Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 587

AFIC on its record discount, passive investing and pricey stocks

Imagine overseeing a return of over 28% in a year and beating your benchmark, only to see all of that relative gain (and more) wiped out by something that isn’t under your control.

That’s exactly what the story has been at AFIC (ASX: AFI) recently, as its investments have outperformed but its discount to NTA surged to 10%.

You could spend all day coming up with reasons why the discount has become so large compared to history. But it’s probably just supply and demand – because you could speculate that demand for AFIC shares is probably being hit from three sides.

Number one: there is an alternative again

Those seeking income in retirement have alternatives to equities again. They can get a 4% yield in bonds instead of needing to jack up their risk profile.

AFIC is not your average LIC when it comes to its historical discount (it has often traded at a premium), but Andrew Mitchell and Steven Ng’s article that featured on Firstlinks in June showed a convincing connection between higher interest rates and higher LIC discounts on average.


Number two: the continued rise of passive

With total costs of just 0.15% last year, AFIC is a remarkably low-cost way to own many of Australia’s biggest companies. But, then again, so are index-based ETFs. Given that passive ETFs are very much in vogue and LICs are very much out of vogue, which option has been more likely to woo investors seeking that kind of low-cost exposure?

Number three: attention shifting overseas?

Instead of primarily investing in Aussie shares and considering different options for that, investors are tilting more towards global shares.

The data below from ASX and Vanguard might be skewed a bit by the fact that ETFs are especially attractive for those seeking international equity exposure because they minimise issues like currencies, higher trading commissions that come with owning foreign stocks. But Australia's strong (and growing) appetite for global exposure is clear.

Could this have sucked away some demand for AFIC shares too? Overall, I don’t think it’s crazy to suggest that AFIC’s discount has faced a triple-headwind from three of the biggest investing trends post-2022: higher interest rates, the continued rise of passive investing and ETFs, and increasing demand for international shares.

Passive ETFs versus LICs – an unfair fight, but for how long?

The past few years have been a dream environment for passive ETF adoption. Markets have generally been on the up and up and returns from many markets (especially in the US) have been concentrated in the biggest players.

This is a very tough environment to beat the index and provides a tailwind for those selling investors the lowest cost exposure to it. On the other hand, the potential benefits of a low-cost LIC like AFIC versus a passive ETF – and, yes, there are some – haven’t had a chance to shine recently.

Let’s start with dividend protection. If you own an ASX200 index fund through an economic slump, the underlying companies are likely to cut their dividends. As a result, you will probably receive less income that quarter or year, income you may have been relying on.

A well-known benefit of LICs is their ability to hold cash and franking credits to support the dividend in weaker years. This allowed AFIC to maintain a flat dividend through the payout cuts of early Covid and during the GFC. 

In his interview with me last week, CEO Mark Freeman told me that AFIC regularly assesses its ability to repeat this trick in future crises. With its current franking balance and reserves of retained profits and realised capital gains, he said AFIC could maintain its current fully-franked dividend even if none of its holdings paid a dividend for 18 months.

Is that the kind of benefit that is forgotten in bull markets? When the big four banks have increased dividends handily for several years? And when mining and energy shares delivered a dividend bonanza in 2022/23? 

Another obvious difference between AFIC and an ASX200 tracking index is that AFIC can pick and choose what it invests in. As AFIC’s portfolio manager David Grace put it, “the index is the last buyer at high prices and the last seller at low prices”.

Grace sees the relative valuations of CSL (ASX: CSL) and Commonwealth Bank (ASX: CBA) as a prime example of how an index can keep bidding up one name while shunning another, based on nothing but share price action.

How, given the far superior growth and returns profile of CSL, he says, can these two companies trade at a similar P/E ratio?

Does AFIC suffer from its headline similarity to ASX200?

Apart from a few big-ish overweights like CSL, Macquarie (ASX: MQG) and Transurban (ASX: TCL), AFIC’s top 10 holdings did not look vastly different to those of the S&P/ASX 200 index as of October 31. 

The ASX holdings below are based on the iShares Core ASX200 ETF. If a holding did not appear in both top tens, I have shown the percentage held in that share by the other product in brackets.

