Jenny Lowe highlights undervalued investment companies offering a leveraged play on the markets.

During bear markets investors have a tendency to flee shares at a lightning pace, and one effect of such pessimism is the widening of discounts on investment trusts.

For adventurous investors, discounts provide an opportunity to get more shares for your money, and in a climate such as we are currently experiencing it is not unheard of for some of the larger trusts to be trading at discounts of 10 per cent plus.

‘Today there are many trusts whose discounts appear likely to improve sharply in the next few years,’ says Nick Sketch, senior investment director at Rensburg Sheppards Investment Management. He cites Gartmore European’s discount of almost nine per cent as one more likely to narrow rather than widen over coming years.

Managed by Roger Guy, the Gartmore European Investment Trust invests in larger companies with strong balance sheets and above-average growth prospects.

Says Guy, ‘We maintained a defensive stance throughout the first quarter of 2009 in light of the deteriorating global backdrop and volatile market conditions. We have recently begun to shift the portfolio towards a more neutral stance in anticipation of a change in the direction the markets are taking and in recognition of an increase in investors’ appetite for risk.’

Banking on a recovery
Mid- and small-cap stocks have historically performed strongly as investors gain confidence in an economic recovery, and for those who believe we are not going to experience a double dip, the BlackRock Smaller Companies Trust is certainly worth investigating. Currently trading at a discount of over 20 per cent, this fund is poised to do well if the current market recovery continues.

The dividend growth record is also strong and the trust yields just over 2 per cent. There are revenue reserves of almost two years’ payout, so if the portfolio experienced a dramatic fall in dividend receipts from its underlying companies there is scope for the reserves to be used to maintain the payout at previous levels.

Rising Markets
Given that most of these vehicles are geared, they generally perform very well in rising markets and poorly in falling ones. In 2008, for example, the investment trust sector underperformed the FTSE All Share by 7.8 per cent, but during the past six months it has outperformed the index by 3.5 per cent.

And with the financial crisis that began last year coming as a surprise to most trust managers, many found themselves highly geared and heading into a downturn, which resulted in a collapse in share prices over the latter part of 2008.

Scottish Mortgage, for example, had a significant level of gearing and heavy exposure to emerging markets, which had a negative impact on the performance last year. However, the trust’s manager, James Anderson, believes that he is now well positioned to benefit from the growth story emerging in Asia.

‘Our central investment thesis that China and other rapidly growing coutries are likely to become increasingly influential in global terms in the future has been reinforced by the events over the past year,’ explains Anderson.

Looking up
Things are also looking up for the infrastructure trusts which, unlike the majority of other sectors, did particularly well through the rocky markets of 2008.

Stephen Peters, investment analyst at stockbroker Charles Stanley, suggests that defensive trusts such as Personal Assets Trust, Ruffer Investment Trust and Capital Gearing Trust are the ones to watch during the recovery period. ‘These funds fully used the remit of being an investment trust and invested in assets and asset allocation decisions that most open-ended funds cannot do, leading in some cases to marginally positive or flat absolute returns.’

One fund that remains the favourite among investors is Neil Woodford’s Edinburgh Investment Trust, which boasts a portfolio of high-quality companies and is standing on an attractive dividend yield.

Similarly, RIT Capital Partners has consistently caught the eye of the investor, having added significant value for shareholders over the long term.

Alan Brierley, head of investment companies at Collins Stewart, comments, ‘The shares suffered a brutal derating during the last quarter of 2008, falling from a 21 per cent premium to a 15 per cent discount on concerns over its private equity exposure. However, there has been a recovery since, with the shares now trading on a modest premium, a level we regard as fair value given the fund’s long-term performance record.’

Meanwhile, in the alternative investment sector, private equity investment trusts have been successfully raising funds over the summer, with both JPMorgan Private Equity and Electra Private Equity obtaining new money from investors. Simon Elliott, analyst at WINS Investment Trusts, predicts, ‘The next couple of months could be a bumper time for fundraising for the private equity sector as a whole.’

Long-term potential
One name worth keeping an eye on here is the renamed Henderson New Star Private Equity Investment Trust – a product originally managed by New Star before the merger earlier this year.

The trust, which was launched in 1997, has suffered from a very wide discount to net asset value (NAV), partly because of the troubled sector, but also because of the the collapse of New Star and uncertainty over its future.
However, the trust has enjoyed a tightening of the discount following the appointment of new manager Ian Barrass. He says that one of the first aims will be a further narrowing of the discount to NAV – still the widest of private equity funds of funds.

‘We were surprised at the quality of the existing underlying investments. This will be a good platform for growth when we can make more commitments. Going forward, however, the portfolio will be given a more focused approach.’

He adds, ‘The trust has the potential to provide an attractive platform for investors as and when the European private equity markets recover.’

And according to Simon Elliot, discounts among private equity trusts will tighten further if markets continue to strengthen.