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Are share buybacks a secret weapon for investment trusts?

An investment trust can repurchase its own shares and these ‘buybacks’ can serve to restore the balance of supply and demand in the market. Following the announcement of the largest ever investment trust buyback from Scottish Mortgage, Rob Morgan looks at what they mean for investors.

| 13 min read

Investment trusts (ITs) have some important differences when comparted to open ended funds such as unit trusts and OEICs. One important feature is that investment trust shares are traded on the stock market. This means their price is dictated by supply and demand – and therefore sentiment – rather than being calculated from the values of the investments it holds (also known as its ‘net asset value’ or ‘NAV’).

Over time the price of IT shares tends to broadly track movements in the NAV but not always. Their shares can trade at a value that is higher or lower than this. This is known as trading at a ‘premium’ or a ‘discount’ respectively and reflects how positive or negative investors are feeling. This can be down to:

  • the prospects of the underlying assets,
  • confidence in the manager to deliver
  • other issues such as the level and cost of debt, and how easy it is to trade its shares.

This represents an added risk over funds whose price is derived directly from the value of the assets, and a discount widening for an investment trust can be a source of frustration to investors. Poor performance can be worsened by waning investor sentiment, and even strong underlying returns can be eroded by investor indifference.

Yet in other instances a discount can work to an investor’s advantage. If the value of the trust’s assets, indicated by the NAV, is significantly lower than the value implied by the share price, then it may represent an opportunity to buy into a portfolio of assets at a discount. Over time this can lead to superior returns if that discount closes.

That’s far from a given, though. Discounts can stay stubbornly high for a long time, perhaps because investor sentiment towards the asset class the trust invests in remains weak, or in some cases because a NAV is viewed sceptically, or perceived to be not fully reflective of events since it was last published. This is usually daily for trusts investing in shares and other asset traded in the markets but less often, and with less certainty, for other areas such as property, infrastructure assets or private companies. Other factors such as expensive gearing (borrowing to invest), cost or low liquidity (ease of trading the shares) can also mean a trust justifiably remains stuck on a substantial discount.

According to the Association of Investment Trusts, the average investment company traded at a discount of 16.9% on 31st October 2023. This was the widest for a month-end since December 2008 when the world was engulfed in the global financial crisis.

Discounts narrow a little

Last year did see something of a perfect storm for investment trusts. Higher inflation and interest rates, a higher cost of debt were partly to blame. In some cases, greater selling pressure created by weaker sentiment towards certain asset classes such as UK shares or infrastructure investments added to this.. Regulation surrounding the disclosure of charges also put off many important institutional buyers.

Since then, things have improved, and the average discount is around 11% today. Partly, this is down to better sentiment among investors and a more benign outlook for inflation and interest rates. But the actions of some investment trust boards have also played a role. Some trusts investing in assets that are harder to trade (“illiquid assets”) have managed to sell some of these investments and this has helped provide investors with greater confidence in the stated NAV. Others have decided they are too small to be effective, and either put themselves up for sale or sought permission to wind up, which involves a sale of assets and a return of cash to investors.

All else being equal, these actions unlock some of the value inside these smaller trusts. Assets are migrated to a more appealing vehicle or realised at closer to stated NAV, and we have been pleased to see a good deal of activity focused on these activities in the interest of shareholders. There has been something of a quiet revolution with a rash of mergers, acquisitions, or wind ups.

Among the 400 or so investment trusts there were four mergers and eight liquidations in 2023 alone, according to data from the Association of Investment Companies (AIC).

Buybacks to the rescue?

Persistent large discounts have also become a feature of many bigger, more appealing trusts. Here there are other ‘self-help’ actions that can often be taken to help keep a discount in check. An investment trust can repurchase its own shares if it has enough cash to do this, and these ‘buybacks’ serve to mop up excess shares from the market. This helps restore the balance of supply and demand and increases net asset value per share for the smaller number of shares in circulation. Doing this when shares are trading at a steep discount can be highly beneficial to shareholder value, particularly if the assets in the portfolio are relatively inexpensive at the time and subsequently move higher.

Buyback programmes often involve the investment trust board setting a formal or informal discount level – when the discount reaches 10%, for example – at which point it will consider making purchases. Variations of this include regular redemption or tender offer facilities. This is where investors can sell shares back to the company at a predetermined price with reference to the Trust’s net asset value rather than the trust buying its own shares in the market.

