Discounts in decline

Boards are increasingly proactive in addressing discounts says David Prosser.

Discount 50%

Investment company boards continue to focus on value. New data from Numis Securities reveals that investment companies spent £1.1bn during the first half of 2021 buying in their shares.

That is quite an advance on the same period of last year. The first six months of 2020 saw investment companies buy £686m worth of their own shares, so this year’s total represents a 62% increase. Scottish Mortgage’s £409m buyback programme does account for a significant chunk of this year’s first-half activity, but even stripping out that initiative, buyback activity has accelerated sharply.

In most cases, these buybacks reflect the determination of investment company boards to keep control of the discounts at which their shares trade relative to the value of their underlying investment. When supply of an investment company’s shares outstrips demand, the price of the fund will move to a wider discount even if the underlying assets have not changed in value. Buying in shares – and then cancelling them – addresses that mismatch and should therefore keep discounts in check.

It is an important point. For many years, financial advisers have worried about investment company discounts. These are simply a consequence of the way investment companies are structured, with investors buying exposure to the fund’s assets through a fixed pool of share capital, but it can cause anxiety. Advisers and investors worry that the need to anticipate discount movements adds additional complexity to the decision-making process.

However, investment companies have increasingly recognised these concerns and sought to address them. Many funds now have formal discount control mechanisms, requiring the company to take specific actions if the share price slips below an agreed level of discount. Others operate similar policies on an informal basis.

Witan and Alliance Trust, which both made share buybacks during the first half, are good examples. Alliance’s policy is to begin buying in shares if its discount moves beyond 5%; Witan says it seeks to limit its discount in normal market conditions (effectively committing it to action, but with a little wiggle room).

The result of such interventions has been a steady decline in average discounts over recent decades. While discounts routinely traded in double figures during the 1990s and 2000s, they have been falling ever since, albeit with occasional spikes during exceptional periods, such as last year’s Covid crisis. Indeed, in the past 10 years, average investment company discounts have gone above 10% in just two months – March 2020, as the Covid-19 pandemic broke in the UK, and June 2016, following the EU referendum.

As investment company boards have become more decisive and active, so discounts have come down – today the average fund trades on a discount of just 4.4%. In addition, by the way, boards with funds where the shares have traded on premiums to net asset value, have not been afraid to issue new shares, which has helped avoid over-valuation.

What does this mean in practice for investors and their clients? Well, in simple terms, it means that if you buy a mainstream investment company, you can feel reasonably relaxed about discounts and premiums.

That should be reassuring for those who used to worry about valuation. Discounts and premiums are just a function of the investment company structure – and should not really represent a reason to decide against an investment. But for those for whom this issue has given pause for thought, the news on discounts has been consistently reassuring.