I am not bashing AFIC’s portfolio by pointing this out. Far from it. These companies, by and large, are high quality businesses with strong competitive positions. They align with AFIC’s approach.

AFIC has held many of these companies for decades, benefitted from their growth, and has capital gains tax to think about for shareholders. These companies also contribute to an important component of AFIC’s dual goal of capital growth and income through the payment of fully franked dividends.

I do wonder, though, if potential investors might be put off by the similarity at first glance. In that case, why not pay even less in fees for an index fund without needing to worry about a discount or premium to asset value?

I put this question to Freeman and co. Their take was that AFIC’s portfolio actually is rather different to the ASX200. Especially once you look beyond the top 15 holdings or so.

They pointed to the fact that AFIC only held a total of 56 names versus the benchmark’s 200 as of the last annual report. And to their far bigger positions in some of their favoured smaller-cap firms like ResMed (ASX: RMD) , REA Group (ASX: REA), Reece (ASX: REH) and CAR Group (ASX: CAR) than the index holds.

Over the long run, they hope that continuing to hold companies of this ilk – and adding to them in periods of share price weakness – will benefit AFIC shareholders in the same way that holding onto names like CBA has benefitted them in previous decades.

For now, though, I see a chance that investors could just glance at AFIC’s biggest holdings and not see much scope for performance that is vastly different from the market average.

Will the discount ever close?

The big question for many AFIC shareholders – especially those who bought at a premium – is what might narrow the current discount.

If the interest rate theory holds water, you could argue that elements of the discount are cyclical. But are rates likely to go that much lower again? When I look at any kind of historical chart, I constantly have to remind myself that the zero interest rate policy era was anything but normal.

In our conversation, Freeman and co didn’t seem to be relying on that. Instead, they feel that marketing and education could bridge some of the gap. They also think that advisors could have an easier time recommending AFIC to clients now that it doesn’t trade at a premium.

They are also buying back some shares. As Freeman put it, “we look at opportunities every day and don’t see anything cheaper”.  Looking at AFIC’s share repurchases since February, when it announced its latest buyback authorisation, makes two things clear:

  1. AFIC has ramped up buybacks since September, from zero shares repurchases to over 3 million shares bought back at the time of publishing.

  2. These buybacks still seem like a drop in the ocean. 3 million shares represents less than a quarter of one percent of the total shares outstanding!

AFIC discount and buybacks since February 2024

Potentially attractive, but not for the discount alone

I can't stop thinking that AFIC trading at 5 or 10% discount to NTA doesn't make any less sense than it trading at a 5 or 10% premium did. In fact, it probably makes a lot more sense. I have absolutely no idea why anyone would buy a LIC at a 5 or 10% premium.

Given the headwinds AFIC could continue to face on the demand front, I would be more confident in the discount merely not getting much worse than it returning to NTA or a premium. And for that reason, I don’t think I would buy AFIC purely because of the historically big discount.

I still see plenty to like about AFIC, though.

First of all, it offers incredibly low-cost exposure to Australian companies of an above-average caliber. At 0.15%, its cost is only 8 bps more expensive than the management fee of Vanguard’s passive Australian Shares Index ETF. Its costs are lower than the fee on active "factor" ETFs focused on higher quality shares of the kind AFIC focuses on. And, of course, it is streets cheaper than most managed funds. 

AFIC has also proven itself as an excellent long-term steward of capital. Let's not forget, either, that a smoothed dividend could also seem a lot more important in the future than investors seem to think it is now. In an expensive equity market, investors looking for income and a long-term approach to capital growth might find the 10% discount attractive. Just don’t bet the house on it closing.

 

Joseph Taylor is an Associate Investment Specialist at Morningstar.

