Investment trust discounts are nothing to be afraid of, despite Saba’s claims: THE INVESTMENT ANALYST

Investment trusts offer a world of opportunities to tap into but how can investors sort the wheat from the chaff? In our Investment Analyst column, experts run the rule over what’s on offer.

In this column, Thomas McMahon, Head of Investment Companies Research, at Kepler Partners, looks at how investors should consider activist Saba’s attempt to take control of seven investment trusts.

As a new analyst, I was taught that one of the attractive features of investment trusts was the discounts: you can buy 100p of assets for 80p, and boost your returns when the discount closes.

This meant it was a surprise to meet managers for the first time and discover that many of them were embarrassed about trading on a discount.

While I thought I was seeing an exciting opportunity, which added to the case for buying the shares, they viewed it as a judgement on their performance or the attractiveness of their strategy.

I think this is a consequence of the psychological quirk that makes investing so difficult: we tend to view a high price as evidence of success and a low price as evidence of failure.

We instinctively feel that a high price means other people value the good in question, and a low price means they don’t. This explains some baffling facts such as the existence of ‘bling’.

Viewed from this perspective, a discount is evidence you are unwanted and unfashionable.

If a trust is trading on a discount, it must be because other investors know something you don’t, and that is why they are steering clear. But this is usually nonsense.

Discounts are generally dependent on much more boring things to do with the investor base’s behaviour and preferences.

Discounts have been wide in the investment trust sector since 2021 for a simple reason: you have been able to get decent returns on cash accounts and everyone has been convinced the sky is about to fall in economically, so they don’t want to be invested in risky assets.

There’s really not much the board of an investment trust can do about that.

But this is the logic behind one of the charges laid by hedge fund manager Saba Capital, headed by Boaz Weinstein, against the board of seven investment trusts it is seeking to take control of: Baillie Gifford US Growth, CQS Natural Resources Growth & Income, Edinburgh Worldwide, European Smaller Companies, Henderson Opportunities, Herald and Keystone Positive Change.

Saba has built large stakes in these seven trusts, allowing it to force boards to call a meeting to vote on its resolutions: sack the boards, appoint Saba in their place, sell off some or all of the assets and return a part of the proceeds in cash to shareholders.

Any remainder would sit in a Saba-managed fund, which would have the strategy of buying other trusts, winding them up, rinse, repeat.

The seven investment trusts that Saba Capital is seeking to take control of

Saba is on the attack over discounts

One of Saba’s main criticisms is that the boards have not done enough to tackle persistent discounts.

The truth is, though, that there isn’t always that much a board can do without going nuclear. They can buy back shares, but there is patchy evidence that this delivers meaningful narrowing of the discount. Sometimes an improved dividend offering can have a marked impact.

Ultimately, a board can offer a full cash exit, which raises the possibility that a trust might fold if enough shareholders vote to exit – this wouldn’t have to be all, but just enough to make the economics or the strategy hard to maintain.

There are good reasons not to do this, however. Winding up the trust means that the ability for others to invest in the strategy and benefit from any NAV growth and future discount cycles is taken away. For this reason, boards view it as an absolute last resort.

There will be many thousands of investors in each of these trusts who like the strategy and want to benefit from any NAV gains, plus the gearing that trusts can take on to boost returns, plus perhaps any discount narrowing as the icing on top.

Moreover, any investment strategy should be judged over a reasonable period of time, and so boards mustn’t over-react to a period of underperformance from a manager. So, I don’t think it is bad governance to be slow to push the red button.

Discounts don’t matter for long-term investors

Something that I think is missed by the Saba criticism of persistent discounts is that they don’t actually matter from a long-term shareholder perspective.

You pay the share price when you buy and you receive the share price when you sell, and the longer you hold for, the less impact any discount movement has on your returns.

You are not being short-changed if the share price is lower than the NAV per share – what matters most is the price at which you bought.

Consider some of the top performers in the investment trust sector over the past decade. Oakley Capital Investments has delivered a share price total return of 278 per cent over 10 years. This means if you had invested £10,000 in January 2015, you would now have £37,800.

CT Private Equity has done almost as well, with returns of 262 per cent.

But over this period, Oakley’s discount has moved from 23 per cent to 28 per cent, and CTPE’s from 22 per cent to 28 per cent.

The discounts have actually marginally widened, but this has been irrelevant in the grand scheme of things.

And actually, a similar point can be made about Herald, one of the trusts Saba wants to take control of. Over the 10 years to the end of last October (before a sharp narrowing of the discount as Saba’s stake emerged), the share price total return was 203 per cent while over this period the discount moved from about 17 per cent to about 12 per cent.

What this illustrates is the genuine balancing act for boards to strike between the short-term interests of shareholders – a 12 per cent discount closing to par is a nice, immediate 14 per cent gain – and the long-term interests.

This really requires an assessment of how attractive you think the long-term returns are likely to be to a strategy, with the discount being a secondary consideration. 

