Using the Z-score to spot undervalued investment trusts

2 mins. to read
Using the Z-score to spot undervalued investment trusts

One of the attractions of buying investment trusts is that you can often pick them up at a discount to net asset value (NAV). This feels like you are getting a bargain because you are paying less for the shares than what the underlying portfolio is worth, but it can be misleading.

An investment trust that is trading at a 3% discount may seem like it is good value, yet if the shares normally change hands 8% below their NAV they are actually relatively expensive and it could be better to wait.

A good way to judge it is to look at its Z-score, which is calculated by working out the difference between the current discount and the average discount measured over the last year and then dividing it by the standard deviation of the discount over the same period.

The Z-score provides an indication of value against history with a score of -1.5 or less suggesting that an investment trust is cheap and a score of 1.5 or more implying that it is expensive. The calculation assumes that discounts are normally distributed and exhibit mean reversion characteristics.

One area that looks like it could be cheap relative to its recent past is the infrastructure sector. These funds have generated strong returns and offer high inflation-linked income, but they have sold off following September’s Labour Party Conference when it was suggested that a Labour Government would bring Private Finance Initiative (PFI) contracts – where many of these funds invest – back in-house.

According to data from the analysts at Winterflood, HICL Infrastructure (LON:HICL) is trading on a premium of 2.9% compared to its average premium of 11%, while BBGI (LON:BBGI) is available on a 10.9% premium, which is considerably less than its average premium of 15.9%. They both have a Z-score of -2.

The recent increase in interest rates by the Bank of England has also dented the appeal of some of the income-orientated property and debt funds. For example, Standard Life Investments Property Income (LON:SLI) and UK Mortgages (LON:UKML) have Z-scores of -2.4 and -1.7 and could be a bargain if you think that further increases in rates will be slower than expected.

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At the other end of the scale is the Standard Life UK Smaller Companies Trust (LON:SLS), where the shares have moved from an average discount of 5.3% on to a premium of 0.4% following a period of strong performance. The fund now has a Z-score of 3.1.

Other smaller companies trusts with high Z-scores are: Henderson Smaller Companies (LON:HSL), Aberdeen Smaller Companies Income (LON:ASCI), and BlackRock Smaller Companies (LON:BRSC).

Z-scores can be a useful starting point, but they do not tell you how the trust will perform in the future, so it’s always important to look carefully at the fundamentals so that you can make an informed decision.

Each investment trust’s Z-score is published on the Morningstar website and you may also come across them in the financial press. If you decide to use them please be aware that they often change quickly as the discounts can widen or tighten dramatically over the course of a single day.

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