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LICs need a genuine raison d’etre

Listed Investment Companies (LICs) have been given a lot of stick lately. Many LICs have traded at substantial discounts to their Net Tangible Assets (NTA), causing much angst for their shareholders. One small LIC – Monash Absolute Investment Company (MA1) - has recently taken the bold move to convert to an Exchange Traded Managed Fund (ETMF). As reported in Morningstar on 10 June 2021, Monash founder and co-portfolio manager Simon Shields said about the discount problem:

“Within two years of its listing, we thought, this is reflecting badly on us. We felt it was besmirching us to be managing a LIC that was trading at a discount and we weren’t prepared to have this situation continue.”

As the manager of a LIC that has been successfully trading at a premium - Plato Income Maximiser (PL8) – we have a different take on LICs. In the absence of a mechanism to arbitrage the difference between NTA and market price, the price of a LIC simply reflects relative supply and demand for the LIC. LICs trading at a discount have more shareholders wanting to sell the company than buy it, simple as that.

Throughout this paper, the same arguments can largely be made for Listed Investment Trusts (LITs).

So, here are five reasons why a LIC may trade at a discount.

1. No raison d’etre

We feel LICs should have clear reason for being, that is, a clear appeal for investors - for investors are the people who buy and sell the LIC. If a LIC is simply a carbon copy of a managed fund, with no special features, and perhaps a more costly fee structure (taking into account listing and directors' fees) then one might question what is the raison d’etre for that LIC.

Our LIC has a clear reason for being. A LIC structure lends itself to banking profits and smoothing income payments across financial years, providing a regular income stream to retirees. PL8 is still to our knowledge the only LIC that pays its shareholders regular monthly fully franked dividends, fulfilling retirees needs for regular income in a time when many traditional income assets can’t even keep pace with inflation.

Other good reasons for a LIC or LIT structure may be to access assets that don’t lend themselves to traditional managed funds or ETFs, such as illiquid assets like real infrastructure, private equity or private debt, or assets that retail investors are less likely to have in their portfolio like small cap or micro cap stocks.

2. Manager greed

Manager greed can take many forms. LICs are a great way of raising permanent capital for the manager but that doesn’t help the investors in those vehicles.

Greed can be reflected in fees. The fee structures of some LICs can be excessive. In my opinion, it’s difficult to justify fee structures in excess of 1% pa, particularly when the company also has to pay for the costs of a listed vehicle. (For comparison, PL8 charges a management fee of 80bp pa + GST).

And many managers also charge performance fees on top of that! Some argue that performance fees align interests, but should not all managers seek to maximise returns for their clients in any case? And they can be aligned by investing in their own funds/LICs/LITs. 

Greed can also be reflected in asset size. In the hype and hubris of an IPO campaign, managers might issue more capital than they initially planned, or more than a normal market, not an IPO campaign-influenced market, can bear. Once the hype of the IPO dies away, if there are more sellers than buyers, then the LIC will likely trade at a discount. In this case, a buy-back may help equalise supply and demand.

3. Inadequate size

There is a reasonable amount of evidence that size matters, with bigger LICs more likely to trade at or above NTA. Partly, this may reflect economies of scale in terms of costs. Buying back stock exacerbates the size problem.


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4. Poor performance

Whilst its not always the case, company performance is often the reason why LICs trade at a discount, with shareholders wishing to exit an underperforming asset. Trading at a discount then exacerbates the underperformance, causing a potential vicious circle.

The problem is that no manager can outperform all the time, and investment styles like growth or value can have long periods of underperformance. Until recently, value has performed miserably around the world for about 10 years.

Of course, if the manager is just rubbish then the LIC deserves to be trading at a discount, but if it’s purely a matter of style, contrarian investors may use the discount to enter the contrarian asset at an attractive price.

5. Lack of communication

As in all things, communication is also key. LICs and their managers need to clearly communicate with their shareholders, keeping them regularly informed. Lack of communication may also help explain why some LICs trade at a discount to NTA.

Summary

I believe that well-managed, reasonably-sized LICs with a real raison d’etre for investors (not the manager) and reasonable fees should trade pretty close to their NTA over time. For small LICs with little investor appeal and excessive fees, perhaps they may be better off closing or converting to another structure.

 

Dr Don Hamson is Managing Director at Plato Investment Management. This article is general information and does not consider the circumstances of any investor.

 

 

 

15 Comments
Simon
July 20, 2021

Do the older lic investors who comment on this site stick to DCA methods or do they plonk money in their chosen old school lics only on gloomy days??? Trying to implement a plan of DCA of 5k every quarter but main stream media seem to be in love with ETF's at the moment.

Danny
July 02, 2021

I love LIC's. ETF's are my larger holding but LIC's are my fix for individual shares. They still keep spitting dividends and have done really well for me for many years. When I say LIC's, for me, its the grand daddy's (AFI, MLT, ARG etc.).
I enjoyed the excitement around MLT. I ended up selling at a premium in the new financial year as was not comfortable with in my opinion - were over valued SOL shares.
I think LIC's have a place. Also in response to a poster saying they don't have cash to take advantage of market drops, if I am not mistaken, don't some of them hold a certain % in cash?
Cheers

Geoff
July 04, 2021

Spot on Danny! I've had AFI and ARG since 1985 and swear by them as a SMSF product, franking credits and only 0.18% management fee!

A LIC investor
July 01, 2021

Gday Don

Agree with most commentary though personally think the key is really a fully franked distribution yield that is attractive relative to market, and size & liquidity. Marketing helps to keep the discount low, though half is smoke and mirrors so doesn't help investor. Still amazing the industry doesn't have proper reporting standards for performance. Reporting portfolio performance is not what investors receive so time the industry cleaned up its act and highlight all the fees and charges investors are really paying.