A buyback policy can offer some reassurance to investors that a discount won’t be allowed to drift. However, not all trusts have a policy, and some boards and managers worry that reducing the number of shares in circulation can effectively shrink the trust. This can, in turn, lead to less liquidity in its shares in the future, making it more difficult and expensive for investors to trade. However, owing to widespread discounts across the sector, there are currently record levels of share buybacks occurring. Several trusts on our Preferred List, including Worldwide Healthcare, RIT Capital Partners, Smithson and Personal Assets were among the most active over 2023.

Scottish Mortgage announces biggest ever investment trust buyback

More recently, the board of Scottish Mortgage, the largest equity investment trust and constituent of the FTSE 100, announced a £1bn buyback over the next two years aimed at closing its persistent double-digit discount.

According to the board, the buyback is supported by “strong operational results” across both the public and private portfolios, and “free cashflow from the portfolio companies having more than doubled over the past year”. Justin Dowley, its chairman, said: “We remain committed to using share repurchases strategically to enhance liquidity in our shares and to seek to facilitate trading around net asset value.”

This is the largest ever investment trust share buyback programme by value, representing 9% of Scottish Mortgage shares at the time of the announcement. The Trust had previously been trading around a 15% discount, one of the widest of the Global peer group, despite already buying back shares to a limited extent.

Regardless of whether this large buyback shifts the discount permanently or not, this action stands to be accretive to NAV, and in the short term at least it has been well received by the market. Shares rose by rising around 5% in the aftermath of the announcement and the discount narrowed to around 10%. Iti llustrates that a well-timed and sufficiently bold buyback policy can move the price well before it’s implemented. It’s also pleasing to see the board and the manager’s conviction in the portfolio that the move implies.

Other buyback successes

Shares in private equity trust Pantheon International have responded well following a £200m buyback programme and tender offer for shares that took place in October 2023. The Trust’s shares had drifted to a near-50% discount earlier last year, which has narrowed to 33%in recent weeks.

Plans for the next financial year have not yet been announced, but the Chair of the Board stated: “Our next step will set out a clear continuing buyback mechanism to be implemented over the next financial year, beginning June 2024. This is an extension to our capital allocation policy of dedicating a proportion of the company's net portfolio cash flow to share buybacks.”

There’s no doubt that these shareholder friendly policies have increased the desirability of the Trust to investors and helped offset significantly weak sentiment towards private equity as an asset class. Yet perennially popular trusts have also been acting. Ruffer Investment Company conducted its first ever buyback last year with shares in the trust straying onto a rare mid-single digit discount. The purchase of 150,000 shares by the Board wasn’t a huge deal for a such a large trust, but it is a symbolic move to show it is prepared to step in when it believes it is appropriate to do so.

In a similar vein, Asian Total Return Trust has bought back 8m shares at an average discount of 6% over the past year for a total sum of £33m. The shares currently trade on a 7% discount, the lowest in the AIC Asia Pacific sector where the average is 12% currently.

Given the discounts prevailing across most of the investment trust universe, it is good to see that an active buyback policy is becoming the norm rather than the exception. Alert boards that are willing and able to keep their discounts to NAV in check through buybacks and other mechanisms create a virtuous circle of increased investor support and confidence, and less volatility in the discount to NAV going forward.

Our view on buybacks

Although we do not believe share buybacks are a silver bullet for quickly closing investment trust discounts, they are often a sensible long-term use of capital, especially when a trust trades on a large discount to its assets and the underlying portfolio represents good value too. They effectively serve to buy more assets per share the manager has already deemed to be undervalued.

Not all trusts can carry out significant buybacks, though. Some don’t have enough cash to repurchase enough shares to make a difference. That’s especially the case for trusts with illiquid assets, which cannot be sold readily to realise cash, or those with high levels of expensive debt that needs to be repaid as a priority as interest rates have risen. They simply haven’t had the firepower to achieve a tangible result, while others have been too timid with their policies.

Part of the reason we favour larger investment trusts for our Preferred List is because they tend to have the luxury of being able to buy back stock without shrinking to an uneconomic size or causing liquidity problems. Where buybacks do then occur, and they are often sufficiently bold to make a difference, longer-term investors stand to benefit from improving asset values and tightening discounts.

Investors still need to be careful and do their research before committing to an investment, though. It is necessary to consider whether an investment company’s strategy meets your objectives and take account of charges and borrowing as well as the discount to net assets available. Buying based on the discount and any potential buyback activity alone is unwise. You should also be confident in the area in which it invests, and it should be an appropriate fit within a well-balanced portfolio.

More broadly, increased buybacks, alongside the concurrent trends of redemptions, liquidations, and ongoing merger activity, mean the investment trust universe is slimming down. Longer term it should be in better shape, though. There will be fewer trusts but those remaining will be stronger, more appealing vehicles that are efficient and cost-effective for shareholders.

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