If boards simply wound up anything on a stubborn discount, investors would have been unable to invest in the three trusts just mentioned, and benefit from the striking returns.

So, while some of Saba’s points are well-made, I think their claims about discounts reflect their relatively short-term approach.

For persistent, wide discounts, conditional tender offers – whereby 15 per cent or 20 per cent of the shares are redeemed close to par, but the existing strategy continues – are a well-worn strategy that might be preferable to a full cash exit or change in strategy. 

This allows the board to test whether the discount is preventing shareholders who want to sell from doing so. And if assets dwindle over time, a wind-up may then be for the best.

Discounts can fit some trusts 

Additionally, I think these examples illustrate that often a discount can be considered appropriate by the market. Both OCI and CTPE invest in private equity, and the discounts could reflect the fact that portfolio company valuations, and thus the NAVs, are estimates – private equity prices are only proven at exit.

Saba has targeted trusts that invest in listed equities, but you can make a reasonable case that even these should trade at a discount in the normal state of affairs.

Trusts are generally themselves small or mid-caps, which means liquidity in the shares is relatively low.

For any large investor, if they wanted to sell in size, they would likely to have to accept a lower price, so discounts could be seen as reflecting this.

Furthermore, trusts tend to use their immunity from inflows and outflows to invest in less liquid assets, whether that be smaller equities, private companies or unlisted assets.

So, you could argue this illiquidity means the price is less certain and so a discount is appropriate in the normal course of events.

Boaz has himself referred to this illiquidity as justifying the use of an investment trust structure to house his proposed fund of investment trusts.

Logically, we might expect Saba’s London-listed fund of investment trusts to trade on a discount, as do the closest comparator funds. And so while he makes the valid point that if he loses the votes, discounts on the trust are likely to widen, this may well happen if he wins the votes too.

Perhaps we can look forward to notifications from the board of that future fund about how they are considering the use of cash for buybacks against the other attractive investment opportunities, but have decided to hold fire for now to balance the long-term interests of shareholders with the potential short-term gains?

Targets: Saba Capital is run by the activist investor Boaz Weinstein

Saba’s aim is wide of the mark 

Lots of the criticism of Saba uses the term ‘opportunism’ pejoratively. I think though, that what Saba is doing is what all investors are trying to do, which is make money by leveraging the quirks of the structure, so criticising them for seeking to take advantage of wide discounts seems to miss the mark.

Saba’s list of targets is certainly questionable, though. Lots of the obvious candidates for wind up or restructure in the space have walked out into the blizzard alone already, with 2023 and 2024 seeing a ruthless culling in the sector as boards of many of the obvious under-sized or under-performing trusts merging or winding up their companies.

While some of the trusts targeted have performed badly for some time, European Smaller Companies Trust seems particularly poorly chosen given its strong performance versus the benchmark over short and long time periods.

ESCT also has a continuation vote due in September which would give shareholders the chance to vote for an exit.

With 29 per cent of the shares, Saba would be able to influence any board action around the vote in a few months’ time – so to force the board’s hand now seems to indicate a short-term mindset. Indeed, its actions seem timed so as to benefit Saba’s plan of gathering assets for a fund of funds, rather than to benefit ESCT’s other shareholders.

It is also regrettable that the board of Henderson Opportunities Trust seem to have decided to wind up the company following buying from Saba, before Saba revealed their end game. Saba can indeed point to poor recent performance, but HOT has long been known as a great way to play a rallying UK market, which, admittedly, is something we haven’t seen for some time.

HOT’s aggressive positioning, high level of gearing and tendency to swing from a discount to a premium was a great way for investors to get punchy access to a bull market, with the wide discount during poor markets part of the attraction (as it led to the opportunity). Good night, sweet prince.

Whatever you think, make sure you vote 

Investors in the trusts under attack by Saba have an interesting choice in front of them. 

They all trade very close to par at the time of writing, meaning that it might be tempting to book the short-term gain on top of what has hopefully been good long-term returns too.

Probably the best approach, though, is to think about what you want to be invested in over the next five years: the existing strategy or Saba’s proposed trust, the details of which are sketchy.

Importantly, Saba has not committed to a full 100 per cent cash exit for any of the trusts except one (Herald) and has not given a percentage they might offer. 

So, a vote for Saba seems to commit you to at least some of your cash remaining invested in a Saba fund until it lists and you can sell your shares into the market (which is how the discount would likely open up). 

Indeed, these terms are worse than those proposed by the boards of Keystone and Henderson Opportunities, both of which have made 100 per cent cash exit offers.

Whatever investors prefer, they should participate in the votes. Voting is typically lower in trusts where there is a higher proportion of retail investors on the register – like those targeted by Saba.

The investment trust structure offers investors a say in the future of their company, but like a vote in a political election, this means nothing if it isn’t used.

Investors should take the opportunity to make their voices heard rather than let others speak for them.

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