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

Investors do not need to look too closely at a Listed Investment Company (LIC) report in our Education Centre to see that the majority trade at a discount to the value of their Net Tangible Assets (NTA). This is disappointing for existing investors who cannot realise the market value of their investment but it’s potentially an opportunity for a new buyer.

While it's not a good look for LICs generally, it also reflects poorly on the market’s opinion of the fund manager when there is little appetite for their investment skills even when available at a 15% discount. For members of the board of a LIC, as I have been in the past, the discount dominates board meetings with much time spent on near-fruitless attempts to remove the discount. If the manager also runs a large unlisted business, why would anyone invest at NTA in an open-ended fund when the struggling closed-end LIC is much cheaper?

It’s also problematic to grow the fund by issuing new shares at a discount because existing holders are diluted when buyers come in at a lower price. Loyal investors are already disadvantaged when their outlay at NTA is now worth 15% less than if they had gone into an equivalent unlisted fund at initial issue of the LIC.

Fund managers often start off loving the LIC structure because it locks in funds and fees with no potential for redemption and outflow, but they underestimate the work involved in managing a listed company and coping with the flak if performance is poor. When I was on the board of 452 Capital, the small LIC took as much management time as the multi-billion dollar unlisted portfolio. Many fund managers, such as Simon Shields at Monash, Sam Shepherd at Bennelong and Bill Pridham at Ellerston have exited the closed-end LIC structure to focus on other funds.

Why are investors reluctant to buy discounted LICs?

If boards, fund managers and existing holders are vexed, one group of stakeholders which can benefit is new buyers. As the dominant spokesperson and promoter of LICs, Geoff Wilson, loves to say, the best feature of LICs is buying $1 for 80 cents. He criticises other fund manager for not knowing how to nurture a LIC investor base and relying too much on the committed capital to retain their funds.

It sounds straightforward to buy a $1 worth of assets for 80 cents but investors may be reluctant because:

  1. They are not confident the fund manager (or perhaps any active manager) can deliver consistently strong performance in future, at least matching an index.
  2. There is often poor liquidity in the smaller LICs, and buying or selling a decent quantity can take time.
  3. The bid/offer spreads may be wide, and a loss of some percentage points may occur simply in the buying and selling process.
  4. The active fees are high in a world with ETF and index competition. It is common for LIC annual management fees to be 1% or more with an additional performance fee. Some academic work suggests the discount is the present value of the future cost of the active fee.
  5. Some LICs are poorly supported by their managers, committing little effort to marketing such as regular webinars and writing for newsletters to raise their profile.
  6. The discount may widen. The chart below on premiums and discounts since 2014 shows they are volatile and there are examples of 10% discounts moving to 20%, making what was a 10% ‘saving’ look expensive.

Premium/Discount by Market Capitalisation Band

Source: IRESS, Company Data, Bell Potter Estimates

When is it worth discount harvesting?

Given these drawbacks, what are the circumstances where a LIC might be more worthy of support?

1. Use a buy-and-hold strategy

The starting point, regardless of the discount, is to find a good fund manager.

Investing into any equity fund is a long-term decision, at least five years and preferably 10. Investing should be contrasted with trading, where a short-term view is taken based on a perceived anomaly or near-term opportunity. As part of a long-term portfolio, investors must accept that markets rise and fall, fund managers have good and bad years, investment styles ebb and flow.

This is even more so with LICs versus unlisted funds. At least with a managed fund or ETF, the investor can be confident of entry and exit at NTA, plus or minus a small spread.

One way to mitigate the risk or loss on sale due to the discount deteriorating further is to commit not to sell, or to hold for a long time. It also matters less if liquidity is poor or trading spreads are wide if an investor considers the LIC a core part of a portfolio. With no desire to sell, the benefits of the large discount can accrue.

2. Enjoy the larger income or dividend flow

Once the discount fear is removed, the appreciation can start. If a portfolio of underlying assets is paying 5% net income on a $100 investment, that’s worth 6.25% if bought for $80. LICs are companies which pay tax, and dividends are decided by the board, with the ability to smooth the payments and create a more consistent income flow. This contrasts with ETFs and unlisted funds where income and capital gains must be paid out each year. LICs disclose in their accounts the amount in their Profit Reserve and Franking Account Balance as a sign of ability to sustain future dividends. 

