value assets there can be more justification for a more structural, embedded premium, especially as people look more to that yield and how it compares with other cash flows such as fixed income,” Lovett-Turner explains.

The story is different for equity-focused investment companies on a premium – currently dominated by the Baillie Gifford stable. “Many Baillie Gifford funds are trading at consistent premiums on the back of strong performance and retail demand,” says Elliott. However, he adds, investors still need to be wary of extremes, as premiums can and do fluctuate with swings in wider sentiment.

Alongside the growing interest from the retail market has been a rise among retail-focused investment managers, including Baillie Gifford, JP Morgan and Janus Henderson, in the use of both discount control mechanisms (whereby the manager reduces the number of shares in circulation through buybacks, to avoid deep discounts opening up) and new share issuance, which helps avoid excessive share price premiums. These controls are particularly important in reducing the risk that private investors lose out by buying at excessive prices, and they therefore help these trusts to continue to attract new inflows.

Simon Elliott makes the further point that the increased prevalence of premiums is a function of the way investment trusts are now traded. “In the olden days, market-makers looking to meet a surge in demand for a particular trust could always find an institutional investor willing to take some profit and surrender some shares,” he observes. “Nowadays, buy-and-hold strategies are much more widespread and it’s quite difficult to be that proactive.”

In effect, re-ratings occur partly because market-makers don’t have any easy calls to make to find stock for buyers – which is where new issuance comes in. “It amounts to a virtuous circle as investment trusts become more mainstream,” Elliott adds, with managers benefiting from growth in the size of the fund and investors in turn seeing costs fall through economies of scale.

So what should investors bear in mind when they encounter an investment company trading at a premium? It’s useful, first, to get a sense of how significant the differential is in historical terms. Various websites including the AIC's provide detailed statistics on discounts and premiums, and these are a useful place to start.

The most obvious check is to see how the current premium of the fund you’re interested in compares with its 12-month high, low and average levels. If the premium is at the upper end or out of sync with its annual range, more homework is clearly warranted.

“Then you really need to understand the fundamentals,” says Lovett-Turner. “Think about the valuation of the underlying assets. Listed equities are liquid and a high premium can be vulnerable and dangerous, whereas alternatives valuations are more subjective and less frequent, so it’s worth investigating the basis of the valuation. Look also at the yield and ask whether it justifies a premium rating.”

The bottom line is that, whatever type of investment company you’re looking at, it’s important to do your homework – and if you’re paying over the odds, be sure you understand what’s underpinning that premium.​