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8 factors to consider when assessing LICs

Driven by a range of factors, including strong investor demand for fully franked dividends and the introduction of the Future of Financial Advice (FOFA) reforms, the popularity of listed investment companies (LICs) has surged in recent years. Currently, there are almost 100 LICs, up 83% since 2012, offering investors exposure to a range of asset classes, investment styles and markets.

As LIC managers, we believe LICs are a superior investment structure for a range of reasons, as described below. To access these benefits, we invest in other LICs through the LICs we manage. When assessing a LIC as an investment proposition, we consider the following key factors: 

1. Quality and integrity of management

Fundamentally, funds management is a people business. It is essential to have confidence in the integrity and ability of the investment manager. An assessment of LIC investment managers should give consideration to the ‘bench strength’ of the entire investment team, not only the high-profile personnel.

Investors should also consider the investment manager’s expertise in managing funds using the LIC structure. We favour specialist LIC managers, as opposed to those who manage money through a number of different types of investment structures.

2. Track record of performance

The performance of a LIC’s investment portfolio reflects the quality of the investment manager and its investment strategy. A proven investment approach will deliver consistent performance in both up and down markets, and the track record must be judged in variable market conditions.

In our view, a truly active investment approach which gives the manager maximum flexibility, including the ability to hold cash, increases the opportunity to outperform the market.

3. Ability to pay fully franked dividends

For many investors, the principal benefit of LICs is their ability to pay a consistent and growing stream of fully franked dividends. In addition to receiving franking credits from underlying investee company dividends, LICs also derive imputation credits from tax paid on realised company profits, unlike managed trusts, LICs retain these franking credits and capital profits in a profit reserve.

Therefore, it is critical to consider a LIC’s ability to pay franked dividends over time. While listed companies are not permitted to disclose future dividend payments prior to board approval, a LIC’s capacity to pay dividends can be determined by referring to its franking account balance and profit reserve in its annual report. For example, a LIC with a franking balance of 50 cents per share, has the ability to pay out a fully franked dividend of $1.17 per share, subject to its profit reserve.

4. Discount or premium to NTA

Distinct from unlisted managed funds, a LIC’s shares can trade at a premium or a discount to its underlying assets, referred to as net tangible assets (NTA). If the per share NTA is more than the share price, the LIC is trading at a discount to its NTA. This can present an investment opportunity as it allows an investor to buy a portfolio of shares for less than their current market value. It can also represent a buying opportunity for investors given the potential for its shares to trade at or above its NTA. If a LIC is trading at a discount, prospective investors should evaluate the likelihood that the LIC will trade closer to or at its NTA by assessing the factors outlined in this article.

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5. Marketing and communications

Effective marketing and communications initiatives, such as presentations and regular market updates, are important for building a LIC’s reputation. They raise its profile among investors and the broader investment community, such as financial planners, advisers and research houses. This can increase demand for the LIC’s shares and assist in narrowing or eradicating a discount to NTA.

6. Shareholder engagement

Pro-active, consistent and responsive shareholder engagement demonstrates an investment manager’s respect for their shareholders, without whom they would be redundant. A regular programme of initiatives to engage and communicate with shareholders may include presentations and email updates about the portfolio and market conditions. Effective shareholder engagement can also assist in reducing a discount to NTA.

7. Liquidity and structure

Liquidity is important, particularly when investing large amounts of capital. As a LIC grows through capital management initiatives, such as dividend reinvestment plans, option issues and capital raisings, its on-market liquidity can expected to increase.

The LIC structure also provides an inherent advantage for investment managers. Unlike a managed fund using a trust structure, a LIC provides a stable and closed-end pool of capital, ensuring the manager is not forced to sell investments to fund redemptions (often at the bottom of the market) or buy investments due to inflows (often at the top of the market).

8. Variety of investment exposures

Taking into account their own investment objectives and strategy, investors should consider the investment exposure a LIC provides. LICs offer a diverse range of investments, including different sized companies, asset classes, industries, investment styles and geographic regions. More recently, two philanthropic LICs, Future Generation Investment Company (ASX: FGX) and Future Generation Global Investment Company (ASX: FGG), offer access to a group of fund managers, while also supporting Australian charities.

With minimal investment and for the cost of brokerage, investors can utilise LICs to create a diverse investment portfolio, or compliment directly held investments.

Gathering insights

There are a range of sources to consider when researching and assessing LICs. LIC investor websites, shareholder presentations, reports by independent research houses, media (such as Cuffelinks) and the ASX website all provide useful information to understand and evaluate Australian LICs.

 

Chris Stott is Chief Investment Officer of Wilson Asset Management (WAM). This article is general information and does not consider the needs of any individual, and WAM may or may not hold some of the investments mentioned. For more investment insights, follow Wilson Asset Management’s website and on social media.

4 Comments
Peter
June 10, 2017

Ok another thing to look at is if a LIC is trading at a significant premium, then the manager offers a SPP plan to all shareholders and significant SPP to sophisticated investors and institutions all at a discount to the share price and sometimes this can be quite a big discount. HOWEVER it is also at a premium to the NTA and therefore accretion positive to the NTA. In other words it is a way for the manager to easily increase the NTA and hence performance of the fund while actually doing nothing.

The same applies to DRP and the sale of unused DRP shares to sophisticated investors and institutions also at a discount (albeit a smaller on) but a bigger premium to NTA. The NTA goes up.

One can only do this for so long.

Finally what is the outcome - A large increase in the size of the LIC and when it gets too large, an inability to be as flexible and more difficulty to move in and out of positions. The LIC then struggles to maintain the performance it has had in the past. Then you will see the share price head towards the NTA even if the LIC manages to post acceptable performance.

Ian A
June 08, 2017

I agree with above comments. My pet hate is LICs who only show their performance BEFORE fees. That's where research reports that show pre-tax NTA including dividends performance such as the following found on Cuffelinks are valuable. It tell the investor the true story:

http://cuffelinks.com.au/wp-content/uploads/Indicative-NTA-20170605.pdf

Graeme
June 08, 2017

I have difficulty reconciling the two arms of Factor 7. When ‘selling’ the IPO, most managers tout the advantage of “a stable and closed-end pool of capital”, yet after listing a number of these same managers have “dividend reinvestment plans, (and post listing) option issues and capital raisings”. After 25 years as an investor in LICs, I’ve concluded that for a number of them, capital management is a marketing, rather than investing, tool.

Elliece; I am in complete agreement with your comment on performance measurement. There are a number of different 'formulas' used, and the differences can be sufficiently large as to make the published figures useless. Best to just ignore them and work out how it affects you individually.

Elliece
June 08, 2017

Thanks Chris

Insightful but you are missing a few key points.

* Key for performance is looking at NTA performance including dividends. Be wary of fund managers who display portfolio performance only, as this is not what you get as a shareholder. External managed LIC's like to highlight portfolio - ignoring large management fees, tax and turnover costs.

* Look at LIC accounts to see where your dividend is being paid from, as a number of LIC's after all their costs are effectively paying you dividends from your capital, as they issue new capital every year to fund your dividend. How sustainable will your dividend be in a genuine downturn, if profit is down and they cant raise more equity?

 

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