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You&#39ve never NAV it so good

In my last few articles, I have been looking at the meaning of some of the more important aspects of information about share prices contained in the quality newspapers.

I have tried to bring particular attention not only to the usefulness of this information, including the analytical formulae which can be derived from it but also to the limitations of these formulae in assessing individual shares as well as collective investments which hold these shares.

This week, I will be extending this discussion to the application of these principles to a special type of listed share – investment trusts. On the one hand, these are listed public limited companies just like all the other listed company shares. On the other hand, they are totally different from those other companies for a number of reasons, the primary one being that they do not involve themselves in any form of trade except for buying and selling shares in other listed companies.

This, I know, is an obvious statement to make to financial advisers but one which is important to make to set the scene for the link between my last few articles and this concluding discussion.

First, analytical formulae such as earnings per share and price/earnings ratios are still valid for investment trust shares although, I would suggest, generally less so than for shares in trading companies.

The earnings per share calculation is usually applied only to the trading profit of a company whereas the value of investing in shares in the vast majority of investment trust companies depends not only on the income profit it generates in a particular accounting period but also on the capital gains achieved on the investments.

I would suggest that more attention should be paid to calculations derived from a trust&#39s net asset value rather than its stated annual profit. A quick look at a couple of examples should illustrate this view.

First, let us look at the BFS managed properties investment trust. At the time of writing, the NAV is stated as 72.8p per share. This, in simplistic terms, is the value an investor is getting if investing in these shares. That value will rise or fall in future years as the value of the underlying assets held by this investment trust rises or falls. Such fluctuations will occur if those assets (property, in this example) generate more income than required to meet expenses and/or (more important) if the underlying value of those assets fluctuates.

So, what is so special about investment trust shares? Well, the share price of the above trust at the time of writing is 83p. This represents a premium over the NAV of around 10p or 15 per cent. Therefore, new investors are only acquiring 72.8p worth of value for every 83p they invest and are, therefore, in fundamental terms, paying too much for the underlying value in the company. Why would they be tempted to do this?

There can be only one reason – they believe the management of this trust has been and is likely to remain so successful that they are prepared to pay a premium to get a share of the action. There is a finite number of shares in an investment trust (unlike the units in a unit trust, which may be created or cancelled according to demand) so an increase in demand for these shares chasing a restricted and falling supply from sellers causes the share price to rise.

Shares trading at a premium to their NAV is by no means unusual with listed trading companies but is quite rare with investment trusts. However, investors should understand that such a premium indicates relatively poor underlying asset value for their investment but also, probably, relatively very good prospects for future growth.

Contrast this investment trust share with the following example, the British smaller companies investment trust. This trust (investing in, as the name implies, shares in smaller companies listed on the UK stockmarket) has a stated NAV of 77p compared with a share price of 52p.

Good news for investors? Yes, in a way. For every 52p they invest, they are gaining investment performance from 77p worth of assets. Its share price is trading a significant discount to its NAV.

This can be looked at in a number of ways. It could be considered that investors are making an immediate “profit” of around 50 per cent of their investment. More realistically, bearing in mind that this profit could only materialise if the market started to value the shares at or around their NAV, they may consider that, say, a 10 per cent return from the underlying assets would give around a 15 per cent return on their money (10 per cent of 77p = 7.7p which is around 15 per cent of the 52p buying price).

But beware. The prices of shares in investment trusts are driven as much by the interaction of supply and demand as by the underlying NAV. Clearly, this trust has a history of more sellers than buyers, indicating even at first sight (proved correct under closer examination) that the shares have consistently underperformed historically.

This is a crucial additional factor in assessing investment trusts – the trend in their NAVs over the last few years. Trusts whose NAV has increased significantly and consistently in recent years will generally attract buyers and deter sellers, thereby leading to a narrowing of the discount or even the movement of the share price to a premium over its NAV, as in the case of our first example above.

Therefore, with our second example, a braver investor might be attracted for two particular reasons – the high discount to NAV (more investment for their money) and the possibility that, if UK smaller companies enjoy a good run and if the trust can keep up or even amplify this good run, then more buyers will be attracted and the share price – presumably already enjoying a good run because of good performance – will further benefit from a narrowing of the discount.

Using this line of reasoning, the BFS property trust in our first example has arguably less potential upside as a poor shortto medium-term performance will not only directly hurt the NAV (and, therefore, the share price) but could also threaten its premium share price.

Consider this scenario involving the BFS managed properties trust. From a current NAV of 72.8p (share price 83p) let us suppose or predict that this will fall to only 60p over the next three years. Progressively over this period, we might assume that the share price will fall proportionately to the fall in the NAV to around 68p from 83p.

However, we might also assume that the balance between supply and demand will change towards a surfeit of sellers, resulting in a more accelerated fall in the share price to, say, 55p (a 20 per cent discount to NAV). Thus, a fall in NAV of around 20 per cent (72.8p to 60p) could result in a 35 per cent fall in the share price.

Bad news for a successful investment trust? Hardly. Premiums and discounts exist at least as much due to market expectations of future potential as an assessment of past performance, indicating a bullish position on the BFS trust and a bearish position on the British smaller companies trust. If you think you can buck the trend, the choice is yours.

The two example trusts I have used in this article are by no means extreme examples and are not intended to indicate a preference one way or the other. They do, however, usefully indicate a major aspect of investments trusts which investors and their advisers should take into account.

In future articles, I will use other criteria to assess investment trusts in their different forms, contrasting them with other collective investments where appropriate.

Keith Popplewell is managing director of Professional Briefing


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