 

26 Comments
Laurie
November 24, 2024

agree very much with the comment that post-tax NTA is an important valuation metric (although I see that some smaller LICs are including capital losses as tax assets which doesn't help)

Harry
November 24, 2024

This is an erudite contribution to the available pool of literature relating LICs. Congratulations Joseph! Discount or premium to NTA is one important criteria that I examine before purchasing or selling a LIC. The NTA is an easily accessible and authoritative momentary index. Emphasis is on momentary. The MER is another easily accessible index for ARG, BKI and AFI stables of LICs. Less so with many other LICs but I won't go there. Having attended many, many annual presentations for ARG, AFI and BKI the Directors openly acknowledge many of the cited issues in Joseph's contribution. Moreover, the Directors at ARG, AFI and BKI, in my opinion, present their data with a sense of authenticity, humility and purpose. Less so with the Directors of some other LICs but, again, I won't go there. One problem for me, and I have asked this question at ARG, BKI and AFI presentations, is whether or not the NTA is a reflection of real long-term value. For instance, in an overheated market, the NTA is 'inflated'. A drop in the market will affect NTA. Hence, in my opinion, the discount or premium to NTA is, in some ways, illusory. How does one assess the real value of the NTA? Accordingly, I try to limit my purchase of LICs to times when the market is depressed. Is this a good preventive strategy?

Marvin
November 24, 2024

NTAs should be calculated on an after tax basis(allowing for tax on unrealised cap gains)
Both LICs trade close to their values on this basis

michael
November 24, 2024

agree

Paul Collins
November 27, 2024

I am Interested in this comment and wonder why. If you value ETF on a pretax basis why do you not do the same with LICS. Put another way if the ETF sold the share and paid capital gains tax it would have franking credits to distribute.

Matt
November 24, 2024

What the article omits is the key personnel risk that comes with investments in LICs and managed funds not faced by index ETFs. One only needs to look at Platinum and Magellan as leading examples of this significant risk but it affects every managed fund.

I might add that lics and managed funds have essentially been jawboned into reducing excessively high fees by lower cost ETFs. Prior to the widespread arrival of ETFs in Australia retail investors were taken for a ride with funds charging high fees (who remembers the 4% up-front investment fee managed funds charged when you invested with them) and the majority underperforming the market. While fees have come down, has performance really changed. The quoted number is still 80% of managers can't beat the market. Why waste your time trying to sift through all the fund managers to find those who can beat the market only to discover that the key investment personnel have moved-on. In this context passive ETFs are a no brainer.

One last point, and with all due respect to the financial media, if Warren Buffett recommends that all people need to do is invest in an S&P 500 index fund, his advice carries a far greater weight to me than the financial media.

Luke
November 24, 2024

Snagged some ARG right at a whopper discount to NTA before they commenced their buyback program later than AFIC. Could retail investors in the two big LICs be liquidating to participate in new lic ASX listing this month that will be paying monthly divvies.

Josh
November 24, 2024

The conversation is often on the discount/premium relative to *pre-tax* NTA. At the heights of a bull market surely the widening tax payable is impacting the discount. I’d hypothesise that the cyclical variance in the discount/premium to post-tax NTA would be lower.

PN
November 23, 2024

As a share holder of AFIC, ARGO and VAS I've seen the brutally stark performance difference between them....
Over the past 2 years AFIC's share price is -1.2%, ARGO is -1.6% whilst VAS is +17% !
That's pretty nasty for these LIC's in anyones language.
I have some cash to put into the market and I'm thinking I'll plough into into these LIC's and take advantage of the 11% discount... but I'm nervous now about whether that gap will close any time soon.

Jason
November 22, 2024

Argo is in the same boat also started a buyback program. Both AFIC and Argo should also consider:

- more media campaign - managing directors and others should go out there more and market the product; that's what Buffett did for Berkshire Hathaway and Bogle did for Vanguard. Vanguard is a marketing machine.

- publish returns going back 75 years or since inception and compare against the accumulation index

- pay quarterly dividend

- stop DRP and stop issuing new shares via DRP - people can buy on the market if they like. Brokerage fee is very small these days.

- stop issuing new shares to managing director for performance based bonus - give money instead and they can buy if they want

- consider providing daily NAV/ NTA like index funds

Marcel
November 22, 2024

A quarterly dividend (such as IOZ) would definitely make AFI shares more interesting.

Doug Hill
November 22, 2024

A very well informed piece.
There is a lack of deeper understanding of the merits of LICs and the drawbacks of ETFa.

Bruce Wookey
November 23, 2024

Very informed comment Doug , this is a great piece, and having advised both Argo and AFIC, suspect it’s time to run the buy side ruler over both in what will continue to be a volatile but fundamentally overpriced domestic equities market.

