The experience of the past two years has fully vindicated that advice, while at the same time creating exceptional opportunities for those who do understand and appreciate how discounts operate.

What do we mean by a discount as the term applies to investment trusts? We mean the gap that can appear between the share price of an investment trust and its reported Net Asset Value (NAV) per share. When the price of a trust’s shares is below the published NAV, it is said to trade at a discount. When the share price is higher than the NAV, on the other hand, it is said to trade at a premium.

Unique to investment trusts

The existence of premiums and discounts is a unique feature of Investment trusts, and one of the characteristics that marks them out from unit trusts, OEICs and other types of so-called open-ended funds, which always trade around asset value. There can be significant changes in the way that discounts and premiums move. Today, fewer than a dozen of the 300 odd trusts that I follow regularly trade at a premium, whereas two years ago there were literally scores of them.

In fact, the average discount across the investment trust universe has widened dramatically from an all-time low of just 2% at the start of 2022 to 16% now (and it was as wide as 19% at one point last summer). We call a period of general widening discounts a derating. Since 16% is just an average, it means that many trusts by definition have experienced an even greater derating than that since the first quarter of 2022.

Trusts in the so-called alternative asset areas of the market, such as renewable energy, infrastructure, private equity and commercial property, have experienced the worst of it, with a number of trusts selling on discounts of more than 50% to their most recent reported NAV. Traditional all-equity trusts have also seen discounts widen, but not to the same degree. The days when popular or well performing trusts were able to grow in size by issuing shares on a regular basis - something that is only allowed when shares are trading at a premium, as many were before 2022 - are gone for now.

Mismatch between supply and demand

If you boil it down to basics, the existence of a discount is simply the product of a mismatch between supply and demand. If there is a shortage of buyers, the share price can easily fall to a discount. If there are more buyers than sellers, it may well trade at a premium. To that extent the discount is a function of market forces.

Another factor, more pertinent to alternative asset trusts than conventional ones, is that the reported NAV may be wrong, or at least investors think it is. Offices, factories, wind farms and railways take time to build, buy and sell, so the NAVs of trusts that invest in them are typically based on periodic expert valuations, rather than daily stock market prices. They can be out of date and slow to adjust to changes in market conditions.

Impact of higher interest rates

What is very clear is that the most important factor driving discounts wider recently has been the impact of higher interest rates. There is a clear and logical correlation between the cost of money and the level of discounts. Higher interest rates make cash and gilts more attractive alternatives for income investors and draw investors’ money away from trusts which sell primarily because of their higher dividend yields. Higher interest rates also increase the financing costs of trusts which use debt to enhance their returns.

Is it possible to control discounts? Boards of trusts do have a number of options for trying to bring supply and demand for their shares back into balance. One way is to restrict supply by buying back an investment trust own shares, either in the open market or by giving shareholders a periodic tender or redemption offer (and in the last resort winding up the trust altogether). Such discount control policies have become much more common and can be effective, though not instantaneously. Alternatively, boards can redouble their efforts to stimulate demand through better marketing and communications, or by demonstrating that their holdings are worth more than the market thinks, for example with a successful asset sale.

Potential for seriously good bargains

We have seen examples of all that and more in the last 18 months. A period of wider discounts undoubtedly hurts shareholders by reducing the current value of the trusts they own, but the chance to buy anything priced at £1 for just 80, 60 or even 50p can also create seriously good bargains. Experienced investors who understand that there is a cycle in discounts, just as there is a cycle in financial markets, know that the way to make the most money out of investment trusts is to buy (or add to holdings) when they are trading at unjustifiably wide discounts and sell (or trim existing holdings) when premiums instead are commonplace.

Be aware however that it can take time for the cycle to play itself out and timing it successfully is no easy matter. While one can confidently predict that discounts will not remain as wide as they are now forever, there is nothing wrong either in simply sitting back and riding out the latest wave in the discount cycle, sure in the knowledge that the traditional strengths of the investment trust structure will again come through as the cycle corrects itself over time.

Jonathan Davis is the editor of the annual Investment Trusts Handbook and the Money Makers podcast and newsletter (www.money-makers.co).