29 Sep Investment Company Discounts
Can the ‘investment company discount’ be further reduced if companies were able, at least in part, to buy-back and issue shares on demand to investors at their intrinsic value rather than having the price of their shares set by the auction process on an exchange and actively market this to investors and shareholders?
A while ago we wrote about what motivates companies to unbundle some of their investments. One of the objectives cited by the unbundling companies was the desire to simplify their group structures and to increase their focus so as to facilitate an improved understanding by investors. In other words, they are attempts to reduce what is referred to as ‘information asymmetries’ that lead to a fairly sizeable difference between the company’s share price and the combined fair value of its underlying assets. This discount is the amount by which the company’s share price is less than the sum of the fair value of the company’s investments net of debt.
Unit trusts, unlike companies, do not suffer from such a discount as they are bought and sold at the aggregate value of their investments attributable to each unit in issue net of applicable fees. Their units are however not sold on an auction basis on an exchange but are issued and repurchased by the fund in accordance with the terms of the relevant trust deed and prevailing market regulation. Is this the primary reason for the differences in valuations?
Not a recent nor South African phenomenon
‘Investment company discounts’ are neither a recent nor South African issue. In 1966, Eugene J. Pratt, then Vice President and Director of Investment Research at Niagara Share Corporation of Buffalo, New York, published an article in the Financial Analysts Journal entitled: “Myths Associated with Closed-End Investment Company Discounts”. In his article, Pratt notes that closed-end investment companies generally trade at a discount to their asset value whereas mutual funds typically trade at their asset values, excluding any fee paid to the investment advisor. Pratt attributed this discount to six myths, namely, a going-concern capital gains tax liability; a liquidation scenario capital gains tax liability; the cost of management; the company’s performance; the redemption factor (the fact that shares are not repurchased but traded on an auction basis); and the sales effort (the number of advisors actively selling the company’s shares). His contention was that if an investment company has a satisfactory performance record, there is no mathematical or logical reason why a discount should prevail. He concluded that this discount was “primarily the result of a lack of sales effort and public understanding”.
There are not many investment holding companies listed on the Johannesburg Stock Exchange that have an investment portfolio akin to an actively managed general equity unit trust. Furthermore, an effect of International Financial Reporting Standards (“IFRS”) is that an investment company’s asset value or book value is often not a reliable reflection of the fair or market value of its assets or investments. Remgro, arguably South Africa’s best-known investment holding company with an investment portfolio that covers multiple sectors, and one that we covered in our article on ‘unbundlings’, publishes the ‘intrinsic’ value of its investment portfolio for each reporting period.
In terms of Remgro’s analysis, its shares have over the last three financial years traded at an average discount of 22.54% to its stated intrinsic net asset value. This is after adjusting for potential capital gains tax liabilities. On Pratt’s analysis this attributes the discount to the cost of management, the company’s performance, the redemption factor and selling effort.
Unit trust portfolios
As far as unit trusts are concerned, the Local Investment Platform Fund List published by Allan Gray as at 2 June 2020 shows that in respect of general equity, actively managed, tier 1 funds with performance-based fees, the latest available total investment charge or TIC ranges from 0.82% to 1.22%. If this is what the investment market is prepared to bear, then it is probably not unreasonable to assume that the Remgro portfolio should bear a similar “cost of management”, bearing in mind that this should include the fee paid to an investment advisor for promoting the share to investors. This attributes a significant portion of the average 22.54% discount to company performance, the redemption factor and selling effort.
The question is then, could the ‘investment company discount’ be further reduced if companies were able, at least in part, to buy-back and issue shares on demand to investors at their intrinsic value rather than having the price of their shares set by the auction process on an exchange and actively market this to investors and shareholders? It seems legally possible to provide for this, assuming that solvency and liquidity requirements can be met. Compliance with stock exchange rules may however pose challenges.
Company performance and selling effort
This, in theory, would then leave the ‘investment company discount’ to intrinsic value only being attributable to company performance and selling effort. The “selling effort” is no doubt directly impacted by factors such as liquidity and public spread. However, has the demise of the traditional stockbroker and their replacement by a financial advisor incentivised by financial product providers through commissions and rebates not a contributing factor?
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