SO AUTO-CANNIBALISM is back, alive and kicking. Devouring your own tail, eating your own innards, call it what you will: in the investment trust world it goes by the name of share buyback and is an honourable thing, of sorts.
It is a tempting option when, as with the giant Alliance Trust this year, the shares swooned way below the net asset value of the underlying portfolio. The discount ballooned out to 27 per cent at one point.
Last week, Alliance bought in 4.85 mil
lion of its shares at 317p a share, at a full cost of £15.4 million. Even after this purchase shares in Alliance at 317.2p this morning, still stand on a discount of 17.4 per cent.
This is the first-ever buyback that the trust has undertaken and the company stressed that this did not represent the adoption of a discount control mechanism. Sporadic buybacks do not automatically enhance a share price but can stabilise the discount and allay investor concerns.
The discount seems particularly anomalous in this case, because not only did Alliance manage to raise its dividend over a rocky first half, but its defensive portfolio which was not shown to best effect at the interim stage has caught up strongly. So for the year to last week, Alliance shares are up 50 per cent against a FTSE World Index gain of 23.6 per cent and an average for the global growth sector of 36.7 per cent. In fact Alliance's performance puts it in the top quartile of its sector, ahead of such stalwarts as Monks Investment Trust, British Assets and Securities Trust of Scotland.
Other trusts have gone full charge down the buyback route. Since Witan adopted its 10 per cent discount target in December 2004, the fund has bought back 129 million shares worth £537 million and equivalent to 38 per cent of its share capital. Foreign & Colonial IT adopted a similar target in November 2005 since when it has bought back 211 million shares worth £569 million and equivalent to 24 per cent of its share capital.
Should other trusts now follow suit? Alliance is by no means alone in having a 17 per cent plus discount. I counted no less than 129 of them out of 598 on the TrustNet list at the weekend. This figure includes, of course, some weird and wonderful growths – hothouse hedge fund triffids, venture capital mutants, spindly split capital hybrids and collapsed property exotica.
Singling out the misconceived, the miscarried and those overtaken by misfortune, there are at least seven popular conventional retail investment trusts where the discount to net assets, even after a strong market recovery, stands at 17 per cent and more.
This does not make them a Magnificent Seven just because of yawning discounts. Such a gap between a trust's share price and its net asset value can signal a poor investment management record, a worrisome level of gearing, an expensive borrowing book or the plain unpopularity of a specialist sector at any one time.
Today's list of high discounts features many trusts specialising in the smaller company sector. This has taken a severe battering during the past 12 months as investors dumped their more risky investments and fled to the perceived safety of the bluest of blue chips. Last year was one of the worst for the UK Smaller Companies sector. It suffered a 41 per cent fall in total return, against a FTSE All-Share loss of 'just' 30 per cent. Smaller companies are more exposed to economic adversity and to capital famine when the banks seize up.
So a yawning discount can signal both a warning as well as an opportunity. With a recovery now on the horizon, how are smaller companies likely to fare? According to Martin Wood of Financial Express Research, back in 2000-03 the smaller companies sector led the stockmarket into the abyss. Its loss in total return over that period plummeted 52 per cent at one point against an All Companies sector fall of 40 per cent.
But in 2003-06 it was the smaller companies sector that clocked up a gain of 135 per cent, against the all companies' 89 per cent rise in return. So investors who can take a five to seven year view might well take the opportunity of buying into this sector when in discount terms it is 'down and out'.
Trusts specialising in Japan also have discounts running into double figures. So I have included JP Morgan Japanese Investment Trust even though its discount, at 17.22 per cent, is fractionally less than that at Alliance. The dividend yield at 3.8 per cent is notably higher than that for trusts specialising in this area.
