David Harris considers the dilemma facing many investment company boards of whether or not to implement a discount control policy.

One of the first articles I wrote after leaving the Association of Investment Companies (AIC) in 1999 was on the problems that discounts caused to the investment trust sector. Ten years on and the subject will not go away. However hard the investment trust sector tries to address the problem of share price discount to net asset value (NAV), the difficulty stubbornly refuses to disappear.

For those who still do not recognise the phenomenon, let me explain the situation that exists. Investment trusts are companies listed on the London Stock Exchange. More often than not, their shares trade at a discount to NAV, which means that the total value of their shares is less than the total value of the net assets they hold.

Occasionally, they can trade at a premium, whereby the total value of the shares is actually greater than that of the assets. It is important to understand what this means, and how the discount should be assessed, before buying a particular investment trust share.

Reading the runes
The discount is one aspect of performance that applies specifically to investment trusts. Shares in a trust can be measured either in terms of the price at which they trade on the stock market or the value per share of the assets in which the trust has invested. The actual calculation of the discount is simple: the difference between the share price and the NAV divided by the NAV.

Primarily, the discount is a function of supply and demand for a trust’s shares. A widening discount will indicate that there are more potential sellers than buyers. Although discounts, and particularly the volatility of these discounts, are important, there are few simple rules available that will address the problem consistently.

If a trust trades at a discount then common sense tells you that there is room for a price rise – thus, potentially, making it a more attractive investment than a trust trading at a premium. However, if it were as simple as this, the market would jump in and invest in all trusts trading at a discount and thus eliminate the problem.

Some ten years ago, the issue of marketing and promotion came into the spotlight. The AIC launched a high-profile marketing effort to persuade investors to buy trust shares.
This was backed up by more active education, advertising and marketing from the fund managers. For a time, there was an element of success, but this was abruptly halted by problems of alleged mis-selling of split-capital investment trust shares and the bear market of 2000 to 2003. As far as I can see, little ongoing, persuasive or effective effort has been made since then to address the demand side of the discount equation.

Demand and supply
Addressing demand is, to me, a much more attractive solution than any available on the supply side. However, in order for existing shareholders to sell at a price close to NAV, new shareholders have to similarly buy close to NAV. Such new buyers will be cautious of buying into a trust at close to NAV when there is a chance that the discount may widen substantially the very next day. This, for many, is not acceptable, however confident they may be about the prospective longer-term investment returns.

While marketing and promotion continue to be vitally important, unless they are allied to good stock market performance and control of the supply of shares, they will, unfortunately, prove to be broadly ineffective.

Over recent years, an increasing number of investment trust company boards of directors have seen fit to address the supply side and implemented their own discount protection mechanisms.

Where boards have made a commitment that the discount level will be protected at a certain level, this provides good news for new shareholders, as it offers them a discount floor, under which the trust will not trade. It is also good news for those shareholders seeking an exit and for the trust, as it should help to reduce short-term shareholders, or arbitrageurs, and replace them with long-term investors. In effect, the discount risk will have been taken away from the investor and transferred to the trust and its investment manager.

Hidden problems
What this has meant is that the board of a trust has made a commitment to protect a certain level of discount by using the company’s balance sheet to provide cash to buy back shares in the market. The theory behind this approach is that, were these shares not bought back, the excess supply over demand in the market would cause the discount of its share price to NAV to continue to widen until such time as it reached a level at which a buyer for the shares might emerge.

However, this action shrinks the size of the trust, and while it is a way of providing a better exit, should the discount remain wide after the transaction, short-term shareholders could decide to use the cash they have raised to go through the same process again, thus shrinking the trust even further. If these actions are taken to their ultimate conclusion then the trust will cease to exist – not what shareholders who wish to remain invested, the board or its investment manager are seeking to achieve. Hence, the goal that the board seeks to focus on should be a balance between supply-side control and demand-side marketing.

Unrealistic expectations
So how have these discount control mechanisms worked in the recent market turbulence? In their excellent Annual Review, Cazenove have analysed all trusts that have stated they will operate hard discount targets. In total there are 104 trusts (this figure includes different classes of share) that have such a policy. Of these, Cazenove found that 60 are more than five percentage points outside their discount target and 49 more than ten points outside (of which 38 are in the hedge fund sector).

Having investigated the reasons why this was the case, they have concluded that too many trusts were simply unrealistic when initially setting hard discount targets. While liquidity in markets has deteriorated markedly since these targets were set, only a small number – mainly large trusts with very liquid assets – ever set a credible target in the first place.

One example of this, it can be argued, is Witan Investment Trust, at which a proactive buy-back mechanism is in place to try and maintain an appropriate level of discount of around ten per cent. The trust’s marketing director, James Frost, believes they have, broadly, managed to achieve this since 2004. While the discount level became more volatile during the last quarter of 2008 due to market turmoil, they continued to buy back shares and ended the year only just outside their target at 11 per cent.

The control is achieved and managed by the trust’s CEO and its broker. The discount is monitored throughout every trading day and the broker is empowered to buy back shares when the discount falls below the stated comfort level. Larger buy-backs require additional approval from the board.

Increased flexibility
Cazenove concludes that trusts must operate a more flexible approach. It believes that, in current market conditions, some trusts could even be destroying shareholder value by operating buy-backs. If a trust has insufficient cash on its balance sheet it may have to sell investments to buy back shares. If the realisation price is at a bigger discount to the NAV than the share price, the NAV would actually be reduced.

Standards of corporate governance within the investment company sector have improved greatly in recent years and boards have been actively trying to enhance shareholder value with the introduction of discount control mechanisms. While they may not have got their calculations or objectives entirely correct, they must continue to strive to improve, and make suitable adjustments to their aims where necessary. If not, they must ask themselves whether their trust deserves to exist at all. Above all, they must be fair to shareholders.

Investment trusts will continue to offer interesting and profitable routes to market as the current economic woes subside. These attractions will be materially enhanced where the board of the trust sets credible targets for control of the discount and couples this with a determined effort to promote the merits of the trust through ongoing marketing initiatives.

Unfortunately, even if this is done, I do not believe the discount problem will disappear completely. But I hope that whoever is writing about the subject ten years from now will have more positive progress to report.

David Harris is an independent consultant and a former head of adviser services at the AIC.