27th May 2022
Regular readers and existing investors will know how heavily engaged we are with the investment trust and company sector. As a reminder of our engagement policy, we never enter into an investment requiring activism to generate our required rate of return (which is, at a minimum, a positive real return after charges over the medium to long term). We buy an investment company because we think the investment adviser / manager is skilled and the Board competent. Occasionally though, we do need to engage more heavily and attempt to constructively influence the actions of a Board to enhance shareholder returns in a sustainable fashion. With inflation running at over 8%, we can’t afford not to do this, as achieving a positive real return from investable assets has arguably never been harder.
One fruitful source of return of investing in investment companies is the narrowing of a discount. Reams of paper have been used up discussing and analysing how to eliminate a discount, and I will not attempt to summarise these arguments here. Instead, I will focus on one aspect: share buybacks – perhaps one of the most contentious issues in the sector. Buybacks are contentious as they require a Board to shrink the company / trust. In doing so, they risk reducing the liquidity of the shares over the longer term, but even more saliently they risk the very existence of the trust – if it gets too small, the constituency of potential investors becomes too small and makes the costs of running the trust relative to the asset base far too high. If the trust has to wind up, no more fees for the manager and no more fees for the Board. And yet, the Board are meant to act in the interests of shareholders, and buybacks are very clearly in shareholders’ interests most of the time that a trust is trading at a discount.
The point we make consistently to Boards is to stop tying share buybacks to the discount. The discount is not controllable. It is a reflection of investor sentiment. Sportsmen and women are constantly told to “control the controllable” – one can’t directly impact the result of a football match but one can impact the process. Consistent execution of a successful process will lead to good results. So, it is with investment companies. Boards should not say things like, “there is no evidence that buybacks narrow the discount therefore we won’t consider them”. This is utterly beside the point. If an investment company has the liquid resources at its disposal to implement buybacks, and this doesn’t have other negative investment implications (like a big increase in the LTV beyond acceptable levels), then the decision of whether to buyback or not is about capital allocation. Nothing else. The thinking should be: “what is the best use of shareholder funds to enhance NAV per share for continuing shareholders.” A Board that thinks like this will have a much better chance of running a trust that doesn’t suffer from a discount. When a trust is trading at a discount, the Board can purchase the portfolio at that discount enhancing NAV/share for remaining shareholders in a very low risk fashion. The alternative – giving the funds to the investment manager – relies on that manager being able to invest those funds at a higher rate of return than can be generated from the existing portfolio AT A DISCOUNT. This is as close to a no-brainer as there is. The argument against doing this rarely relates to shareholder benefits. Boards often say the manager has access to great investment opportunities – but they would say this wouldn’t they? Buybacks can reduce liquidity in the shares by reducing the free-float, which remaining shareholders might not like, but this line of argument simply isn’t strong enough. Liquidity would be better if the trust was able to grow backed by a Board that shareholders know will allocate capital efficiently – and traded at a premium.
If a discount persists for a long time despite a Board’s best efforts? Well then, we’re sorry….. sometimes you have to listen to the market. Maybe the best place for the mandate isn’t in the investment trust sector and it should be wound up. The last thing a Board wants to be accused of is perpetuating the existence of a trust at the expense of shareholders to ensure the continuation of a stream of annual directors’ fees. Persistent discounts are not good enough. The IPO investor probably paid a 2% premium, and the loss of value caused by the discount opening from that point to today should be regarded as a deeply regrettable and temporary phenomenon. (It is one reason why we detest z-scores – a measure of valuation that says a trust is expensive if its discount is narrow relative to history. That kind of thinking entrenches discounts.) Unfortunately, other parties in the sector – brokers and the investment managers and advisers are conflicted in perpetuating investment trusts’ existence. I forgot who said it (probably about a thousand people by now), but in sport you have to risk losing to win. The same is true of running investment trusts.
Ben Conway – Head of Fund Management
For professional advisers only. This financial promotion is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. FPC313.