Managers such as Wilson's Leaders (ASX:WLE) and Plato (ASX:PL8) have realised that retirees want income and have focussed their LICs on yield, so convincingly that they both trade at premiums of around 12% (despite availability of Plato's unlisted fund at NTA). Clime (ASX:CAM) has embarked on the same income strategy but it is still available at a discount of about 6%. If the latest quarterly fully franked dividend of 1.32 cents is sustained for a year to give 5.28 cents on the current price of 86 cents, that's a healthy 6.1% fully franked or 8.7% grossed up.   

Some LICs are fixed interest which hold debt instruments rather than relying on share dividends, and again, these interest payments are grossed up for the discount. For example, Neuberger Berman (ASX:NBI) and KKR (ASX:KKC) are at discounts of 15% and 17% respectively.

3. Find a size sweet spot

The chart above of premiums and discounts shows the largest discounts to NTA are in the smaller LICs worth less than $200 million. The large, traditional LICs valued at over $1 billion, such as AFIC, Argo, Djerriwarrh and BKI offer high liquidity, good trading volumes and decent support, and usually trade around their NTA. WAM Capital is large with similar support. However, at the other extreme, tiny LICs of less than $50 million do not have the resources to market actively, and suffer from fixed costs as a high percentage of their FUM. Although still small and therefore often suffering poor liquidity, those between $50 million and $200 million may be in a sweeter spot of large enough to cover costs but available at a decent discount.

Katana (ASX:KAT) is a manager with a strong long-term track record and a LIC at a 10% discount, but its small size means it does not receive much broker coverage and supply is limited. 

4. Identify a potential recovery story or turnaround

To remove the discount, a manager needs at least two things: sustained good performance and the ability to promote their story. Investors who see a fund manager perform well while the LIC stays at a discount could move ahead of the recovery. There is sometimes a delay in the share price realising the NTA has improved. 

Everyone has different views on particular fund managers, and some well-known fund managers do not have well-supported LICs. These vehicles are unusual animals that respond strangely to market vagaries. Perhaps a seller owns a large parcel that must be liquidated, and they hit bids hard and push down the price. It may be that a long-established manager has hit a rough sport and gone out of style for a while. Perhaps there are options overhanging the price, or a high-profile portfolio manager has departed recently. There are many reasons the market ignores a LIC.

Rob Luciano’s VGI Partners Global Investments (ASX:VG1) holds around $540 million in assets but trades at a hefty discount around 16% due to poor recent performance (down 22% in 2022). However, the business was recently acquired by Regal and Phil King is the new manager of the sister Asian Fund (ASX:RG8) and he should have more supporters to reduce its 15% discount. 

Magellan’s Global Fund (ASX:MGF) Closed Class is also at a considerable discount around 17%, while billions rest in the unlisted fund around NTA. There is an instant arbitrage opportunity for thousands of investors. It is well known that Magellan’s conservative positioning in 2021 left its relative performance struggling, but it holds a high-quality portfolio of leading global companies. Other well-known funds or portfolios include Pengana (ASX:PIA) at 16% discount, Hearts and Minds (ASX:HM1) at 19% off and Alex Waislitz’s Thorney Technologies (ASX:TEK) at a whopping 36% discount. A recovery of popularity of any of these names may produce a windfall return. HM1 recently changed many of its managers in an attempt to reduce its discount.

Other high-profile managers such as Anton Tagliaferro's IML and its listed fund, QV Equities (ASX:QVE) and Perpetual's equity fund (ASX:PIC), are available at more modest discounts. Platinum Global (ASX:PMC) once dominated international equities and prices at a 13% discount, while Spheria Emerging Markets (ASX:SEC) at 16% off was previously more popular. 

5. Potential to convert from LIC to open-ended fund

When a fund manager converts a closed-end LIC to an open-ended fund, investors enjoy the benefit of the discount removal, less some transaction costs. One downside is the conversion takes a lot of work, up to a year, subject to shareholder approval.

Reports from large fund managers whose LICs trade at a discount sometimes reveal a restructure is a possibility, flagged well in advance. Based on a comment in a recent interview, Magellan may be a candidate although the committed capital of a LIC is especially valuable as their other funds are in outflow. Here is a short extracts from a discussion between Head of Distribution, Frank Casarotti, CEO David George and Portfolio Manager, Nikki Thomas:

“Casarotti: So, David, what if the fund actually does deliver on its objectives and absolute returns and relative returns and yet, we're still seeing this persistent discount, what then?

George: Well, delivering on the objectives should support a narrowing of the discount and the fund can continue to engage in the buyback. But if the options expire in March 2024, that may provide us with other avenues to explore. In the meantime, we'll be looking at fund disclosures and client engagement plans to make sure that we're communicating frequently and transparently.

