Brexit bargains?

There’s no doubt this is an anxious time to be invested in equities. The UK stock market is down around 10 per cent from its peak earlier this year, while many international markets have fared even worse. The headwinds facing equity investors, from international trade tensions to slowing growth in China, look ever fiercer.

Against that backdrop, new research from Winterflood Securities points out that shares in half of all UK equity-focused investment companies are now trading at a discount to the value of their underlying assets that is wider than the 10-year average. Indeed, in several cases, these funds’ discounts are currently trading at near 10-year highs.

Investors in UK equities, Winterflood argues, are feeling especially cautious given the ongoing impasse in the UK’s Brexit negotiations with the European Union. The widening of discounts on UK-invested closed-ended funds reflects nervousness about the possible impact of a no-deal Brexit on the UK economy.

It’s difficult to counter such sentiment, particularly in the short term, given how the Brexit negotiations continue to lurch from one crisis to the next. And shareholders in these investment companies can be forgiven for feeling dispirited about the way in which valuations have slipped over the past year or so.

Still, there’s an important point to grasp here. The discount on a closed-ended fund doesn’t count for much unless you happen to be buying or selling. The price of the fund’s shares only really matters if you’re planning to trade; at other times, what’s more significant is how the value of the fund’s assets is changing, since this is what will, over time, drive the returns that investors earn.

One way to think about investment company discounts is as a mechanism that offers a point of flex. When a closed-ended fund is being buffeted by negative investor sentiment, the fact that its share price moves independently of the value of its underlying assets, according to supply and demand, gives a valuable element of protection. The fund is able to brace for the difficult times, with its portfolio intact, until sentiment recovers.

Compare this structure with an open-ended fund, where investors are also feeling very nervous about the UK market in the current environment. These funds have seen outflows of around £10bn since the Brexit referendum in 2016; that money is gone for good – and many open-ended fund managers will have had to make significant disposals to meet these redemptions. Unlike in the closed-ended sector, open-ended funds do not have a structure that provides a safety net.

This contrast may be of little immediate consolation to investors in investment companies reflecting on the disappointing returns of recent times. But while share price performance has been worse than performance as measured by net asset value returns, this disconnect will reverse when investor sentiment improves, to the benefit of investors who hold tight. Plus investment company boards have the option of intervening if discounts continue to widen – with share buy-back programmes, for example, that can help bring discounts down.

Indeed, there are analysts and advisers now arguing that this is the moment to increase exposure to UK-invested investment companies. After all, citing the above-average discounts on these funds is simply another way of saying that they are unusually cheap. Investing in equities is a long-term pursuit that’s very different from short-term trading, but such arguments are food for thought for anyone reviewing their asset allocation for the months and years ahead.