Catching Zs

Feeling the strain after a long night of watching election results? For financial advisers looking to put a bit of zip in their step, can we recommend catching a few Zs? That’s not a suggestion to go back to bed – rather, to go hunting for cheap looking investment trusts, where “Z-scores” can show the way.

For the uninitiated, investment trust analysts use Z-scores to study whether a fund’s current valuation looks cheap or expensive by historical standards. The idea is to look at the discount or premium at which the shares of the investment trust currently trade relative to the value of its underlying assets; then compare that to the trust’s typical discount or premium in the past.

It's a smart way to investigate pricing opportunities. Advisers know that investment trust shares tend to trade at a discount or premium. But they also know that while a discount might seem to imply the fund is currently undervalued, they also know that this may be misleading; perhaps the fund has traded on even wider discounts in the past. Similarly, a premium rings alarm bells with advisers who don’t want to overpay for assets. But the fund may be less expensive than it seems if the current premium is much narrower than has previously been the case.

Z-scores are statistical measures that take the guesswork out of these considerations. A fund’s Z-score is calculated by taking its average discount over a set period – say five years – away from its current discount, and then dividing the answer by the volatility of the discount. A negative number suggests the current discount is unusually wide (or that the premium is unusually narrow); a positive number suggests the opposite.
Broadly speaking, investment trust analysts start to take note when Z-scores fall below -2 or rise above 2. The former suggests a fund is potentially cheap at its current price, while the latter suggests it is potentially expensive.

Still, the word potentially is important here. Z-scores should never be seen as automatic buy or sell signals; rather, they are indicators that suggest an investment trust is worthy of further investigation. No single statistic can ever tell you everything about what’s going on at a particular fund.
In fact, there could be many reasons why a fund is trading outside of its usual valuation range. Perhaps its manager has changed, for example, or its board has just taken direct action to tackle a discount or premium. Sometimes, sentiment towards an investment sector can be so strong – whether negative or positive – that every fund within it sees its valuation shift.

Nevertheless, Z-scores are a great way to look in more detail at investment trust discounts and premiums, and provide an objective rating in what is more usually a subjective conversation.

Investment trust analysts publish regular data on Z-scores, and you can also get this information from several independent performance monitoring services. 

As for the trusts that catch the eye right now, the analyst team at Deutsche Numis has recently published a list of ten investment trusts with a Z-score of -2 or even lower. They include a number of well-known funds including Majedie Investments, Pantheon International, Majedie and Smithson, as well as several more specialist investment trusts.

To reiterate, the fact these funds are currently priced cheaply in Z-score terms does not constitute a reason, in itself, to buy them. Still, for advisers seeking opportunities for clients during the second half of the year, this could be an excellent place to start looking.