DISCOUNTS remain the most puzzling aspect of investment trusts so far
as most new investors are concerned. Put quite simply, the discount is
the gap between what trusts sell for and what the real worth of their
underlying portfolio actually is.
A trust with 1,000,000 shares might be worth #1m. Each share would
have assets of #1. If it sold for less, it would be said to sell at a
discount; if it sold for more it would be selling at a premium.
Discounts, or premiums, arise because there is no ''right'' price for
any company's shares. Investment trusts are first and foremost
companies. Their business consists in buying, holding, and selling
shares in other companies so as to benefit their own shareholders in two
ways; first, by generating a flow of income from dividends from the
shares they hold, and secondly from enhanced capital values enjoyed by
these shares.
That flow of income is passed on to the trust's own shareholders after
paying the interest on any borrowings the trust has incurred to gear up
the possible capital growth.
How people will value any trusts' shares depends on an assessment of
these factors. How good has a management been at making the assets grow,
and using borrowing prudently? How good at increasing dividends, in
spite of paying the interest on borrowings?
These, and similar, assessments have always affected the rating of
investment trust shares but one vital factor reduced the impact: there
were far more investment trust shares available than there were
shareholders willing to take them.
The discount mirrored that fact. The law of supply and demand
dominated the valuation of investment trust shares as it does the shares
of any company. Professional investors traded the shares within limits
laid down by size of the discount which widened and narrowed
accordingly.
Investors were always unhappy about discounts because although they
delivered compensations (a higher yield than would otherwise have been
provided, for example) they added to trusts' price volatility. Managers
were affected by discounts as well. They were not good for morale, and
they greatly reduced the ability to raise new capital or start new
investment trusts.
Two forces have moved to eliminate the discount. The first is the
changed climate for private investors, the second the ingenuity of
increasingly professional and sophisticated trust managers.
Although private investors have continued to be net sellers of
equities during the past decade, they have become big buyers of
investment trust shares. Helped by fiscal changes, British companies
have been paying higher dividends since 1979 and trusts have started to
support healthy and growing yields which are worth much more to
recipients.
Trusts also partly ran down their gearing, which has left more of
their income for dividend payments.
Savings schemes have started to do the trick of returning trust shares
to those for whom they were originally intended -- individual, and not
institutional, holders.
Apart from the effect of new and sustainable demand from private
investors, the main force tending to reduce discounts has been
structural. Clever managers noticed that, if they packaged their trusts
in novel ways, the valuations placed on the various parts of the package
would collectively eliminate the discount.
That is to say, if you launched a trust with more than one category of
share the valuation placed on each category, when added up, would come
to near, and possibly even more than, the total assets the trust would
enjoy.
The two essential features in this process were options and split
levels. Options, known as warrants, permit the future purchase of a new
share in the trust at the issue price. The normal structure has one
warrant for ever five shares initially issued.
The future usually runs for up to 10 years, with the warrant owner
being able to exercise his option annually. That right to buy is always
worth something; and that something was often enough to allow trusts to
be launched without going to a discount of much significance.
Since there is nothing for nothing, the sting in the tail of every
warrant is its dilution of the existing capital when exercised. But the
exercise date is far away when a trust, or a warrant, is launched. In
the shorter term the existence of the warrant prevents a big discount
from opening up.
The second device was to split the trust's capital in such a way that
some shares got all the income and some all the capital growth over a
specified lifetime, seldom more than 20 years and sometimes less. There
could be variations on this theme whereby some capital growth would be
available to the income shares (an example is River and Mercantile
Geared).
Getting all the income from both sorts of capital would mean that
income shares would offer such a large, and growing, dividend return
that they would retain their value (or go to a modest premium in the
package).
The capital shares would normally trade at a discount, but that was
eliminated by an immediate transfer of assets from the income stocks
which would remain floating high because of the high dividends promised.
In effect income shares boost the capital shares from the beginning of a
trust's life.
Such structures have become ever more complex with zero pref-erence
capital shares being added. These enjoy no income but a guaranteed
annual capital increment payable when the trust is wound up. They help
therefore to gear up the ordinary capital shares and, eventually, boost
the income of the income shares.
Where warrants are added, allowing future purchase of geared capital
shares, the result is a very highly geared instrument indeed (viz
Scottish National Trust warrants.)
When all instruments are lumped together at their market valuations,
hey presto, the discounts have either disappeared or become negligible;
and a important psychological barrier to buying investment trusts has
been dismantled.
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