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Nick Sketch: do the pros outweigh the cons of discount controls?

Nick Sketch: do the pros outweigh the cons of discount controls?

Discount controls are usually not great for an investment manager, because buying back stock shrinks fees.

That may be balanced by the fact that keeping a discount tight can prevent more drastic action that might be worse for the manager’s revenue than a modest trim to fees. However, most of us don’t put the interests of the managers first.

For most shareholders, the benefits look clear, but not all cases are the same. Traders may actively like wide absolute discounts and discount volatility, even if neither helps the long-term owners of the company, but most investors simply want exposure to a good manager without the prospect of a widening discount damaging returns between when they buy and when they sell.

Reducing risks

For a large trust with a liquid portfolio and no debt, buying back stock so supply and demand are met at a tight discount adds to net asset value (NAV) and reduces an unnecessary source of risk to existing holders. It is also cheaper than occasional tenders or more major structural changes.

However, a key lesson of the last decade is that it is vital  investors know the policy and can believe it: a half-hearted buyback policy that is halted at the first sign of trouble or that buys back too few shares is probably worse than useless for all concerned. A trust that opts instead only for opportunistic buybacks risks being viewed (and traded) more like an equity than a collective investment, but if that is the stated policy, at least investors know where they stand.

Even if targeting an explicit discount limit via buybacks is appropriate, the point at which action should be taken will vary. A case could be made for a formal discount control at Alliance Trust and at Templeton Emerging Markets, but the right trigger levels would probably be rather different.

For trusts that are small, buying back stock regularly can make them even smaller, which brings additional risks. Few can afford to research properly a (say) £40 million trust, so a shrinking fund can enter a vicious circle.

More generally, for trusts that invest in smaller companies, private equity or property (as examples of less liquid assets), or those with significant debt, targeting a tight discount via buybacks is often inappropriate.

Several trusts have fixed lives, though far fewer than in the days of splits. Investors will doubtless be offered a rollover vehicle at maturity if there is demand for one, but this route gives a fixed date when investors know they have certainty over the discount. For many long-term investors, this can be enough to prevent discount worries acting as a reason not to own a trust. Critically, and unlike a steady buyback policy and hard discount target, this approach is suitable for smaller and less liquid assets. However, like any other structural feature, it would be surprising if features like this made a trust attractive if one does not have a high conviction in the manager.

At first sight, discount controls look good for the NAV and the discount (so a double-win for the share price), but bad for liquidity. After all, who would sell shares cheap when they can sell to the manager on known terms every month?

Cleaning out weak holders at non-distressed prices won’t itself help liquidity for buyers, though it will help other sellers.

However, a credible discount control mechanism and a credible investment case in combination can produce a virtuous circle. The shares trade at around NAV, so the company can meet demand by issuing new shares or can buy back and cancel if needed, and is essentially behaving rather like a unit trust, but with the benefits of real-time pricing. Thus, if there really is high demand for the shares, then they will either trade at a big premium or there will be consistent issuance of new stock – which can only be good for liquidity.

Witan has bought back nearly half its shares in the last decade or so, but genuinely strong performance and a coherent approach means it now trades at a tiny discount. If demand continues, Witan, led by CEO Andrew Bell, could be issuing stock before too long, and the strong getting stronger should not surprise anyone.

Of course, an increased focus on discount controls may be just one more factor making niche trusts into an endangered species. It may also discourage innovation on capital structures or a focus on less liquid assets. To put it another way, it is usually right when fielding any investment question to answer that the issue is a lot more complex than it appears, and that is certainly true for discount control mechanisms.

Nick Sketch is a senior investment director at Investec Wealth & Investment 

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