Andy Adams: Alliance should consider Laxey's buy-back proposals

Alliance Trust will come under pressure this week from Laxey Partners, an offshore arbitrageur, to introduce a formal discount control mechanism.

Laxey has a tabled a resolution at the Dundee investment trust's annual general meeting on Friday which would force the board to buy back shares whenever the trust's discount exceeds 10 per cent to net asset value (NAV).

The Alliance board has responded by starting to buy back its own shares but strongly recommends shareholders to vote against the resolution. Whether it makes sense to set a hard discount target is being hotly debated ahead of the shareholder vote.

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In my view, Alliance should in fact go much further than Laxey's proposal. I see no reason why any investment trust with a reasonably liquid underlying portfolio should not issue and buy back shares in order to maintain its share price very close to NAV.

Indeed, good practice should require such a policy so that, over time, good practice becomes standard practice.

Restrictions on investment trusts buying back their own shares were lifted as long ago as November 1999. So far, however, the new powers have not been fully exploited. Most investment trusts which have taken buy-back powers have used them only to buy in shares at as big a discount as possible, to increase the underlying NAV per share.

While this must be viewed as a good thing, it misses the main point. The new powers do not just allow trusts to make enhancements to their NAV by buying back shares at a discount. They make it possible to abolish the discount itself, and to ensure that the trust thereafter sells consistently at around NAV.

Since November 1999 one Edinburgh-based investment trust, Personal Assets Trust, has been able to guarantee that it will do so - an undertaking now enshrined in the company's Articles of Association. And it has grown very substantially in size over this period. What Personal Assets has done, many other trusts, including Alliance, could do - provided the board is prepared to take the risk that its trust may initially shrink in size before it hopefully starts to grow.

Alliance argues that a rigid discount control mechanism would endanger the ability to pay a growing dividend by forcing the trust to change the structure of its portfolio; that it would impair investment flexibility, limiting the company's ability to actively manage the portfolio; and increase the total expense ratio and the cost of debt.

On the question of dividends, it is true that the trust may need to hold a higher percentage of cash or near-cash which might, at present, reduce the underlying portfolio yield slightly. But we are currently in a world of artificially low interest rates which cannot last for very long.Even in these atypical circumstances and with a full-blooded discount elimination policy, I see no reason why the dividend should not continue to grow.

On the second point, academic research has indeed shown that discounts tend to widen when the market falls. This suggests that in extreme market conditions, the board could be forced to buy back shares aggressively, making it necessary to sell underlying investments in a hurry into a weak market. If, however, investors really believe that the board will immediately act to eliminate any discount that arises, as in the case of Personal Assets, this should become a self-fulfilling prophecy, there will be no pressure to buy back shares and there will not be a problem. As regards the effect on the total expense ratio, the board should seek to cut expenses back to the kind of level that Alliance has achieved in the past. If eliminating the discount causes the trust to shrink to the point where fixed costs became increasingly burdensome, which is difficult to imagine given its size, the trust should be liquidated, merged or unitised. After all, the board should be acting for the benefit of its shareholders. But I do not believe this would happen.

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I would encourage Alliance shareholders to vote in favour of the formal discount control mechanism. This, however, should only be treated as a first step towards complete elimination of the discount and the restoration of Alliance as one of the prime vehicles of choice for long-term private investors.

• Dr Andy Adams is director of the Centre for Finance and Investment at the School of Management and Languages, Heriot-Watt University.