Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 193

Why LICs differ in dividend sustainability

With company reporting season now behind us, we take a look at how the listed investment company (LIC) sector fared. The majority of LICs reported lower earnings for the six months to 31 December 2016, mainly due to lower dividend income. Some LICs, mainly those with a small cap-focus, experienced lower capital appreciation from their investment portfolios. The potential for lower earnings had been well-flagged by many LICs given the lower dividends from the mining, energy and retail sectors and ANZ Bank.

Dividends flat despite lower LIC profits

Despite lower reported earnings, most LICs reported good portfolio returns (pre-tax-NTA plus dividends) for the period with the S&P/ASX 200 Accumulation index up 10.6% for the six months to 31 December 2016. The average portfolio return for the large-cap focused LICs under our coverage was 7.8% while the mid/small-cap focused LICs produced an average portfolio return of 3.7%.

The apparent disconnect between the good portfolio returns from the large-cap focused LICs and the lower reported earnings reflects the fact that most, particularly the larger, long established LICs, report only dividend income and realised profits in the income statement. These LICs are long-term investors, so unrealised portfolio revaluations are not recognised in the income statement. Many of the newer LICs, particularly a number of the small-cap focused LICs, tend to hold investments for shorter periods and their reported earnings rely more on capital appreciation, with both realised and unrealised gains and losses reported through the income statement.

Given the trend of lower reported earnings, it was not surprising to see few increases in interim dividends. As shown in the table, all of the large cap focused LICs in our coverage held dividends flat, except CBG Capital (ASX:CBC) which reduced its dividend. A number of the mid/small-cap focused LICs announced modest increases in dividends. Amongst the LICs with an international focus, Cadence Capital (ASX:CDM) reduced its dividend, not surprising given relatively low profit reserves, while Hunter Hall Global Value (ASX:HHV), which has a high level of profit reserves, increased its dividend despite reporting a lower profit.

Update on dividend sustainability

In our August 2016 LMI Update, we discussed dividend sustainability and how this is a critical issue when choosing LICs. We mentioned that LICs that rely largely on dividend income for earnings are less likely to report losses during periods of market downturns, and therefore the dividends they pay to their own shareholders are likely to be more sustainable. However, if the companies they invest in are forced to lower dividends due to reduced earnings, then, depending on their own payout ratios, the LICs may also be forced to reduce dividends, or at best hold them at current levels. We have seen this occur in the recent reporting season, with the lower dividend income from portfolios resulting in flat dividend payments by the large-cap focused LICs. In our report we also noted that LICs with a greater reliance on capital appreciation were more likely to be forced to reduce or even stop payment of dividends in a sustained market downturn. However, with positive market returns this has not been the case over the past six months. Portfolio gains and reasonable profit reserves have allowed some of the mid/small-cap focused LICs to slightly increase dividends.

Whilst LICs need to generate profits in order to pay dividends, it is possible for them to pay out more than they generate in profits in a given year by dipping into retained profit or dividend reserves from prior years. So it is possible for LICs to smooth dividend payments to their shareholders by retaining profits rather than simply paying out 100% of earnings each year. The table above shows our estimates (based on the latest published accounts) of the number of years each LIC under our coverage (excluding those that don’t pay dividends) could retain current dividend payments without generating any additional profits. This is a good indicator of dividend sustainability when markets turn down. Coverage of one means that a LIC could maintain its current dividend payout for one year without generating any profit in the current year. There a number of LICs with dividend coverage of more than two years which means they are reasonably well placed in the event of a sustained market downturn.

Attractive yields remain but watch profit reserves

Despite the flat, or modest increase in dividends, the LIC sector still offers attractive yields for investors. We calculate an average dividend yield of 4% across the Australian share focused LICs with most LICs paying fully franked dividends. We think it likely that the LICs will experience stability in their dividend income over the next six months and do not expect to see many reductions in dividends from the sector. It is possible we may see modest dividend increases from some LICs.

It is important to watch management commentary for any indications of potential changes to dividend payments. We note that Djerriwarrh Investments (DJW), one the highest yielding LICs currently, has already said it expects to cut its dividend from 24 cents per share to 20 cents per share in 2017. Also, keep an eye on those LICs that have low levels of profit reserves as this could also be an indicator of a potential dividend reduction.

