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Is it time to go bargain hunting amongst investment companies?

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29 March 2016

With discounts widening since the end of last year David Prosser explores whether now is a good time to buy investment companies.

Is it time to go bargain hunting amongst investment companies? The discounts to which shares in many closed-ended funds have slipped relative to the value of their assets in recent weeks should certainly give financial advisers and their clients pause for thought. After a sustained period of falling discounts, now could be the moment to pick up investment companies on the cheap.

By the end of February, shares in the average investment company were trading at a 7.2 per cent discount to the value of its underlying assets according to investment company analysts at Winterflood Securities – that compares to 4.6 per cent at the end of last year.

Now, there will be some advisers who regard this valuation volatility as vindication for the view that investment companies are riskier and more complicated vehicles than open-ended funds. Concern about discounts has usually been the most significant issue for those who feel less comfortable with the sector – and the closed-ended structured of an investment company means there will always be scope for shares in the fund to trade at a discount or premium to the value of its assets, depending on demand and supply on the open market at a given time.

However, it’s important to stress that while discounts have indeed widened during 2016, as investor confidence has been hit by global stock market volatility, they remain low by historical standards – in recent decades, double-digit average discounts have been more typical, rising to 20 per cent plus during times of stress.

There’s good reason to think we are not now heading back to these longer-term averages. For one thing, demand across the sector has been boosted, with more advisers recommending investment companies than ever before to their clients, particularly since the retail distribution review reforms of three years ago. Moreover, investment company boards have made a commitment to confront excessive discounts: many now have formal discount control mechanisms in place, with provisions for action such as share buy-backs once discounts hit a certain level.

There will still be some volatility. However, in the context of lower average discounts overall, it’s possible to look at cheaper investment company valuations as an opportunity. In other words, the fact that the discount on the typical fund is now more than a third wider than at the beginning of the year, could be seen as a buy signal. Indeed, we’ve already seen some advisers describe the opportunities in the sector as remarkable.

This is not to say that any investment company now trading at a significantly wider discount than two months ago is worth buying. Valuations can be a good starting point for considering an investment, but advisers will still need to be convinced about the merits of the fund over the long term.

Nevertheless, now might be a good time to get acquainted with “Z scores”, the yardstick by which investment company analysts assess valuations in the sector. The rating essentially tells you to what extent a fund’s current discount varies from its historical range: a negative Z score suggests a cheaper valuation, while a score below -2 is considered to be an especially strong signal.

Numis Securities, the investment trust analyst, publishes a list of Z scores daily. They shouldn’t be the be-all and end-all of any investment decision, but for advisers pondering how to take advantage of cheaper valuations in the investment company sector, they’re worthy of investigation.

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