When things look really bad in the markets, buy investment trusts.

Last week I found myself in front of a presentation for an interesting fund. It was an investment trust established to buy other investment trusts which trade at a significant discount (Don’t worry, I’ll explain all the terminology in just a second).

The presentation threw up some really interesting points (the first of which was that I should probably steer clear of this particular fund, but that’s a story for another day).

And there were some great points of investment principle. Especially for anyone, like me, that likes to buy at a discount.

How it all works

Investment trusts are the original pooled investments – they go way back to Victorian times . They allow investors to want to buy into a diversified portfolio, managed by a professional team of investors.

Investment trusts are formed as individual companies and traded on the stock exchange like any other share. The only difference is that these companies are set up solely for the purpose of investing in other shares.

But the thing about these trusts is that they can trade at a valuation which is different to the value of the investments of which they’re comprised. And they often trade a discount to their underlying assets.

Needless to say, this can throw up interesting investment opportunities. If I can buy trust at 70p, yet I know it’s got a pound’s worth of assets, then I’m going to be tempted.

Lesson one: a contrarian indicator

Investment trusts can be a great bellwether for pinpointing overvalued sectors.

No investment fad passes the City by. If there’s a real estate boom, you can be sure real estate trusts are cropping up. The dotcom era saw its fair share of pooled funds set up to take punters money, that’s for sure.

As you can imagine, when these investment trust are floated, there’s no discount available. Nobody’s going to sell you a pound’s worth of assets for anything less than a pound.

But as time goes on, investors that want out need to sell the stock in the market. And like any other stock, the price is a pure function of supply and demand.

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Trusts in the former ‘faddy’ sectors can trade at massive discounts, even as low as 30p in the pound!

Lesson number one, then: popular new investment trust issues can be an indicator that a sector is overvalued.

(In fact, only a few months ago I warned that this was precisely the problem with fresh issues in the utilities and energy sector. Needless to say, many of these funds have subsequently crashed.)

Lesson two: when to buy investment trusts

Cast your mind back to the crisis years of 2008/09. Investors were scared – very scared! There were certainly more sellers than buyers in the market for investment trusts. Discounts were massive.

Essentially, what the market was saying was: “We think these markets will fall further, we’re discounting it into the price.”

But this makes little sense to me. Next day the market could go up, or down. Why should the investment trust suddenly factor in, say, another 20% discount on top of recent market falls?

As you can imagine, when the markets turn around, so the discount narrows. So essentially, investment trusts do particularly badly in savage markets. But the upside is that during the good times, they can perform very nicely indeed. Not only benefiting from the rising market, but the closing of the discount too.

That’s my tip for the day. If you’re a contrarian investor, like me, you like to buy at the point of maximum pessimism. And that’s a good time to look out for deeply-discounted investment trusts.

This article is taken from our FREE daily investment email, The Right Side

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