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Consider a LIC before you bite into equities

 

All unlisted managed funds are sold at their net asset value (NAV). Imagine if one day, Asgard, BT and Colonial First State all sent a note to their advisers saying that as a special One Day Sale, their funds would be sold at a 20% discount to NAV. Like buying CBA at $52 when it’s trading at $65, or BHP at $28 instead of $35 on the market. Advisers would be forwarding emails and preparing new Statements of Advice for clients before they’d finished their morning coffee. Even if clients made no greater allocation of money to the market, they would switch from other investments to this one-off bargain.

But it cannot happen. Unit prices must be calculated at NAV, as defined in product disclosure statements, and adjusted for small transaction costs, the same price is used for buyers and sellers. Sellers would not be happy to sell at a 20% discount. When ‘retailing’ managed funds, you can’t run ‘specials’.

Yet that’s what happens regularly in the Listed Investment Company (LIC) space. Some of the best fund managers in the market, often holding large cap portfolios suitable to many investors, at times trade well below their NAV. Just consider what 20% is in the world of investing. It’s 2,000 basis points. A fund manager would run a highly successful business if they could outperform the market by 2% per annum for 10 years. Investors switch from active to passive managers to save 50bp in fees every year, and here’s 2,000bp on the table.

The estimated discounts to NTA of the major LICs on the ASX are:

Source: Patersons Securities Limited. As at 21 March 2013. EMA = Exponential Moving Average. This graph is based on the pre-tax NTA of 30 of the largest and most liquid LICs in Australia. Other graphs which choose another group of LICs may produce different results. For example, the ASX estimates the weighted average sector discount to pre-tax NTA is currently  3%, or unweighted (simple average) of 8%.

Alternative ways to gain ‘market’ exposure at lower cost

Disappointment with active management, including relative (worse than the index) and absolute poor performance, has encouraged many investors who want equity exposure to consider alternatives to traditional managed funds. LICs are one of them.

There are three trends most often cited as evidence of the move from paying for active management:

1. The rise of Exchange Traded Funds (ETFs). In Australia, the vast majority of ETFs are index funds, some with fees less than 10bp per annum, a fraction of the active management cost. Investors know they cannot control the returns, but at least they can minimise the costs.

2. The growth of index and quasi-index funds within traditional managers. When markets struggle, fund allocation is increasingly driven by financial advisers wanting to show their clients their advice fees are justifiable by reducing costs on the asset management side. Index options on their favourite platform cost as little as 40bp, or slightly higher for non-capitalisation indexes such as those offered by Realindex in Australia (which already has over $5 billion under management).

3. The move into SMSFs. Almost a million trustees have decided to manage their own money, and only 14% of their $500 billion finds its way into traditional managed funds. A decade ago, in June 2004, SMSFs held only $39 billion in listed shares, but now the amount is almost $200 billion.

Each of these moves is driven by the desire to reduce costs and control investments, but they all have one thing in common: they pay full freight for the assets they buy.

Trading levels of LICs

Cuffelinks is not a stock-picker and does not provide individual stock recommendations. There are many factors to consider when buying a suitable LIC, as described below. The ASX produces a monthly report on LIC premium and discounts to NTA, showing the full range of 60 LICs on the ASX, as shown here.

The total market cap of LICs on the ASX is over $20 billion, so it is a decent size for investors to consider, and three times the size of the Exchange Traded Fund (ETF) market. There are three LICs with a market cap over $2 billion, and many over $200 million. The largest LICs often have the smallest discounts, because they are well-known and respected, and investors buy them when the discounts become historically wide. Some smaller LICs have large discounts, but there may be particular factors which warrant this: a highly concentrated portfolio, poor performance history, high costs relative to size. The biggest discount does not equal the best opportunity.

For a liquid, diversified, high quality fund offered by a reputable manager, LICs available at a discount are like a free gift for a long-term investor who does not need to sell at a time when the discount remains. Is there a compromise in asset or fund manager quality? Putting aside the debate about whether any active manager can consistently outperform the market, some of the most respected asset managers in Australia ply their trade managing LICs - Geoff Wilson of Wilson Asset Management, Sam Kaplan of Ironbark, John Murray of Perennial, John Abernethy of Clime. There is as much chance that these guys will outperform the market as anyone in a managed fund, yet there are many times when their LICs trade at a discount to market.

It is the seller of the LIC who is leaving the value on the table. For a LIC that has moved to a significant discount to its NTA, it is the past investors who have already underperformed, effectively losing more than the market, and have given up on the investment before value is restored. The LIC that listed at $1 may now be trading at 80 cents while the NTA is still $1. Investors have lost patience, sold and gone into term deposits. It leaves the door wide open for those who want equity exposure at a discount.

