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How long can your LICs continue to pay dividends?

With reporting season well and truly behind us, we thought we’d take a look at the state of Listed Investment Company (LIC) balance sheets and their dividend coverage.

The company structure of LICs allows them to retain earnings and regulate the payment of dividends in any given year. This is an advantage LICs hold over trust structures. As a company, they can transfer after-tax profits to their dividend profit reserves as a prudent measure to improve the capacity to pay future dividends, consistent with forward policy guidance.

Some LIC dividends draw on previous reserves

With an estimated overall 25% decrease in dividends paid by ASX companies over 2020, it is unsurprising that in in the first half of FY21, most equity LICs paid out more in dividends than they reported as net profit, thereby creating payout ratios greater than 100%, as shown below.


Source: Iress, IIR

We see that many of the LICs in our Australian Shares - Large Cap and Mid Cap sectors that relied on dividend revenues had payout ratios greater than 100%. However, LICs that rely more heavily on capital gains to generate returns or had global exposures were able to book realised gains to boost their net profit and thereby reduce their payout ratios.

While payout ratios of more than 100% are clearly unsustainable in the long run, some LICs have the ability to tap their retained profits/reserves to make up the shortfall, while others elected to prudently reduce their dividends to reduce the burden on their cashflow and balance sheets.

How many years of dividend coverage do LICs hold?

To check the sustainability of LIC dividends, we look at how many years LICs in each category could maintain current dividend levels given the latest reported retained earnings/profit reserve.

On average, the Australian Large Cap category has 3.2 years of dividend coverage. WHF and FSI have the greatest number of years of dividend coverage, at 8.1 years and 6.9 years, respectively, if they were to maintain the current dividend amount. Both these companies were able to draw on reserves to maintain and in the case of WHF increase the dividend throughout the volatility of 2020.

TOP, ECP, OZG and CIN all have in excess of 15 years’ dividend coverage. Taking these four outliers out, the Australian Mid/Small Cap category has an average of 5.3 years dividend coverage.

There are only three LICs with less than two years of dividend coverage in the category (WAM, FGX and QVE). LICs focused on the smaller end of the market are more likely to rely on capital gains for the payment of dividends with lower levels of income typically generated through the portfolio. A strong first half of FY21 in the markets saw some LICs increase their profit reserves and boost their coverage ratios.

The Blended LIC category has a healthy level of dividend coverage as a group, with PIC having the lowest level of coverage at 2.8 years. HM1 paid an inaugural interim dividend for FY21. We have assumed the company will maintain the dividend for the final dividend for the purposes of this analysis. CDM’s portfolio performed strongly in the first half of FY21 which saw the profit reserve increase substantially and allowed for the company to maintain its dividend.

The International Shares-Diversified LIC category has a reasonably healthy level of retained earnings/profit reserves as a group. MFF and VG1 have the greatest level of coverage. The gains in VG1’s portfolio saw a significant increase in the profit reserve and allowed for the company to increase its dividend. PIA, WQG, FPC and PAF all have dividend coverage of 9+ years based on dividend declared for the CY2020.

In the Other category, LSF and ALF both have healthy dividend coverage. LSF paid and inaugural interim dividend and is yet to pay a final dividend so we have calculated the dividend coverage level based on the company maintaining the interim dividend amount. In the event significant franking credits are generated, we would expect the company to start paying out a greater amount of retained earnings as dividends.


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Relevance for a steady income stream

In summary, the level of dividend coverage should be considered by investors seeking a steady income stream. For those LICs that have many years of coverage, investors can be confident that there will be reduced volatility in their dividend income.

We note, companies will often seek to frank dividends to the maximum amount possible and therefore the extent of dividends may be impacted by the level of franking credits available. On the other hand, those LICs with a lower level of coverage may be susceptible to a reduction in dividends in the event the portfolio does not perform to expectations.

 

Claire Aitchison is Head of Equities & Funds Research at Independent Investment Research. This article is general information and does not consider the circumstances of any individual, and is based on an understanding of accounting treatment for LICs at the time of publication.