Casarotti: So, Nikki, any closing thoughts?

Thomas: I see Magellan closed class as an opportunity to buy a world-class group of companies at about a 20% discount at the moment, and potentially that discount closes. Anyone investing in a global strategy like ours should be thinking three- to five-year horizons for investing, and you don't want to think that this could happen overnight with the difficult times we're living in.”

No special insights known but Magellan needs to address this.

6. Asset classes without broad support

LICs cover many asset classes which may fall in and out of favour, and once at significant discounts, price improvement is an ongoing problem. Bailador Technology (ASX:BTI) has produced impressive results over time, including converting many of its positions to cash in recent years, yet its discount approaches 30%. Tribeca Resources (ASX:TGF) seems well positioned in a sector with growing demand and supply shortages, and yet it cannot shed its significant 13% discount. In the fixed income space, Neuberger Berman (ASX:NBI) and KKR (ASX:KKC) probably suffer from holding lower-rated corporate paper with a threat on the horizon of a US recession. 

Or perhaps investors do not like what is in the portfolio. An example is Carlton Investments (ASX:CIN) which is a large fund of $850 million, suggesting liquidity and strong support, yet it trades at a 22% discount. A closer look at the portfolio reveals about 40% is in one asset, EVT (formerly Event Hospitality and Entertainment), so any holder needs to like that company.

In contrast, a specialist LIC such as Global Value Fund (ASX:GVF) holds assets which are not available in other funds, and it has developed a following based on its steady performance and strong marketing effort. It trades well at around NTA, although its market cap of around $200 million is not among the big boys. The market has rewarded its consistency. 

Take a view and sit on it

Warren Buffett was talking about finding cheap companies, but the same can apply to LICs:

“It is extraordinary to me that the idea of buying dollar bills for 40c takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find you can talk to him for years, and show him records, and it just doesn’t make any difference. They just don’t seem able to grasp the concept, simple as it is … I’ve never seen anyone who became a gradual convert over a 10-year period to this approach."

Nothing beats good performance, but it is elusive for investors to identify future returns. Some of the problems faced by LICs in trading at a discount can be turned into an advantage if the investor is not worried about liquidity, a wider discount or fees. Investing in assets at 20% below their underlying value can be an attractive buy-and-hold opportunity, as the income or dividend will be 20% higher regardless of share price performance. But if it's a dog, leave it to the fleas.

Some final comments from Peter Thornhill

Many readers of Firstlinks will see similarities between the buy-and-hold in this article and author Peter Thornhill’s preference for buying LICs and holding them for decades. However, Peter likes the large LICs without worrying about harvesting discounts. I asked him why. He prefers the consistency of a long-term proven investment process and:

“I have never bothered with discount or premium with the LIC's. I have begun to unwind my direct shareholdings where possible and moving the cash into a small handful of LIC's, about 6. As I started with the LIC's some time ago, the bulk are the old ones and I have been adding to them steadily so the holdings are substantial. To be honest, I'm too lazy to go digging for a few bits here and there. As I tell audiences, I have better things to do with my life than spending time on the computer.”

Yes, it can take a lot of time and effort to harvest dividends, and each investor needs to decide if it worth the effort. At least with buy-and-hold, once the job is done, there is nothing more involved except enjoying the enhanced income flow.

 

*For consistency in this article, prices and NTA are taken from the latest Bell Potter Report in our Education Centre, where other details can be checked by readers. Discounts are based on pre-tax NTA, in line with the buy-and-hold message in the article. The indicative NTA has been adjusted for dividends. Dividends are removed from the NTA once the security goes ex-date and until the receipt of the new cum-dividend NTA. In some cases, Bell Potter has been unable to verify the Indicative NTA within a reasonable level of accuracy. There is no dilution due to unexercised options. See notes in their table.

 

Graham Hand is Editor-at-Large at Firstlinks, and he owns many of the investments mentioned in this article. This content is not personal advice and does not consider the circumstances of any investor. The prices and discounts quoted are as at 3 February 2023 and change regularly.

 

30 Comments
Robert
November 25, 2023

I do not know what you all are talking about. But what I do know is Geoff Wilson may be the king of LIC, however all the Wilson Asset Management literature promises Preserve Capital and Capital Growth for their listed companies
Let Wilson Asset Management publish how many shareholders are in negative balance, in a big way.
I am embarrassed that I went anywhere near them. Let's all look forward to the usual monthly report threatening dividend and franking cuts.

michael
February 15, 2023

One of my holdings, DJW, has just announced an on market share buyback. Less than 12months ago, they had a SPP at $2.73, I believe. Today's price $2.90
Why? Were they not wise enough to invest the money when the All Ords was 15% lower?