What if the discount increases, and the LIC falls in relative price even further? Consider buying more. What if the discount is removed or it trades at a premium? Sell, or settle back and enjoy the dividends, knowing there has been a capital gain as well. What if it does not move? Keep holding the investment - remember, we are talking about investors who want exposure to the market. This is a cheap way of doing it, and for a long term holder, it does not matter if the discount is not removed. The portfolio delivers superior income along the way, because the yield is higher due to the lower entry price.

Tax and distribution structure

LICs are companies and payment of dividends is determined by the directors, and does not depend on current year’s profits. If a LIC has retained earnings and remains solvent, a dividend can be paid. This differs from managed funds which must pay out all income, including realised capital gains, to unitholders in the tax year it is earned. However, most major LICs focus on paying healthy, consistent dividend yields knowing their investors have chosen them for this feature.

The NTA of a LIC is usually quoted in both pre-tax and post-tax terms. For example, some LICs have deferred tax assets from realised losses after the GFC, which can reduce future tax liabilities if gains are made. In this case, the post-tax NTA may be significantly higher than the pre-tax NTA, but realisation of the value of the asset depends on future profits. Others estimate the tax liability on unrealised gains. Investors should consider the tax components built into the NTA.

LICs usually pay tax on their net taxable income at the company tax rate, and they receive franking credits. They may also receive the benefit of LIC discount capital gains status on some of their capital gains, whereby shareholders are paid a fully franked LIC discount dividend. The investor may be entitled to claim a tax deduction equal to 50% (or 33% for super funds) of the LIC discount capital gain. The extent to which this applies varies greatly between LICs.

Other risks and advantages

The biggest advantage for LICs is that they are closed-end, meaning they cannot face redemptions and become forced sellers, as may happen with a poorly-regarded managed fund, especially in a bear market. This allows the manager to focus on the portfolio without worrying about losing funds unexpectedly. Many managed funds were caught out in the GFC as their investors rushed out of equities, and they added to the selling pressure even when prices were low and falling.

The main disadvantage is that the manager of a LIC is running a publicly listed company as well as an investment portfolio, and has to deal with shareholders, annual meetings, reporting, continuous disclosure, etc. While administrative functions can be outsourced, the manager is the face of the company, like the CEO, and if there is any threat of corporate action such as a takeover (not uncommon in the LIC space), the diversion of time is considerable. Many fund managers would prefer to concentrate on managing money, and some of the best names in the industry do not operate LICs. One high profile manager told me that after a couple of years managing a LIC, and being subject to continuous threat of takeover and complaints about the discount to NTA, he would never go back to the structure. Another said they spent more time managing enquiries about their small LIC than the rest of their large unlisted funds combined.

In summary, the 60 LICs listed on the ASX worth $20 billion cover Australian and international shares, private equity, absolute returns, global resources and some ‘specialists’. They vary in size from almost $6 billion to $1 million, which can have a material impact on fees and expenses. They have different policies around distribution of dividends, availability of franking and tax effect.

When the opportunity comes along to buy one of the long-established names, with a well-diversified portfolio run by a respected manager, who distributes franked dividends with a modest management fee, and available at a discount, then it's the nearest thing to a free lunch the equity markets will give to a long-term investor.

 

3 Comments
Graham Hand
April 14, 2013

Peter, coming back on your second question, the post-tax value is not always the most conservative. For example, some LICs have deferred tax assets such that NTA after tax allowances is higher than before tax (Century Australia CYA is an example). Others have deferred tax liabilities and post tax is lower. I don't think there's one correct answer because it depends on future realisation of the tax allowance. Some LICs propose liquidating their portfolios before the tax effects occur.

I agree with your view to take the most conservative, so I suggest that rather than having a rule about pre- or post-tax, take the lowest.

Geoff Wilson
April 12, 2013

Thank you for the article Graham. In reference to Peter's comments, we (WAM,WAX,WAA) have raised money by issuing options as a fair and equitable way of growing our companies. Option issues tend to have a positive impact on the share price while the shares trade on a cum basis. The manager has to perform for the money to be raised and shareholders have time to exercise their options (usually 12-18 months).

Peter Nixon
April 12, 2013

As a financial planner, I use LIC's as the basis for "starter kits" for new investors or "grandchildren funds" and as the core of most SMSF share portfolios. The prices of the largest trio (AFI, MLT and ARG) are now at substantial premiums to asset value but there are many attractive options which while not at discounts, can be bought up close to asset values Examples now are BKI, CIN, WAM, WAX, PMC, FSI and MFF. I find when the discount is large there is generally a good reason and one should tread warily.

Another advantage of LIC's is that offer exposure to smaller companies (WAM, AMH) and many have Active Asset Allocation strategies which I look for as a part of the investment strategy.

Clients on pension enjoy the idea of companies committed to regular dividends (a feature of many LIC;s).

Two issues to consider:

Should one take NAV as the pre-tax or post-tax value? Conservatively, I always use the latter.

Some LIC's often distribute free options. I see no reason why they should not as the dilution argument can not apply for a closed end fund but this does create some degree of distracting volatility. Comment?

Thanks

 

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