 

10 Comments
S Harvey Langford
May 16, 2021

Good reading

Ben
May 16, 2021

Editor: thanks for this comment, we have sent it to a LIC accounting expert for verification.


The central premise that "retained profit reserve" is a meaningful measure of how long an LIC can continue to pay dividends, in hard times, is an utter fiction, and is entirely misleading. Surely someone noticed that a LIC's "retained profit reserve" bears utterly no meaningful relationship to long how that LIC can continue to pay dividends when it's received dividend income dries up? "Retained profit reserve", is purely an accounting measure. It bears no relationship to the actual assets held by the LIC, and tells you nothing about what they have done with that "retained profit reserve". To all meaningful intent and purpose in this context, "retained profit reserve" is identical to "retained earnings". Where you do think that "retained profit reserve" is sitting, exactly? When an LIC pays out less in dividends than it receives, it will almost invariably use those funds to purchase further assets. For example (pretty much chosen at random): You state that state that WHF has 8.1 years of "dividend reserve", and that this indicates that they have 8.1 years of "dividend coverage" remaining, alongside a payout ratio of slightly over 200%. Yet Whitefield currently has 0.87% of its assets in cash (~$4m) and an NTA of $5.40/4.86 (pre/post tax) (source: April NTA update), and paid around ~$20m in dividends last year; and the Dec 2020 quarterly update states that they intend to repeat this in the year to come. See the issue here? They hold cash of about $4m and intend to pay $20m in dividends. There are only two ways to do this - to assume that the future income flow for year will be in excess of $16m (that's possibly true, or at least close), or, to sell down some of their investment folio and use that to pay dividends. Their "retained profit reserve" is ~$80m (2020 annual report). So at this point, it is fair to ask: What does their retained profit reserve have to do with their ability to pay dividends? In what meaningful way does the "retained profit reserve" in their annual report indicate that they have 8.1 years of dividend coverage at the current rate? The answer: None whatsoever. If they want to pay dividends in excess of their cash earnings, and in excess of their cash holdings, they must either liquidate their investments, or borrow. Exactly like any other company, and regardless of what their books state their "retained profit reserve" is. Finally: it has been quite a few years since an Australian Pty Ltd company was actually required to pay dividends "from profits". It was once the case that this had to be so; but this was abolished a while back. Further, one of course can always pay profits from retained earnings (of which WHF has $54m). So an LIC that has $X spare cash, which it wishes to distribute, and has $0 in "retained profit reserve" can always still distribute that $X as a dividend. If they have sufficient franking, they can still frank it.


The retained profit reserve is utterly irrelevant to an LIC's ability to maintain dividends.  

Scott Whiddett, Pitcher Partners
May 18, 2021

Ben, Scott Whiddett from Pitcher Partners is an expert on LIC accounting and provided this reply.

Ben is correct to have identified that the amendments to the Corporations Act in 2010 meant that a Company no longer needed to identify profits to pay a dividend (1).

However, what your reader may not be aware of is that these changes to the Corporations Act in 2010 led to the Commissioner of Taxation issuing a taxation ruling around the franking of dividends. In essence it warned that a dividend declared in accordance with the Corporations Act, does not necessarily mean franking can be attached to the dividend.

So the issue to highlight is really around being able to frank a dividend.

The Commissioner of Taxation’s ruling details that a franked dividend may only be paid when the Company can identify ‘profits’, as the term ‘profits’ is not defined in the Income Tax Act, the Commissioner of Taxation’s ruling suggests that ‘profits’ are those amounts determined in the context of the Accounting Standards. It was noted that where a Company has prior year accumulated loss the Company must make a decision to transfer the current period profits to a profits reserve and not allow the current period profit to be offset against a prior year loss (and taint current year profits). That is highlighting the importance of transferring profits to a reserve as a method of quarantining profits for future franking of dividends.

