Bargains and bangers on secondhand stall

There are some investment ideas that even I consider very, very adventurous – and investing in secondhand venture capital trusts (VCTs) is one of them.

I mention this because I recently spent a very amusing few hours chatting about such matters with Ben Yearsley, Hargreaves Lansdown’s investment maestro. As you’d expect from someone at a mainstream independent advice firm and brokerage, equity income funds are a big part of his thinking for the next year. But I was fascinated to discover that Yearsley (personally, as opposed to professionally) is going very long on secondhand VCTs.

It would appear that his own portfolio contains a wide range of “old banger” VCTs. I managed to get him to reveal some of these secondhand VCT holdings and they include such highlights (or lowlights, depending on your view) as Aberdeen Growth Opportunities (the biggest part of the portfolio), Aberdeen Income and Growth, Aberdeen Growth, and British Smaller Technology 2. He recently closed a position on Northern 1 VCT. He’s also considering opening some positions on Northern 2, Acuity (“almost their entire range”), Matrix Income and Growth 2, plus a few possible punts on Unicorn and Bluehone.

Now, I can’t divulge any more secrets from Ben’s portfolio, but I can tell you his rationale.

Reason number one is that there is very little liquidity in the secondary market for VCTs, which leads to some strange pricing. Not many people trade their VCTs so, when they do, prices tend to move. Regular readers of this column will be aware of these pricing anomalies after my comments last year on green VCT Ventus 1 – it was trading at around 80p prior to publication but shot up to 95p immediately after – not far off its net asset value. Why buy secondhand though?

Cue reason number two. Many of these funds trade at huge discounts to net asset value (NAV), with some trading at fairly juicy multiples to net cash. British Smaller Technology 2 VCT, for example, is trading at about two times its cash, according to Yearsley. Across the sector, discounts to NAV of 30-60 per cent are not uncommon, especially for the generalist and technology-based funds. That huge discount is partly a function of liquidity but there’s also an element of flight from risk, with investors dumping risky micro cap and venture capital sectors in favour of boring old bonds.

Reason number three is the tax efficiency. Any income you receive is free from income tax. Yearsley notes: “Many of these VCTs have been paying about 4 or 5 pence dividends per annum, which is very interesting when it only costs 40p to buy the fund!” So you can pick up a tax-free income, and any capital gains are also tax-free. However, by buying secondhand, you don’t get the initial tax relief of 30p in the £1 that you get by buying the shares new.

Still, you have a margin of safety in the mismatch between NAV and the share price, some nice income, and the potential for tax-free capital gains. So, if you believe that equity markets are about to stage a recovery, a bet on venture capital and microcaps might be a well-timed move.

At this point, I should point out that Yearsley is one of the few people operating in this space – and not everyone I talk to is quite so confident that secondhand VCTs are bargain basement gems.

Take Martin Churchill from Tax Efficient Review, who’s frequently on the receiving end of telephone calls about VCTs. To say that Churchill is cautious is an understatement.

His first concern is that any quoted VCT prices are fairly “meaningless” – there are very few marketmakers, so the price they’ll offer clearly depends on what stock they hold on their books (not much, by the way). He also thinks that investors can’t really know what the true NAV is. VCT managers have to declare a figure but whether it has any relevance on a “mark-to-market” basis is anyone’s guess. One of the few times when you can get a decent idea of underlying portfolio value is when the fund issues, and prices, a new tranche of shares.

But, more importantly, Churchill is concerned that many VCT shares are trading at big discounts precisely because they’ve been such stinkers – and the managers haven’t made sufficient use of buybacks or other mechanisms to close the gap between the NAV and the share price.

To paraphrase Churchill, the words caveat emptor have a resonance here.

Nevertheless, if there’s one thing I’ve learnt the hard way, it’s that markets aren’t always efficient and eventually revert to mean. Trust me when I say that there are many, many hedge funds about to make an absolute killing out of subprime debt, junk bonds and convertibles – because the bigger the inefficiency, the greater the need for due diligence, and the bigger the potential profit or loss. Mean reversion, or price reversal, teaches that what goes down does eventually go up again.

Why else would investment trusts, listed funds of hedge funds, and VCTs be being devoured by shareholder activists, hedge funds and specialists like Yearsley? They’re buying because markets do turn and, when they do, most cheap stocks start rising dramatically. Not all, but most. The only problem is that most investors don’t have the forbearance, the access to information and the risk tolerance to stay the course.

adventurous@ft.com