Z scores for investment trusts

Should You Use Z Scores For Investment Trusts?

Whether an investment trust is trading at a discount or premium, and what sort of level it is, is one of the key metrics you’ll see mentioned when a fund is covered in the financial press. While it’s important, it’s usually a secondary investment consideration in my view, and you do need something to put it in historical context. Z scores are designed to provide this, so are they worth using as part of your research?

A refresher on premiums and discounts

I’m going to delve deeper into premiums and discounts in later articles but, in short, they are the difference between the value of an investment trust’s assets and the share price which it trades at on the stock market. An investment trust that has a share price in excess of its net asset value is said to trade at a premium, while the reverse is a discount.

Most investment trusts trade at a small discount to net assets, but popular trusts can trade at a premium for extended periods of time. What’s more, the level of the discount or premium will change from day to day as the share price moves.

Net asset values tend to be updated on a more infrequent basis. Some are updated daily, by others are updated monthly, quarterly, or even every six months. So be aware that you often not comparing like with like, in terms of how up to date the two figures are.

You also get situations where the net asset value is only partially updated. A private equity investment trust I hold, HG Capital (HGT) does this. It publishes month-end net asset values, but usually just updated for things like exchange rate movements, recent sales, the market value of any quoted investments. Its main unquoted portfolio tends to be fully revalued only every six months.

So, some net asset value figures can be more informative than others.

How Z scores are calculated

All that said, you’re likely to see that the discount of an investment trust will vary a fair amount over the course of a year. Between 5% and 15% is fairly typical I’d say.

You can see this represent graphically on sites like the AIC, but Z scores allow you to be a little more scientific. They take the average discount over the past year and measure how much it has varied using its standard variation. They then compare this to the current discount level.

This calculation spits out a number. As a rough guide, a Z score of +2 or more is said to be expensive, while -2 or less is said to be cheap. If the movement of the discount over time follows a normal distribution (the classic bell curve shape) then the Z score should only be classed as cheap or expensive 5% of the time.

Z scores can be measured over any time period, but one year seems to be the standard measure on sites like Morningstar. That’s a fairly short timeframe I think, especially as you can see periods of a few years where an investment trust’s discount will steadily move in one direction or another.

Handy for top-ups, perhaps

I can see the virtue in using Z scores when you are looking to make a top-up investment and you’re choosing between several funds that you already hold in your portfolio. If there seems to be little between them, then a wider than average discount could be a useful tiebreaker.

But I would still like to make sure the net asset value the Z score is based on is nice and fresh and doesn’t relate to a valuation made several months ago. For sectors that are valued infrequently, like property and infrastructure, Z scores are of more limited use. I’d also like to take a closer look at the trust in question, to see if there was an obvious reason for something appearing to be cheap.

So, I’d say Z scores are ok as long as you are aware of their limitations. Like all investing metrics that boil down to a single number, they can only tell you so much and are best considered as just a single piece of a much larger jigsaw.


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