Peter
November 21, 2024

Steve has stated that AFIC providing 100% franking credits probably restricts it's investments to companies that offer franking credits. This assertion is false!!!! A look at AFICs investment portfolio reveals this is not the case and indeed it is building a portfolio of high growth USA listed companies which obviously offer no franking credits. Personally I think AFIC's future potential is very much under estimated and as the CEO has suggested investors probably need to be better informed on it's benefits.

Steve
November 22, 2024

The top 25 holdings are all Aussie companies, representing 80% of total assets. The top 10 holdings have over 50% of assets. The usual holdings of many large Aussie investors. IT is the lowest sector weighting at 2.8%, only larger than cash at 2.3%. Any US high growth companies would be a rounding error at best. I have no idea about future performance as can no-one, but the past performance is average at best. Unless you bought 3 years ago when it would be rather painful (I notice the 3 year return is not quoted as this covers the drop from 10% premium to 10% discount - ouch!).

Peter
November 22, 2024

Steve's comments about asset weighting in AFIC is probably not dissimilar to some ETF's. I agree with Steve about performance but it appears to be heading in the right direction with it's investment strategy and I think it is a victim what is simply fashionable at the moment. One thing is certain with AFIC's billions of of dollars in investment it is a safe long term holding.

Steve
November 21, 2024

100% franked dividends. This is a plus and a minus? It forces the manager to hold stocks that give highly franked dividends to pass them on. Many of our fully franked stocks are in low growth sectors like banking or the supermarkets. Makes performance comparison hard to stand out which will eventually bite you. And low fees. So what when the discount is magnitudes higher than the fee? A 1.5% drop in the discount is 10 years worth of fees! Just look at the 5 and 10 year performance numbers, that should be the end of the story. Also please, when you have a story that presumes buyers of an LIC are mainly holding them for income, stop using accumulation indexes. If you spend the income you don't get to reinvest it. Instead show the actual increase/decrease in unit prices and the actual yield in income as separate entities. This might go some way to explaining why the LIC's fall when bond yields rise. Currently AIF is about 5% grossed up yield. I can get 6% on SUBD etf units with minimal capital risk. There are plenty of options.....

Dudley
November 21, 2024

"6% on SUBD etf units with minimal capital risk":

https://www.marketindex.com.au/asx/subd/advanced-chart

Adjusted for dividends / distributions, total return is:
=(25.3 / 25.04) ^ (1 /((DATEVALUE("01/Nov/2024") - DATEVALUE("01/Oct/2019")) / 365.25)) - 1
= 0.20% / y

Capital risk: adjusted price from 22.40 to 25.44.

Minimal capital and return risk would be bank deposits.

Dudley
November 21, 2024

err; that was capital gain / y.

Total return:

= (25.3 / 21.04) ^ (1 /((DATEVALUE("01/Nov/2024") - DATEVALUE("01/Oct/2019")) / 365.25)) - 1
= 3.69% / y

Best:
= (25.3 / 18.96) ^ (1 /((DATEVALUE("01/Nov/2024") - DATEVALUE("30/Mar/2020")) / 365.25)) - 1
= 6.48% / y

Joseph Taylor
November 22, 2024

Hi Steve, thanks for your comment. I used the accumulation index because that is the benchmark that AFI uses and is standard practice. You're right, though, some investors might want to use a different index to benchmark a product against based on their circumstances and goals.

CC
November 22, 2024

AFI holds plenty of stocks in it's top 25 list that don't give franked dividends and can be regarded as growth stocks rather than dividend stocks.
such as CSL, Goodman, Resmed, James Hardie, Reece, REA, Carsales, Xero, Fisher & Paykel, ARB.
AFI is also somewhat underweight the 4 banks, being 20% of the portfolio versus about 25% of the ASX200 index.
Investors can also achieve better than the quoted performance figures by buying only during discount years and avoiding buying during premium years, as I have been doing.
As for the low weighting in I.T, the same applies if you buy index funds too, but at least AFI holds overweight positions in quasi- IT ( Communications ) stocks REA and CAR in it's top 25.
Which I.T sector stocks on the ASX200 do you think are worthy of holding a large overweight in......

