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How discounts work in your favour

One of the many positive features of Investment Trusts is that generally you can buy them for less than they are fundamentally worth, sometimes.  There are two main benefits to this; first, you have the opportunity to make a larger profit and second, you enjoy a higher yield, greater dividend, while holding the shares.  Let me demonstrate this with some examples.

Let us say that ABC Trust is worth £1.20 per share, that is the Net Asset Value (NAV).  However, at the moment the share is not as popular as it used to be and the price in the market to purchase a share (the offer price) is £1.00 which translates into a 16.7% discount.  You buy £10,000 worth so, ignoring fees etc., you end up with 10,000 shares.

GREATER CAPITAL RETURN

If you had purchased them at £1.20, as it would have been with a Unit Trust or OEIC, you would have only received 8,333 shares, but the value on day one would be the same.  Two years on let’s say the trust now has an NAV of £2.10 but you can sell it for £2.00.  The discount is said to have narrowed as it is now less than 5%.  You sell all the shares.  Your profit is £10,000 (10,000 x £2) less cost of (10,000 x £1).  This is described as a 100% gain.  However, if you had done this based on the NAV, like a Unit Trust of OEIC, then your gain would only be £2.10 – £1.20 x 8,333 = £7,500 or a 75% gain.

Quite a difference!  Not only do you gain from the narrowing of the discount but you also accentuate this by holding more shares.  This leads me on to the second point.  Let us assume that ABC Trust was paying a dividend.

HIGHER YIELD

Let us assume that when it was £1.20 to buy it was paying a dividend that was 4 pence per share (pps).  This would equate to a yield of 3.33% on NAV or on a Unit Trust basis but if purchased for a pound the yield is higher.  This is because you end up with more shares and as dividends are expressed as a number of pence per share you receive more cash for your initial outlay.  In our case the yield would be 4% (£0.04 / £1.00).

This can also be worked out in monetary terms; 10,000 shares x £0.04 = £400, your annual dividend. Then £400 divided by initial cost of £10,000 gives a yield of 4% p.a. This yield is locked in throughout the life of the holding in so far as all the while the dividend is 4pps you will receive a return of 4% each year in terms of income.  Even when the price is £2 per share and the papers show a yield of 2% you will still receive 4% as the dividend is unchanged at 4pps.  The yield of 2% is for those who are buying the share that day.

These two points can now be combined to form a superior Total Return, namely a combined return of income and capital performance.  So in our case the return is 108% versus the Unit trust total return of only 81.7% over the two years.

This is what we strive for but it may not always happen.  Discounts can be there for a very good reason and may not narrow, indeed they may widen.  One thing for sure though is that it is far harder to achieve this increase to your growth or income if you purchase a holding at a premium (paying more than it is worth).  Currently good solid income providing trusts have been at about 5% premiums for the last few years.  This may be maintained for a few more years or it might not, and a fall from a 5% premium to a 10% discount is a 15% detraction from whatever the actual NAV has managed.  If the NAV falls during this period the result is very damaging to a portfolio.  Investment Trusts can also borrow or gear the trust which adds a further accelerant to the mix.

It is advisable to use the services of a financial adviser who specialises in Investment Trusts before investing in them.  Why not give me a call on 01306 630001 to discuss this further?

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