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The out of favour trusts that are cheap for a reason

The out-of-favour investment trusts that are cheap for a reason
Investors on the lookout for investment trust bargains risk catching the proverbial falling knife.

Money Observer, April 8, 2020 by Kyle Caldwell

Substantial stock market corrections offer brave investors the chance to go bargain-hunting, but the big caveat and trade-off is the risk of catching the proverbial falling knife.

In the case of investment trusts, discounts to net asset value have widened across the board. During the worst of the sell-off, the average discount figure exceeded its widest point since the global financial crisis over a decade ago, reaching 18.4% on 23 March. That compares with an average discount of 17.6% on 31 December 2008.

By the end of March, the average discount had tightened to 11.8%, which goes to show how rapidly discounts can change and how investors need to be alert to potential opportunities.

There are various ways to detect whether a discount looks ‘cheap’. A useful starting point is to assess the discount relative to its historic average and then against the wider sector.

A more mathematical metric private investors can employ is the ‘z-score’ of a trust. This is another way to compare a trust’s current discount or premium to its historic level. A positive z-score shows the current value is higher than the mean, while a negative value indicates the opposite. As a rule of thumb a score of minus 2 or lower suggests the trust is looking cheap, while a positive score of 2 or more suggests it looks expensive.

While widely viewed as a useful metric the z-score does have its flaws. James Carthew, head of investment company research at QuotedData, points out: “It is a good indication of a significant change in a discount or premium, but because it is an indication of change a relatively small absolute change on an investment company that was trading close to asset value can show up as more significant than a big absolute change in a wide discount. So z-scores are not, on their own, an indication of an investment company looking cheap or expensive, but they are a good indicator of trusts that might be worth a closer look.”


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