I am not disillusioned by share prices diverging from NTA. I am disillusioned by seemingly irrational behaviour that wastes shareholder funds. And by unsupportable fee structures. I have begun to think that all these buybacks in LIC's are, in some way, to benefit the manager.

David
February 15, 2023

Don't take this as gospel, but I believe a lot of LICs put this facility in place in case they want to buy back shares during the course of the year, but don't end up doing it.

Geoff Day
February 14, 2023

Hi Graham I believe the sector should be regulated with sunset clauses introduced and high watermark performance clauses made mandatory.What you don’t point out is that those investors that entered through the IPO have never fully shared in the revaluing of NAV whilst the manager continues to be paid on NAV and may also receive performance fees. Are boards and the manager really aligning their interest to the shareholder?

Mic Smith
February 12, 2023

"........Alex Waislitz’s Thorney Technologies (ASX:TEK) at a whopping 36% discount".
What further needs to be said here is this LIC along with Thorney Opportunity Fund (ASX: TOP) have no high water mark!.
So the poor shareholder gets crushing performance fees taken most every time the share price oscillates upwards!
Not such a good deal after all.

Austin
February 18, 2023

Good point, Mic !

John E
February 12, 2023

Great article (for me as an unsophisticated investor anyway)! For historical reasons, I have held a few BKI for many years ... (grew out of something else?) frankly I don't know if for good reasons or not ... I particularly noted the comments re (a) Geoff Wilson - which I assume meant buy the whole company at a discount and sell at full value? But he did not pay out in cash, it seems ... and (b) the potential tax liabilities built into a realistic assessment of NTA.

Graham Hand
February 10, 2023

We're receiving a few questions on tax so here's some extra from a previous article. This can become a highly complex discussion, with most LIC boards retaining tax specialists to advise on alternatives.

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.

Martin
February 10, 2023

Graham
One big difference with the LICs is those with internal management and those with an external manager.
Those you have exampled as tending to trade around NTA mostly have internal management.
The other thing to be aware of is the NTA after tax on the capital gains were the portfolio sold.
For example AFIC, when it was selling at less than 6% premium to NTA was at over 23% premium to after tax NTA. AGO is similar, but the difference is about 10%. The monthly tables you publish help us to see this easily.
In essence, about a quarter of AFIC value is in tax not yet incurred, due or payable (investing the ATO money).

Graham Hand
February 10, 2023

Thanks, Martin. An important point. It's already a long article and not possible to cover everything. Another point worth making is the different tax treatments as summarised here: https://www.firstlinks.com.au/lics-traders-vs-investors-tax-purposes

The general idea is that LICs are qualified as ‘investors’ or ‘traders’ by the ATO. The defining characteristic of ‘investing’ LICs, and those that generally qualify for the tax concession, is portfolio turnover of 10% or less annually. We will publish more on this again soon.

Steve
February 10, 2023

Probably a silly question but why aren't larger investment firms looking at LIC's trading at huge discounts as takeover targets? Surely buying a business with $200MM of assets for $150MM must be an attractive proposition? If there are any provisions/regulation that prevent this, perhaps removing them might produce a better outcome for shareholders?

Graham Hand
February 10, 2023

Hi Steve, good question. Geoff Wilson has done this several times, which is one reason why WAM funds have become so large. He pays for the target fund with shares in his own fund. Examples include his acquisitions of Premium Investors, Wealth Defender, Century Australia, PM Capital Asia and Absolute Equity into WAM Leaders. Needless to say, he is not popular with some fund managers and LIC company directors who lost their FUM but he claims to be the retail investors' friend. And along the way, he has built a large LIC business and a personal fortune, although it took a few decades.

Tony
February 13, 2023

Watch out for Wilsons profit reserve! Fund members will probably never get out with what is there full profit

Joshua Smith
February 10, 2023

Thanks Graham.
If you had to guess, do you believe Magellan will convert MGF to an open class fund following the expiry of the options next year?

Graham Hand
February 10, 2023

Hi Joshua, I have no special insights and it's only a guess, but given Magellan's unlisted funds are in outflow, and Magellan itself is a listed company, I think they'll want to hold on to the FUM that a LIC guarantees. The risk if they converted to open class is investors would redeem at NTA (and some make a nice gain from buying MGF at a discount). But as David George says, they want to act on the discount so they need to do something.