Claude Walker
November 24, 2024

You could somewhat answer your final question by inverting it. For example, you could ask which IT stocks in the ASX 200 (or ASX 300, or All Ordinaries) are NOT worth owning. You could rule out some with obvious red flags.

One might exclude stuff that is hyped up recent float (eg Nuix a few years ago). Exclude stuff with no profit whatsoever, especially if it has minimal revenue (eg you avoid Weebit Nano and Brainchip when they briefly entered the ASX 300).

Not intended advice, obviously. Just food for thought.

Steve
November 25, 2024

CC the point about the low IT weighting was in response to Peter's comment re building some US high growth stocks - I used IT as a simple category which normally captures high growth stocks. It wasn't a specific choice just an example of a low weighting to what is typically a high growth sector. Hope this helps.

Peter
November 21, 2024

One thing that is rarely mentioned are the franking credits. AFIC 's dividend is 100% fully franked while the most popular ASX ETF's are only partially franked. For those investors seeking income there are tax advantages. Further, AFIC provides a reliable consistent dividend while ETF dividends fluctuate. I think AFIC however should consider paying a dividend quarterly which would obviously make it more appealing to income investors.

Mart
November 21, 2024

Great summary Joseph, thank you ! And isn't it also still the case that ETFs, due to their structure, have to distribute 100% have to distribute yearly any capital gains, therefore creating realised gains ? Obviously this could be a lumpy tax hit annually, and especially 'unknown' when compared with the ability of AFIC to smooth dividends annually. So it looks like LICs are a better option for those relying on fairly predictable income (retirees etc) ?

Joseph Taylor
November 22, 2024

Hi Mart. Yes, ETFs need to distribute gains that are realised within the portfolio in the same period they occur, while LICs can retain them and distribute them at a time of their choosing (potentially to smooth a dividend later). There are other positives and negatives to ETFs and LICs that investors need to consider as well, though.

 

Leave a Comment:

     

RELATED ARTICLES

The catalyst for a LICs rebound

Why LIC discount harvesting is a buy-and-hold decision

LIC discounts widening with the market sell-off

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

US election implications for investors and Australia

The return of Donald Trump to the US presidency brings the prospect of more US tax cuts and deregulation, but also more tariff hikes, trade wars and policy uncertainty. Here's what it means for markets going forward.

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Taxpayers betrayed by Future Fund debacle

The Future Fund's original purpose was to meet the unfunded liabilities of Commonwealth defined benefit schemes. These liabilities have ballooned to an estimated $290 billion and taxpayers continue to be treated like fools.

The rising tension between housing debt and retirement balances

Australians are taking more mortgage debt into their 60s than ever before. Retirement planning assumptions haven’t adapted and could result in future income projections that ultimately disappoint retirees.

Latest Updates

Shares

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

Superannuation

Addressing the gender super gap

The harsh reality is that most women retire with significantly less superannuation than men. There are many reasons for the gender super gap and here are some possible solutions to fix the long-running issue.

Superannuation

Meg on SMSFs: Where are the risks in our major super sectors?

Given the amount of money in super, it’s not surprising that there is a lot of focus on risk. SMSFs are often portrayed as the riskier option for the community as a whole, but does that tell the full story?

Superannuation

Global pension reforms and how Australia can improve

With plans to retire next year, Mercer's David Knox looks back at the global pension index he helped create, the key trends and developments since inception, and what Australia can to do to get better.

Shares

Cyclical stocks will drive markets higher in 2025

Magellan's Head of Global Equities, Arvid Streimann, thinks that although stock price momentum will slow next year, cyclical companies will lead the pack. He outlines the risks to his forecast and the stocks he likes best.

Economy

How this GDP per capita recession compares to history

GDP was 0.3% for last quarter but the real story is this was Australia’s seventh consecutive quarter of negative GDP per capita growth. How does this economic drought compare to past ones, and what can we expect in future?

Investing

The mispriced investment opportunity in global defence

Markets benefitted from peace for 40 years, but a military resurgence is now underway, fuelled by geopolitical tensions and technological advancements. Defence spending is soaring, offering potential opportunities for investors.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.