Peter Rae is Supervisory Analyst at Independent Investment Research. Extracted from IIR’s February 2017 LMI Monthly Update. This article is general information and does not consider the circumstances of any individual.

6 Comments
Garry B.
March 10, 2017

Another factor to consider is LIC Capital Gains Tax Deduction. This occurs when long term holdings are sold at a profit and the CGT consequences are passed through to the shareholder. The tax effectiveness depends on your tax rate-not much use for SMSF. The older style LIC's will often pay these type of dividends, but the newer share trading type will not be able to. An LIC CGT deduction can be quite nice when you come to filling in your tax return.

Ian A
March 09, 2017

Thanks for this article Peter.

In regard to your following comment it doesn't appear correct to me? The difference in reporting of unrealised capital gains / losses in the Income Statement for low turnover LICs (don't) and Trading LICs (do) should be irrelevant if using pre-tax NTA plus dividends for performance comparison. The reason being that pre-tax NTA "includes" unrealised capital gains for "ALL" LICs but not deferred tax on this.

"Despite lower reported earnings, most LICs reported good portfolio returns (pre-tax-NTA plus dividends) ...

The apparent disconnect between the good portfolio returns from the large-cap focused LICs and the lower reported earnings reflects the fact that most, particularly the larger, long established LICs, report only dividend income and realised profits in the income statement. These LICs are long-term investors, so unrealised portfolio revaluations are not recognised in the income statement. Many of the newer LICs, particularly a number of the small-cap focused LICs, tend to hold investments for shorter periods and their reported earnings rely more on capital appreciation, with both realised and unrealised gains and losses reported through the income statement."

Could Peter (author) or others here please comment on whether my understanding is correct?

Thanks in advance.

Peter Rae
March 09, 2017

Thanks for your comment/question, Ian.

Your statement that "pre-tax NTA "includes" unrealised capital gains for "ALL" LICs but not deferred tax on this..." is correct. Pre-tax NTA is a measure of total portfolio return (including realised gains, unrealised gains, income and expenses) and is the way that we compare LIC performanc?e.

However, what the article is pointing out is that there is a disconnect between total portfolio returns (pre-tax NTA + dividends) and reported statutory net profit for the LICs that don't report unrealised gains in the income statement. Their income statements comprise primarily dividend income plus any realised gains, less expenses. During the latest reporting season many of the LICs reported lower statutory earnings due to lower dividend income. However, as the article points out, when you look at the total portfolio returns for these LICs, they reported solid returns.

What the article also says is that LICs can only pay dividends out of profit reserves. LICs that don't report unrealised gains through the income statement (ie they are on capital account) cannot pay out these gains as dividends until they are realised.

The article was aimed at investors who rely on LICs for dividends.

Hope this helps.

Regards
Peter

Ian A
March 09, 2017

Thanks very much for that Peter.

Yes, fully understand the statutory reporting difference between the dividend harvesters and Trading LICs. In hindsight I read your comments out of context. All makes sense now.

An interesting example is Whitefield (WHF) which cops bad press from numerous investors due to no dividend growth since the GFC. It didn't cut its dividend of course during the worst of the GFC. So those who focus solely on dividends are missing WHF's real performance (accumulation NTA growth) which has been much better than most of the other older style LICs in recent years.

So given the above and the gloss many LICs put on profit announcements including performance BEFORE fees in some cases all I can say is that thank goodness there are Research Reports such as yours available where we can get the most important performance data being pre-tax accumulation NTA annualised over different time periods.

Thanks again.

Ashley
March 09, 2017

Unrealised portfolio revaluations are not recognised in the income statement – yes but the unrealised gains in underlying shares should be reflected in high LIC prices – that’s the problem with LICS. And the div yield of 4% is not attractive since it is 10% lower than the overall market yield. Attractive means better, not worse!

Gary M
March 09, 2017

I guess there are people out there who look for income in LIC’s but it isn’t me – I thought if anything it would be total return prospects.

 

Leave a Comment:

     

RELATED ARTICLES

LIC reporting season wrap for 2017

How long can your LICs continue to pay dividends?

Four simple strategies deliver long-term investing comfort

banner

Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Fear is good if you are not part of the herd

If you feel fear when the market loses its head, you become part of the herd. Develop habits to embrace the fear. Identify the cause, decide if you need to take action and own the result without looking back. 

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 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. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.