Adrian
February 12, 2023

As a frustrated investor i expect them too! They have done it already with MHH so hard for them to argue against it as part of their fiduciary duty. They only argunent they have agsinst is the options, but once expired... This FUM will not be the sink or swim issue for Magellan they need to back themselves to outperform their benchmark not cling on to this LIC and all rhe distraction it creates.

Peter
February 10, 2023

Who benefits in the most in these under performing LIC's. My view, it is the directors and the CEO with their large salaries, bonus payments, share options etc. I have been to share holder meetings where the executive team continually give lame duck excuses for poor performance but still claim performance payments and pay rises despite losses for shareholders. Amazingly the directors never seem to be voted out. Share holders can sell their shares (probably at a loss) but the capital remains within the LIC and so the gravy train continues on for the directors. Shareholders must be more active to shake things up to benefit the shareholder and let directors know that their tenure is not secure if the LIC underperforms.

Brian
February 10, 2023

Very good article, thank you.

However the comment
'.. The large, traditional LICs valued at over $1 billion, such as AFIC, Argo, Djerriwarrh and BKI offer high liquidity, good trading volumes and decent support, and usually trade around their NTA. .. '
does not appear to be correct re their NTA's over time.

AFI: 24 of the past 120 months below NTA. i.e. about 80% of the time above NTA.
DJW: 33 of past 120 months below NTA.
BKI: 15+ years of the past 19 years below NTA.
And so on.

Graham
February 10, 2023

Thanks, Brian. I didn't say they don't go into discount. I said they have decent support and trade around NTA. Yes. They are sometimes available at a small discount.

asdf
February 10, 2023

Some academic work suggests the discount is the present value of the future cost of the active fee. UNQUOTE.

If we accept this then the whole article and everything else is irrelevant.

Graham
February 10, 2023

Thanks asdf. At least with a LIC, there is a discount to help pay for the active fee, which you don't get with an active ETF or managed fund.

Ian
February 13, 2023

Spot on Graham.
A good article of course. And the comments, and your own responses to those comments, add real value. What a great site!

Peter Switzer
February 09, 2023

Great article on LICs, well done, Graham

Shiraz
February 09, 2023

" To buy a $1 worth of assets for 80 cents "
In principal it sounds appealing But in practice getting a $ 1 back is rare.
So you hold hold and hold for dividend.ETF widely differs as it is priced nearly to NTA.Trading ETF taking profit is a possibility and dividend may be lumpy but is welcome every quarter

Alex
February 12, 2023

You can sell LIC and take profit too. If you buy at $2 and sell at $3, you still make a $1 capital gain, regardless whether it was below or above NTA.

Anthony Gross
February 09, 2023

Graham on the conversion issue have you looked into ASX code AGX1 Antipodes Global Share a quoted managed fund. If my memory is correct this converted from a listed LIC to a listed unit trust or managed fund. The ASX records today show the fund has a quoted value of about $320M.

Can you make a comment on when Target Market Determination TMD's came in? and how did this affect the market and or discounts for LIC's and managed funds?

for discussion.....Thanks Anthony

Graham Hand
February 09, 2023

Hi Anthony, thanks for the question, I'm not aware that TMDs affected the market for LICs and ETFs in any material way but happy to stand corrected.

Graham Wright
February 09, 2023

Without doubt, one of the best newsletter articles published about LICs, especially in explaining causes and effect of discounts and premiums as we see across the diversity of LICs. I hope that henceforth we see much less of the ignorance that is usually published in reader comments. Premiums and discounts exist and persist and vary for very good reasons and understanding those reasons in each and every case is almost necessary although your advice to buy and hold over the long term tends to negate the negative and reinforce positive effects for the individual investor in most instances. Yes there is an issue re the discount that follows a share issue but lets hope we do not see managers displaying their incompetence by issuing shares at a discount as we have seen in the past. Is there a better way? I hope those much smarter than I are seeking that way for future share issues.

David MC
February 09, 2023

One advantage of LICs over ETFs is that they are able to hold cash so can reduce volatility in uncertain times. I am a fan of the Affluence LIC (managed) Fund which makes use of the discounts and gives great diversity while itself maintaining cash holdings as appropriate.

Mart
February 09, 2023

The stats don't lie and a great list of 'what to do'. Fantastic article Graham, one of your best, thank you !

 

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