Once a year, our quarterly letter to clients is written by co-founder and Investment Director, Can Esenbel:
“The paradox of risk-taking is inescapable. You have to take it to be successful in competitive high-aspiration arenas. But taking it doesn’t mean you’ll be successful; that why they call it risk.” – Howard Marks, Oaktree Capital
We know that we don’t know. Will the US continue to outperform? Don’t know. Will gold carry on rising? Don’t know. This is not to be without views but to remember they are not truth. This is an integral element of our investment DNA. It forces us to stay open-minded and focussed.
The market environment is more dangerous than most investors appreciate. This danger is latent most of the time, but like living on a tectonic fault line danger is ever present. Success should not be dependent on us getting it right or exposure to unnecessary risk – we target success while minimising chaotic volatility.
This isn’t great as a marketing message, but in my eyes, this is the most responsible way for us to invest for you.
We have one portfolio style that is anomalous: the Tactical Adventurous portfolio. It is controlled aggression, forceful and opinionated. Unlike our other portfolios, it adopts a bottom-up approach; focussing on secular trends, themes, and special situations. The aim is to earn excess returns that aren’t dependent on increased volatility or exposure to tail-risks. It isn’t a portfolio that is appropriate for most.
I bring it up as it allows me to talk about the segment of the market that is most fascinating to me currently: UK investment trusts.
Investment trusts are listed investment funds. They trade like a normal share such as Astrazeneca or Unilever, but their business is not pills or soap but investments. Their closed-ended nature makes them great vehicles for more illiquid assets or for a manager with a long investment timeline. Not having to worry about redemptions, they can, for instance, employ counter-cyclical strategies instead of having to sell because of redemptions during weak markets. It’s a big advantage compared to open-ended funds (unit trusts or mutual funds as they are often known).
When investors sell their shares, it is the share price that is affected. Thus, the price may diverge from the investments' net asset value (NAV). In a balanced situation 100p of assets would result in a 100p share price but this rarely happens.
In the chart below for Smithson Investment Trust you see that until 2022 it traded at a small premium to net assets but has since fallen to a discount:
Valuation for an investment comes in two parts – what we pay and what we believe it is worth (a figure higher than the price we paid). Time will tell us if our view becomes consensus or not.
With an investment trust we know the value of the company, it’s the NAV. This makes them far cleaner to study than a normal company. It is rare though to see an investment trust sell at a small discount or premium; they tend to fluctuate, sometimes dramatically. This can be for valid reasons, of course. The NAV can be wrong or hard to value or there may be an issue at the company that warrants caution.
But there are many instances where the trust holds liquid, marketable stocks and still sells at a discount. This table back in February 2024 from the Association of Investment Trusts highlighted the trusts that held Nvidia, the most popular stock this year:
All the above are selling at discounts to their NAV. We can dig deeper and look at the top ten holdings of Polar Capital Trust below:
I would say that if we accept mega cap tech is the place to be then this fund shouldn’t be selling at a 10% discount. The fact that these trusts sell at a discount suggests structural issues within the trust sector. I won’t delve too deeply into what they are. The main relevance to us is whether they will persist?
We start with “yes” as a default answer to this question. This suggests that a) discounts are larger than can be explained by the value of the assets held and b) this is likely to persist until something forces a change.
Our investigations have led us to investment trusts that have the potential to grow their assets at a decent clip and are selling at significant discounts to their NAV. Discounts are particularly large for investment trusts that are small, and those with underlying assets that are hard to value. Funds selling at 40p-60p per 100p of assets are not uncommon.
That level of discount suggests consensus is that the NAV will fall significantly, and that the possibility of growth is a dream. Our inkling is that price weakness and discounts are not all about asset quality. They are also about structural issues. If so, the probability that the assets are not duds is higher than the price suggests.
Should NAV growth resume and narratives change then a fund selling at a 60% discount can benefit from both a growing NAV and a discount that has a chance to narrow. The mechanisms that depressed the price start to work in the other direction.
George Soros explained this to the FT back in 2009:
“Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people lose faith, but the prevailing trend is sustained by inertia… Eventually a point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.”
If our fund example resumes NAV growth at 10% per year for the next 5 years and the discount slowly closes, we’ll earn a return of well above 10% per year. Those extra returns have not come from superior returns generated by the manager, they come from the discount closing. This is enormously powerful – leverage without the downsides of leverage.
A sensibly constructed portfolio of opportunities with this type of payoff profile will, in time, do well. As Howard Marks wrote in the quote at the start, we must take risk to have a chance of success but taking risk is not a sure thing. An investor can do everything right and not succeed; conversely, they can make poor choices and hit the jackpot. On an individual basis everything is possible.
But some paths provide a higher probability of success than others. Part of that is good analytical skills, part is understanding the nature of the environment and part is putting it all together. Weakness in any of those components introduces fragility; conversely if our foundation is solid then we create the potential for higher returns derived from skilful action where good luck adds to returns rather than defining them. That is our goal in all our activities.
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