Investment trusts are currently so cheap that what would normally be considered extreme discounts are failing to excite even the most ardent of bargain seekers. Indeed, it would be unsurprising for potential investors to dismiss any listed fund that fails to trade at a double-digit discount, such is the abundance of ultra-cheap opportunities available.
However, in Questor’s view investors must look beyond price when they are deciding which investment trusts to buy. Certainly, some ultra-cheap funds are worthy purchases, as we have highlighted in recent columns, but other trusts that trade at narrow discounts or even at modest premiums are also attractive when their records are taken into account.
For example, Merchants currently trades at a 0.2pc premium to net asset value but has generated a 48pc total return over the past five years. This is more than twice the 19pc total return of its peer group and makes it a “top-quartile” performer – in other words, it has outperformed at least three quarters of its rivals.
Its recent performance is particularly impressive in view of its focus on British stocks at a time when they are unpopular with investors in every corner of the world. And while it is an income-focused trust – it aims to deliver above-average income and income growth – it also seeks long-term capital gains.
Indeed, despite its lack of the wide discount some rivals offer, the trust offers scope for significant capital growth. Over the past five years its premium has been as high as 18pc, which suggests it currently offers good value for money. And now that the prospects for the economy are widely forecast to improve as inflation falls to the 2pc target and interest rate cuts begin, the outlook for its holdings is likely to strengthen materially.
Currently, 36pc of the trust’s assets are members of the FTSE 250 index of medium-sized companies, which tend to be relatively reliant on the performance of the domestic economy. Its major holdings, though, are familiar FTSE 100 names such as GSK, BP and WPP, which are more exposed to the global economy.
As inflation and interest rates are expected to fall in America and Europe too, the environment for Merchants’ multinationals is also likely to improve.
The trust’s performance should be further boosted by its “gearing” or borrowing, which stands at 8pc of assets. While this may put off investors who are averse to short-term share price volatility, longer-term savers are likely to benefit from the fund’s debt-enhanced returns as looser monetary policy prompts a return to higher rates of economic growth globally.
A stronger global economy also means the trust’s dividend growth rate is likely to improve from its current average of 2.2pc a year over the past five years. While this figure lags inflation of 3.3pc a year over the same period, the trust’s dividends have risen uninterruptedly for the past 41 years.
Such reliability, tied with the prospects for future growth, gives the trust strong income appeal, not least because the dividend yield is already 5.3pc at the current share price.
While it is possible to obtain a similar yield from bonds or even cash, those assets do not have the potential for capital gains or dividend growth offered by the trust. And the fund’s contrarian, “value”-focused approach puts it in a strong position to capitalise on today’s depressed share prices if we believe a more sanguine period lies ahead.
Clearly, the trust’s share price rise of just 4pc since we tipped it in February 2020 is disappointing. But Questor firmly believes that it continues to offer a potent mixture of capital growth and income appeal on a long-term view as shares, particularly those listed in London, finally deliver on their potential.
When this will take place is anyone’s guess. And while there are far cheaper trusts available through which to take advantage of any upturn in British shares, Merchants’ impressive record, sound strategy and income potential make it worthy of its relatively high valuation. It therefore remains an excellent purchase for new investors.
Questor says: buy
Ticker: MRCH
Share price at close: 525p
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