Equity income investment companies on a discount

David Prosser discusses the Stifel research which identifies the equity income investment companies on a discount.

In these dark days for income seekers, is it always necessary to pay a premium for a decent level of yield? Not according to the investment companies analysis team at Stifel: it points out that of the 11 equity-invested closed-ended funds currently offering a yield of more than 4 per cent, shares in nine of them are trading at a discount to the value of the underlying assets.

For liquidity reasons, Stifel’s selection screened out funds with less than £80m of assets, and its ranking includes some very sizeable vehicles, including Murray International, which has a market cap of more than £1.5bn. The analysts do note that following a strong run of outperformance for global equity markets, there are fewer of these high-yielding funds available; last August, for example, it found 14 equity funds yielding 4 per cent or more. Nevertheless, the remainder offer advisers and investors a range of options.

However, it's the discount question that’s particularly noteworthy. In the clamour for income-generating funds of recent times, we’ve often seen the valuations of very many high-yielding investment companies begin to look stretched, with it becoming routine to see shares in large swathes of funds trading at a premium to the underlying assets. That so many of these high yielders continue to offer a discounted purchasing option is therefore reassuring.

Moreover, in several cases, these funds are currently valued more cheaply than before. Dunedin Income Growth, offering a yield of 4.6 per cent, is a good example. Its current discount of 10 per cent is significantly wider than its one-year peak of 7.2 per cent. Similarly, Murray Income, yielding 4.3 per cent, comes at a discount of 10 per cent, against a 6.5 per cent peak. At Merchants, offering an even more generous yield of 5.2 per cent, the current discount is 5 per cent, against a peak of 2.2 per cent.

It’s also worth saying that these funds aren’t valued attractively because they’ve fallen from favour in some way. As Stifel points out, Dunedin Income Growth and Murray Income have delivered net asset value total returns of 26.5 per cent and 25.9 per cent respectively over the past year; both funds are ahead of the market.

In many cases, these are funds with a long-term commitment to offering attractive dividends to shareholders, very often taking advantage of the unique ability of investment companies to maintain revenue reserves from which pay-outs can be funded in poor years for income.

“Many of these trusts have meaningful revenue reserves that can be useful when there are dividend cuts at the portfolio companies in which they invest,” says Stifel. “These reserves can be used to smooth out dividends if necessary, and we do think that by using revenue reserves, these investment trusts should be able to deliver a more robust level of dividend than similar unit trusts, which do not maintain reserves.”

None of which is to suggest these funds offer a free lunch. Most importantly, in contrast to bank and building society assets, these funds require investors to take on the risk of losing money as well as making it in return for those higher yields. In some of the cases highlighted by Stifel, the funds are invested in more volatile sectors – Henderson Far East Income and BlackRock Commodities are good examples.

Nevertheless, at a time when income is in such short supply, many advisers and investors will welcome what the investment companies sector has to offer – particularly given the protection these funds’ revenue reserves offer for future pay-outs.

The nine funds on discounts with yields above 4 per cent identified by Stifel are: European Assets (6.5 per cent yield), Black Rock Commodities (5.2 per cent), Merchants (5 per cent), Dunedin High Income (4.6 per cent), F&C High Income A (4.6 per cent), Value and Income (4.5 per cent), Murray Income (4.3 per cent), Aberdeen Asian Income (4.1 per cent) and Murray International (4.0 per cent).

In addition, Henderson Far East Income and Henderson High Income offer yields of 5.6 per cent and 4.8 per cent respectively, but trade on small premiums of 1.2 per cent and 2.4 per cent respectively.