As far as how a LIC funds a dividend, I think it is fair to remind readers that LIC’s cash holdings can move significantly throughout a year and may not necessarily represent capacity to make a dividend. Some LIC’s have high take up of dividend reinvestment plans, so a smaller proportion of cash dividend paid. Many boards budget their dividend payments in advance and would be making capital management decisions around portfolio realisations and dividend and other cashflow inflows.

Kind regards Scott

Footnote 1

From 28 June 2010, the test became a three pronged test stating that a company must not pay a dividend unless:

1. The company’s assets exceed its liabilities immediately before the dividend declaration and the excess is sufficient for the dividend payment;

2. The dividend is fair and reasonable to members as a whole; and

3. Creditors are not materially prejudiced.

JJ
May 18, 2021

Thanks for the reply from Scott, but even Scott (eventually) notes is that what Ben said was absolutely correct in that retained profit reserve does not represent the LIC's ability to fund their dividend. I wonder when the misinformation around LIC's stop being perpetuated. I suppose never while there are vested interests.

John
May 15, 2021

While this is helpful I think that what is really relevant is how long can LIC's maintain dividends that are fully franked .
An unfranked dividend is equivalent to a return of capital which is not in the interests of the LIC .
Most shareholders in an LIC are true investors looking for a franked dividend.
As an example PIA has a stated intention to pay a constant dividend fully franked . They may have " profit reserves " of 10 years but there were losses at some stage and the unused franking credits will not cover anything close to 10 years .


Dave
May 13, 2021

I have often been told that this is an advantage over ETFs which pay out all profits. Doesn’t this really mean that ETF holders get their returns sooner to do with as they wish. In the end all the profits will have to be returned sometime. The idea that some LICs have 2 to 4 years profits held back from investors mean investors are losing out if the LIC is holding the profit in cash.

Justin
May 13, 2021

Yes, ETF s payout everything.... So your money now. But in reality it maybe a feast or famine effect... With no reserves there is nothing to distribute during lean times. The retaining of dividends is part of a capital management strategy that smooths dividend payments a bit like an allocated pension. Consistently paid and a consistent amount +/-. Retained dividend monies also allow the LICs to access buying opportunities without going cap in hand to the market or holders as a function of their closed ended structures. Noting they also often have loan facilities too

Peter Thornhill
May 16, 2021

Spot on Justin. ETF's are managed funds (unit trusts) dressed up with a market maker. Not only do they have to pay out all income but realised capital gains must also be distributed. In my experience this has led to some large fluctuation in distributions (i.e. your capital being paid back to you) with profound tax consequences. It was one of the reasons I left he industry. The most egregious example was a fund paying roughly $800 to $1000 in quarterly dividends and then, as a result of trading profits, dumping a $13,000 quarterly dividend in my lap at the financial year end with unexpected tax consequences. Added to this was the fact that the fund went ex-dividend and the unit price fell to reflect the payout. Over 9 years my quarterly dividends fluctuated between nothing and the $13K and the unit price rose by less than 3% over the same period. LIC's do not have to pay out realised gains and can reinvest the proceeds from sales on behalf of investors.

JJ
May 17, 2021

Peter,

Nobody is "dressing up" anything. An ETF is a fund that is traded on an exchange. It's literally the whole — Exchange Traded Fund.

You talk about the tax consequences of ETFs, when an accumulator who spends 4 decades accumulating still has unnecessarily high tax effects due to distributions form LICs paid out the entire time.

Also, it is a drag on returns that the LIC holds cash reserves to pay out their dividends, when an ETF investor can reinvest it sooner for those 40 years of accumulation.

As for "smoothing dividends", where do you think the dividends come from if not from the value of the shares? The man in the moon? Consequently, you can easily "make your own dividend" by selling (and you even get 50% off your CGT bill).

Hopefully those reading this are aware that they need to fact-check your comments if they want to make an informed decision.

John
May 13, 2021

Interesting article. Thanks for sharing it.

What is the impact of cross holdings (Example MLT owning shares in SOL) or fund of funds (Example HM1) that comprise several different funds? Doesn't this help to sustain dividend payouts?

 

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