Bob
July 01, 2021

I have been buying AFI on for 20 years but only on those very rare occasions it traded at a discount which are usually small and never last long. Using that approach I have gone from a couple of thousand to 60000 shares over the years. I would think the divs would have pretty much amotised over half my outlay. We are also seeing the manager cherry pick some of the new tech stocks. Buy backs, de mergers like WOW and EDV, special divs etc all create opportunities for cash. For me its been a wonderful investment over a long period of time with a board that communicates well, is entirely focussed on costs and a long term view always on the shareholder. A true set and forget stock in my view. Mind you ARG, MLT AUi etc would probably do the same.Whitefield is another smaller LIC if you just want industrials.

C
July 01, 2021

Beating the market index should be a goal of a good LIC also. Sadly too few of them do.

James
July 01, 2021

Yes Gary, it’s a fine balancing act but one that prejudices the ETF redeeming funds, especially if prudent LIC management has some dry powder in the keg. I’ve also noticed a recent increase in cap. raisings, including by some LIC’s, typical of conditions being above the long-term mean on several criteria.

Adrian
July 01, 2021

Nice article explaining the LIC market in simple, straightforward terms. I agree with Rob's comment too. The LIC market will increasingly become a niche. The demographic is mainly older SMSF investors and as each decade passes it will dwindle, in my humble opinion. We are seeing consolidation now, but the cycle will turn again and already we see LIC's putting out options, soon more IPO's will follow. Younger investors favour ETF's and advisors would be hard pressed to recommend LIC's over ETF's given the reasons mentioned e.g. transparency, liquidity, cost. For long-term investors, LIC discounts and premiums can be a distraction and actually the key thing is to find an honest and capable manager who is going to compound your wealth over time. If you get this right the investment format (ETF, unlisted trust, LIC) doesn't really matter in the long run.

Rob
July 01, 2021

LIC's are standing in front of an ETF freight train. Market message is clear about liquidity, transparency and cost and as the ETF's charge down the track on thematic funds, only scraps will be left on the table

C
July 01, 2021

There is a significant tax advantage with LICs in that actively managed or thematic ETFs must distribute their capital gains to investors in the same way as unlisted managed funds. I recall once getting whacked with an $8K capital gain in my annual fund statement that I therefore had to enter on my tax return , while the funds unit price hadn't gone up much for the year. Whereas LICs only distribute fully franked dividends. As for costs, the large well established LICs such as AFI, ARG, MLT, BKI, AUI, DUI charge MERs of 0.15% or less which is much the same as index ETFs, and cheaper than thematic ETFs ( usually around 0.3 -0.4% ) and a lot cheaper than actively managed ETFs

James
July 01, 2021

One of the often overlooked advantages of LIC’s over the ETF is the closed structure that largely distinguishes them. In a market correction, when many “investors” head for the exits, the ETF will be liquidating in order to fill redemptions, at precisely the time that a good LIC manager will be positioned to take advantage of bargains.
The current wave of conversion-obsession appears to be driven more by predator-insulation and short-term opportunism than strong long-term fundamentals. Give me a well-managed LIC at a nice discount every day of the week.

Gary M
July 01, 2021

James, agree with the general comment that the LIC manager does not need to sell, but how are they able to buy? There is no new money coming in, so the only way they can buy is by selling something (not good in a down market) or using their modest cash holding. Or do you want a LIC manager to hold a lot of cash waiting for the downturn? That ensures underperformance in a rising market which probably increases the discount due to LIC investors selling.

Chris W
July 02, 2021

The LICs usually have a strong inflow of dividends and interest spread throughout the year, drps and spps plus substantial borrowing facilities with several banks that are able to be drawn on for increased investments at opportune times. It is all about cash management and opportunity.

Peter Thornhill
July 16, 2021

You don't have to worry Gary, the LIC's have unlimited access to capital at the drop of a hat.
The primary functions of the share market are to enable companies to raise capital and to then provide a mechanism for you and I to exchange for value ownership of those shares. The fact that it appears to often be treated like a casino speaks volumes about the behaviour of humans.
I have looked back over the last 20 plus years at my LIC holdings and am pleased to report that I have enjoyed over 30 opportunities to purchase additional shares with no brokerage and usually at a small discount.
All were capital raisings by the LIC's to bolster their balance sheets. Before anyone criticises a LIC for this, consider the fact that they are a company just like every other company on the stock exchange.
A parallel with much of Australian industry during the GFC would be worthwhile remembering. At that time credit markets had locked up and the only source of available capital were existing shareholders. A huge flow of capital raisings flooded on the the market as companies bolstered their balance sheets during a rather difficult period. Companies raise capital for a variety of reason, buying another business, paying down debt etc.
Go back and read your comment again in light of the above. Oh, by the way, I have a huge list of capital raisings by other companies in my share portfolios stretching back decades.

Adam L
July 02, 2021

I agree with James - LIC's can operate against the general emotion of the masses. As markets become expensive and managers cannot find value they can accumulate an amount of cash - then when the markets turn they are then able to purchase when value reappears. From what I understand EFT's still need to nominate how invested they will be in the asset class and how much cash they will hold - so from my understanding they are still subject to the emotion of their contributors - they are forced to buy as money comes in and sell as money flows out. When someone sells out of an LIC they are they only one affected by that decision is the way I understand it, where as when a person sells out of an ETF the fund needs to sell to fund the redemption - effectively affecting the fund.
That as well as the franking credits are the main difference / benefits of this platform as I understand it.

 

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