One of the key lessons with investment trusts is not to buy them when they are trading at a premium to net asset value. Why pay more than the actual underlying value of the assets? Anecdotal support for this comes from recent volatility in Baillie Gifford Shin Nippon (ticker: BGS), the Japanese smaller companies investment trust, which clearly illustrates the dangers of investing at a premium.
BGS has been the best performing Japanese trust in the last few years. Its share price has increased by 32% over the last six months (up to 3 June), easily beating the Tokyo Price Index (TOPIX), which has risen 22% in sterling terms during the same period. The trust’s NAV has increased by 39%, resulting in a widening of the discount from 6% at the end of November to 11%. However, as the chart shows, this doesn’t tell the whole story. Towards the end of December, the share price increased above NAV, and for most of 2013, BGS has traded at a premium to NAV. After peaking at 338p on 13 May, its shares have fallen 29%, despite the fact that the NAV has only fallen 13%.
For a long-term investor, who has held throughout the entire period, the share price gyrations and additional volatility caused by the discount may be of limited concern: they will no doubt be happy with their overall return (although nobody likes to see an investment fall by nearly 30%, however much it has gone up before then). However, the rising market also seems to have resulted in an increase in speculative behaviour.
BGS, in common with other trusts investing in Japan, has seen a big increase in share turnover, from a typical level of around 200 trades per month to more than 1,500 in April and May this year. The value traded has also seen a comparable increase. Some investors have clearly been caught up in all the excitement about Japan. To put this into context, from around 2% of the trust’s market value being typically traded each month, this has increased to around 15-20% per month in the last 3 months. A large proportion of the trust’s shares will therefore have changed hands recently. Whilst the share price is only back to where it was at the beginning of March, some investors will have been seriously burnt. It is not clear to what extent these are retail or professional investors, but the relatively small average trade size suggests the majority are probably retail investors.
This is not a criticism of the trust itself and I do not think it is a bad investment, at the right price. In a sense, it has been a victim of its own success. The volatility is a consequence of the fixed number of shares in issue. High demand from buyers initially resulted in an increase in the share price above NAV; it then rapidly fell below NAV in the last few weeks, as large numbers of investors decided to sell. The volatility has no doubt been exacerbated by the fact that it is a relatively small trust, with assets of only around £90m.
BGS’s experience is not unique. Its larger sister trust, Baillie Gifford Japan Trust, another top performer, went from a discount of 10% to a premium of 6%, and back to a discount of 10%. Other Japanese trusts have experienced a narrowing and then widening of their discount in the last few months, but the swings have not been as great; nor have trading volumes increased to the same degree. The two Baillie Gifford trusts do seem to have been a focus of speculative activity. Indeed, as I am writing this, BGS’s share price has increased by over 9% so far today.
There are two key lessons from this. First, is to try to avoid being drawn into speculation. At one point, the Japanese market appeared to be a one-way bet. Most people knew the market wouldn’t continue rising indefinitely, but they no doubt felt it would continue rising for some time. They probably also thought that they would have the chance to sell when it did peak and didn’t anticipate such an abrupt correction. Where it will go to from here is anybody’s guess. Secondly, when an investment trust is trading at a premium to its NAV, it indicates a high level of positive sentiment towards the manager and/or the market in which it invests. The lack of value support makes it vulnerable if expectations are not met or there is a change of sentiment. In such circumstances, investors are likely to bit hit by a “double whammy”: a fall in the value of the underlying assets and the shares moving to a discount. As I’ve discussed in previous posts (see my article here for a more detailed discussion on profiting from discounts), if a trust is trading at a large discount, it is possible that the discount will widen further, but it is far more likely to decrease: it therefore represents an asymmetric bet. Similarly, for a trust trading at a premium, it is possible that the premium may increase further, but it is much more likely to move to a discount. At some point BGS may well be an attractive investment, if its discount widens further to provide sufficient margin of safety.