Have you read The Snowball – the biography of famed investor Warren Buffett?
Did you also feel a few pangs of jealousy?
I don’t just mean for Buffett’s Omaha neighbours, who backed the bargain hunter in his 20s and turned modest nest eggs into billions.
(Though I did send several pangs in their direction.)
No, as a stock picker it was the tales of Buffett uncovering companies trading at less than the cash on their books that I envied.
In theory, Buffett could buy these firms outright, extract the surplus moolah, and own the businesses for nothing.
Talk about a free lunch!
Of course, the market was inefficient back then. Buffett would travel to New York by train to delve for data buried in obscure filings that nobody else even bothered with.
Today, all that information is at the fingertips of countless tech-enabled hedge funds.
Besides, would I have been as dogged as Buffett in ferreting out these nuggets?
Truthfully, no. There’s only one Warren Buffett because nobody else did what Buffett did.
Anyway, it’s all moot because you don’t see value going begging in the market these days…
…do you?
Maybe.
10% off in the stock market
The hidden-value-in-plain-sight bargains I’m thinking about arise with investment trusts.
An investment trust is a fund that trades on the market, like any other share.
And like all funds, it owns a variety of assets.
Sometimes the holdings are unlisted or mysterious – property or private companies, for example.
But more often, trusts own a portfolio of other market-listed companies.
With such trusts you can easily tot up the value of all the investments. Adjust for any debt or cash on the balance sheet, and – hey presto! – you know what the trust is really worth.
In theory, an investment trust could liquidate itself by selling its portfolio and – after costs – you’d know exactly how much cash you’d be entitled to as a shareholder.
Yet despite such mathematical clarity, investment trusts often trade for less (or more) than this so-called Net Asset Value (NAV).
When trusts cost less than their NAV to buy, they’re said to trade at a discount. A trust with a NAV of 100p per share whose shares cost 90p are on a 10% discount to NAV.
Note there are no ifs or buts here. It’s not like saying you believe Tesco is worth 300p per share but the market prices it at just 250p.
With an investment trust that owns listed assets, you can know exactly what its portfolio is worth.
Hence, the discount to NAV isn’t an opinion. It’s a fact.
However, whatever the theory says, it’s all moot because an investment trust trading at a discount is hardly going to just liquidate itself and return the cash…
…is it?
One foot in the grave
Actually, trusts do wind themselves up and dole out the cash every now and then.
In fact, we’ve seen a high-profile example in just the last few days, with the Fundsmith Emerging Markets Equity Trust (FEET) announcing it aims to put itself into liquidation.
This came after the trust’s manager – Fundsmith LLP – told the trust’s board it will hand back the reigns of management.
Given that FEET is synonymous with Fundsmith – and its strident founder Terry Smith – there’s a somewhat formal dance going on here.
True the liquidation proposal is subject to a shareholder vote.
But I’m sure the board has already sounded out enough of FEET’s big shareholders to be confident its proposal will be ratified and that the trust will indeed be liquidated.
Because what is FEET without Fundsmith?
The whole point of FEET was to bring Fundsmith’s Midas touch to a new market.
But unlike Terry Smith’s flagship core equity fund, his firm’s emerging market offering has struggled ever since its 2014 debut.
FEET has delivered a total return of 44% since inception to the end of August this year. That’s well behind the 68% notched up by its benchmark.
Not so much a Midas touch as a Vegas shakedown.
And the share price has done even worse, lagging the NAV with a return of 22% over the period.
Which brings me back to that demonstration of value.
FEET kicked into life
The day FEET said it was seeking self-liquidation, its shares jumped by 10%!
This had little or nothing to do with any activity in the trust’s underlying investments.
Rather, the rise was purely because the market believes the discount sported by FEET will probably soon be closed by the trust selling all its investments at near to NAV, and giving the cash to shareholders.
Before the announcement, FEET traded at a discount of more than 15% to a 1,427p NAV.
After the announcement – and the share price advance – the discount had closed to just 6%.
A nice gain if you were lucky enough to be holding the shares when the news broke.
But it also raises a couple of interesting questions.
Firstly, why did it take a liquidation announcement for traders to get interested in the value clearly on offer with FEET shares?
And why does a 6% discount persist even now?
Best foot forward
Investment trusts may trade at a discount for many reasons – often at once – but it’s mostly centred on uncertainty over future returns.
Investors may doubt managers decisions are creating much value, or even destroying it.
Or it can be because an asset class has fallen out of favour, so there’s simply not much demand around. The torpor can easily lead to investment trust prices drifting away from NAV.
But often a discount seems almost emotional.
FEETs returns have rarely looked good versus an emerging market index fund. It’s even shifted its strategy along the way. The shares initially traded at a premium to NAV as investors bet that the Terry Smith stock picking magic would do it again for investors – the slow slide to a discount can only have amplified the disappointment. It certainly dragged on their returns.
In short, it’s all been a bit of a tumult.
However, with a liquidation ahead, future returns from FEET look relatively superior.
Shareholders will still get any return due from the performance of the portfolio, until it winds up.
But investors who held or bought at the initial wide discount also get a return kicker, in that the discount can be expected to close to near-NAV by liquidation time.
Remember: they will get cold hard cash at that point.
The return from the underlying holdings – and the emerging market index – will naturally fluctuate. But the relative return generated by closing the discount is almost assured.
There is a chance shareholders could vote down the liquidation. In that case, the board would need to find a new manager.
But even if it does wind up, there’s no sure timetable yet. We don’t know how much it will cost to sell FEET’s holdings, and whether the trust will need to price anything below market value to unload any outsized positions.
All of which also answers that second question: why does a small discount still prevail?
In a word: uncertainty.
Traders can’t be sure the liquidation will happen. If it doesn’t, it is very likely FEET’s share price will fall again. The persistent discount is a small margin of safety against these sorts of outcomes.
Look before you leap
If you like uncertainty, then hunting for investment trust bargains can be addictive. But it’s often frustrating.
Some investment trusts stay on huge discounts for years, or even decades. Not everyone is as savvy or principled as Terry Smith. Often only an activist investor buying into a trust will force its board to do anything to realise the value marked down by a big, persistent discount.
Some boards have seemed content to let a discount linger on for years while they collect their fees, which does a great disservice to existing shareholders.
You should also always check to make sure there’s not a technical reason why the discount cannot be closed – often seen with family run trusts that cannot buy back shares without triggering takeover rules – or that the NAV you’re working off is more than just a finger in the air kind of exercise, as can happen with private equity trusts and others that hold unlisted assets.
Okay, I admit it’s not quite as easy as it was for Buffett buying cash marked down in the market. But in today’s very efficient market – and with a dose of luck dolloped in – buying an investment trust that you know is worth more than its shares trade for might just be the next best thing.
