If upon entering a grocery store, someone were to tell you that pork is cheap, and you yourself were already inclined to purchase a pound or two of pork, you might head over to the butcher's counter to check out the price of pork. If this someone were to then subsequently shout out to you "yes, it's cheap! Cheaper than the ballpoint pens over in aisle five", well, you would probably assume these were the ravings of a lunatic, chuckle to yourself, and go about your business.
Cheap is a relative term. Cheap compared to what? There has to be another price against which we can make a comparison. Is pork cheap compared to where it was priced last week? Is it cheap compared to other animal protein, such as a pound of beef? Most importantly, if you come at it from an investment standpoint, is it cheap compared to where it will be priced next week -- when you actually might actually need it for a family dinner?
Purchasing Pork Similar to Purchasing an Investment Trust?
It's the last question that, in my experience, trips up investors time and again. We can't know definitely--and most of us would say even remotely--what the future holds. We don't even know what the price of pork will be next week. So, how can we, as investors, have any certainty what the price of our investments will be worth next week, let alone next year or five years from now?
Investors who use investment trusts (aka closed-end funds or CEFs) often make comparisons akin to figuring out the price of pork. In investment trust investing, there are at least two mistakes investors make all the time. First, they get too caught up in the discount and premium price of a trust. Second, they fail to look at the proper relative relationship when seeking an investment trust. Let's make sure you don't fall into this trap.
For our research purposes, we use Morningstar categories to group funds together and ensure a like-for-like comparison among peers, but when it comes to analysing some closed-end specific characteristics, such as discount and premium trends, we narrow down the peer group to only the AIC sectors, which include only closed-end funds. Indeed, a trust’s discount will only have meaning if you look at it on a relative basis, either relative to its own history or its sector (or both). It is similar to looking at stocks.
For example, deciding to invest in 
General Electric (GE) because its book value is far lower than that of Facebook (FB), while true, doesn't really make any sense. Such a decision would illustrate a careless disregard for not only portfolio construction but also security analysis. Yet, when it comes to investment trust investing, this occurs all of the time. People argue that the long-term discount to net asset value (which, of course, can be seen as price-to-book value) of all trusts is 9%, and since a certain fund is trading at a 15% discount, it must be a bargain. If such folks would simply step back and look at the larger picture, they'd realise they are making a poor comparison.
Comparing Discounts at Investment Trusts
Likewise, two funds might trade at the same level of discount but that would not necessarily make them an equal bargain. Let’s review a quick example by looking at the City Natural Resources trust (CYN) and the International Biotechnology trust (IBT). As of March 8, both were trading at an 18% discount to NAV. But once you compare them with their respective AIC peer groups, you realise that the former fund was trading at a narrower discount than its sector average over both the short- and long- term, while the latter was trading at a wider discount than its sector. On that basis, only IBT would be a bargain. Of course, in reality there is much more that would have to be analysed to arrive at this conclusion. But that's a good place to start.
Successful investors have all, over time, created their own methods for choosing which trusts to purchase and which to sell. As with any investment method, so much depends on one's own personality. Some investors detest leverage, others don't. Some investors would never purchase a trust at a premium, others aren't overly concerned with mild premiums. The important point, in my opinion, is to make sure that when we compare closed-end fund metrics, we are making proper comparisons. In order to do that, trusts with similar business models must be grouped together. Comparing pork to ball point pens doesn't make sense, and neither does comparing and contrasting a Biotechnology trust with a Natural Resources one.
The original version of this article was published on Morningstar.com, a sister site to Morningstar.co.uk. This article was written with notes from Morningstar's Mike Taggart.
