Investment trust enthusiasts could be forgiven for feeling slightly despondent as they contemplate their portfolios and ponder good ideas for their ISA allowances, before the tax year ends on 5 April.

Despite the upbeat editorial coverage and the fact that 2023 was a record year for share buybacks by trust boards attempting to rein in wide discounts, the average investment trust is still trading at a discount to the value of its underlying assets of almost 12%¹.

On the upside, a robust ‘Santa rally’ through November and December meant discounts have narrowed since the end of October, when they were at 16.9% – the widest month-end discount since the financial crisis, according to the Association of Investment Companies (AIC).²

The rally was driven by better news on inflation and growing hopes of interest rate cuts sooner rather than later in 2024; but a marginal rise in inflation in December dampened expectations of any imminent moves by the Bank of England to reduce rates.

As Andrew McHattie, publisher of the Investment Trust Newsletter, observes: “Discounts may not close in meaningfully until interest rates actually start to fall, when investors have a concrete reason to switch back out of gilts and into equities and other real assets.”

But as broker Winterflood comments in its 2023 review, the fact remains that current discount levels could offer a very attractive entry point for canny investors. “There’s the potential for a ‘double whammy’ of improving NAV performance and a positive re-rating when interest rates start to fall, especially if this acts as a catalyst for retail investors to re-enter the investment trust market,” it says.

“It commonly takes a good two or three months of solid gains from strong share prices before sentiment swings,” McHattie adds pragmatically. “When it happens, though, it will likely happen very quickly, and the current malaise will be consigned to history.”

The AIC offers a persuasive historical perspective on the argument that current discounts represent a buying opportunity.

The AIC’s analysis of investment trust returns since 2008 shows that when the average discount exceeded 10%, the average investment trust generated a return of 89.3% over the following five years³.

Which investment trust sectors are offering the greatest attractions? 

So, if you’re keen to bag a bargain with your ISA allowance, even if you then have to bide your time for some months, which investment trust sectors are offering the greatest attractions?

“There are opportunities across the entire closed-ended spectrum, but perhaps no sector offers a more compelling story than UK smaller companies trusts,” observes McHattie.

“They are arguably undervalued against international peers, undervalued against larger counterparts, and undervalued against their own asset values.” This ‘triple whammy’ valuation effect could produce quick, sharp gains when the tide turns and buyers come back, he believes.

The Mercantile Investment Trust invests in quality UK medium-sized and smaller companies. Portfolio manager Guy Anderson says “Mid-cap FTSE 250 stocks have done better than investors think in the recent difficult years, and with interest rate cuts set to boost their low valuations, it’s an interesting time for the sector”.

Anderson notes that while the UK had derated heavily, particularly in his mid-cap hunting ground, the rally in late 2023 was evidence of more positive sentiment as inflation falls.

The Trust’s gearing, at 14%⁴, reflects Anderson’s confidence that the UK small and medium sized companies are set for a revival.

Japan is another area worthy of close consideration by ISA investors, McHattie says. “The underlying fundamentals are backed by corporate change and, critically, by the cheap yen that could provide a tailwind for sterling investors, having been a headwind over the past year,” he explains. Nicholas Weindling, portfolio manager of JPMorgan Japanese Investment Trust concurs with McHattie, noting that “the combination of structural changes taking place in the Japanese corporate sector and the country’s political stability offers attractive investment opportunities for investors.”

What about China?

For Mick Gilligan, head of managed portfolio services at broker Killik, Asia and emerging markets are the most interesting areas for investors willing to take a long view. Both are trading on wide discounts, both in absolute terms and relative to history.

“Part of this malaise is due to weakness in China, as well as in other markets such as Korea,” he says. “The obvious catalyst would be a reversal in the Chinese equity weakness. The Chinese government is making efforts to provide support to the market, and there are rumors of a $280 billion rescue package.”

Gilligan takes a realistic stand, recognising that the global investment community “probably needs to see more wide-ranging reforms and better overall governance in China before making meaningful allocations to Chinese equities.”

Nonetheless, there are clear signs of a disconnect between the market and corporate realities. The MSCI China index currently trades on a price/earnings ratio of 9.2 times⁵ this year’s earnings and is predicted to get even cheaper - yet Bloomberg’s consensus is for average annual earnings growth of 17% over the next three years⁶.

Gilligan argues that in such cases, when a market is sufficiently cheap and earnings growth is good, it's only a matter of time before some catalyst causes markets to pick up significantly.

“It is always very difficult to foresee a catalyst, of course,” he acknowledges. “China was 38% of the MSCI Emerging Market Index in late 2020. That weighting has fallen to 24%, no doubt pushed lower by selling pressure⁷. But if Chinese equities start to perform again, many emerging market funds will be compelled to up their weightings to avoid underperformance. This effect can be self-perpetuating.”

Investing for growth and income

What about prospects for income-oriented investors? How likely are dividend-paying trusts to benefit if and when interest rates come down?

Although big dividend payers tend to have more of a value bias, and it’s primarily growth stocks and sectors that will prosper as a direct consequence of rate cuts, there are a substantial cohort of JPMorgan investment trusts that offer both growth and income.

For example, several of our trusts including JPMorgan Claverhouse, JPMorgan European Growth & Income and JPMorgan Global Emerging Markets Income Trust, among others, have capital growth and income remits, and currently offer dividend yields that exceed 4%⁸.

The environment for the closed-ended sector remains a challenging one, but provided you take a long view and select your investments carefully, with an eye to those focused on high quality businesses with strong metrics, this ISA season could prove a very profitable one in due course.