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Why LICs may be close to bottoming

It’s hard to think of a segment of the market that is more hated by retail investors than Listed Investment Companies (LICs). Hate may be too strong a word as LICs were hated a year or two ago, but now they’re mainly ignored.

Yet, institutions are getting increasingly busy in the sector, including:

  • VGI Partners Global Investments’ (ASX:VG1) trading volume has recently shot up as speculation mounts that Regal may consider merging the $561 million LIC with the $826 million PM Capital Global Opportunities Fund (ASX:PGF). That comes after Regal acquiring both PM Capital and VGI Partners.
  • Saba Capital, a US$4.4 billion global hedge fund known for pressuring funds to act to close discounts to asset values, has taken an almost 10% stake in Hearts and Minds Investments (ASX:HM1), the charity investment vehicle. Saba owns shares in several other LICs including MFF Capital Investments (ASX:MFF), Platinum Capital (ASX:PMC), and WAM Global (ASX:WGB).
  • Wilson Asset Management has entered into a scheme of arrangement to merge with QV Equities (ASX:QVE) to create an almost $2 billion vehicle.
  • Early this year, the board of small caps LIC, Spheria Emerging Companies (ASX:SEC), gave the manager a deadline of one year to close its discount to net tangible assets (NTA), or the LIC will be delisted.

The corporate activity follows a swathe of funds including Magellan, Bennelong, Antipodes Partners, Monash, Partners Group, Forager and others, who’ve pulled or intend to pull listed funds.

The comments from some of these funds has been instructive. When Forager announced its intention to delist the ~$145 million Australian Share Fund from the ASX in October last year, it stated that the fund had tried and failed to narrow the share price discount to Net Asset Vale (NAV):

“Investor apathy towards close-ended investment vehicles has become entrenched and … smaller, less liquid vehicles like FOR are unlikely to trade at NAV for the foreseeable future.”

It went on to suggest that it wasn’t fair for investors who wanted to redeem money that they’d have to do it at a +15% discount to NAV.

And, in August last year, unitholders voted to remove the $465 million Partners Group Global Income Fund from its ASX listing. Partners Group, a global fund manager, cited several reasons for the delisting:

  1. The lack of liquidity led to the fund trading at an NTA discount about 90% of the time.
  2. Unitholders had continued to give negative feedback on the discount and pushed the company to address it.
  3. Buy-backs were an unlikely panacea as while they might boost the share price in the near-term, they were unlikely to in the longer term.
  4. A change to an open-ended unit trust structure would give investors to ability to realise an investment at NTA and also give Partners Group the opportunity to increase the fund’s size.

How do we make sense of the retail investor apathy and de-listings on the one hand, and the hive of corporate activity on the other?

A $51 billion pool of money

Before getting to that, let’s first look at what LICs are and aren’t, and how they compare to listed investment trusts (LITs), and exchanged traded funds (ETFs). LICs are investments funds where money is pooled to buy assets. While LICs are companies that issue shares, LITs are trusts that issue units. This article will refer to LICs for both, for simplicity’s sake.

LICs are ‘close-ended’ as there are a fixed number of shares on issue. ETFs are ‘open-ended’, meaning they can issue new shares, or retire them.

As Graham Hand has previously mentioned in this newsletter, the strength of LICs is also their fundamental weakness. The strength is the committed, or permanent, capital means portfolio managers aren’t forced to sell assets to meet redemptions. The weakness is that without these managers providing liquidity, it must come from the market. If demand for buying is less than the supply of selling, then LIC prices fall and can trade at discounts to NTAs.

Putting the sector in context, LICs are small, though still significant. The market capitalisation of the sector stands at more than $51 billion. The number of LICs listed on the ASX peaked at 115 almost six years ago and is down to 88 now.


Source: ASX

About 62% of LIC assets are in domestic equities and 27% in global equities.


Source: ASX

The LICs sector is dwarfed by ETFs and managed funds. ETF assets under management in Australia reached $189 billion last month.

Australian ETF Industry AuM: July 2001 – February 2024

Despite ETFs getting most of the press coverage, they are still small fry when compared with managed funds (including super, unlisted funds, life insurance funds), which have $4.8 trillion of funds under management, as at the end of last year.

Why the fuss over LICs, then, given their relatively small size? For fund managers, there’s the obvious attraction of having permanent capital and the associated management and performance fees that come with it. This can result in managers choosing to keep LICs listed even if a NTA discount persists, because they want or need the fees, among other reasons.

For investors, LICs can give them access to quality managers, with the ease of trading them on the stock exchange. Right now, they can also get these managers at potentially large discounts to NTAs. LICs can also be useful for income investors as they have the ability to smooth dividend payments via their profit reserves.

LICs struggling with large discounts

Currently, LICs are trading at some of their steepest NTA discounts on record. Whereas some segments of the sector have usually traded at premiums or close to NTA, now all of them are at discounts.

Premium/discount by investment mandate (market cap weighted)

The chart above shows that large cap LIC have traditionally traded at or above NTA, yet they are currently at discounts. The mid and small cap segment is in the doldrums, and has been for some time, reflecting their benchmark’s underperformance versus large caps. Private equity funds trade at the largest discount, perhaps indicating scepticism around valuations for their assets. Meanwhile, fixed income funds seem to be back in vogue.

Breaking it down by market cap, the smaller the LIC, the greater the NTA discount.

Premium/discount by market capitalisation band (market cap weighted)

But even among large cap LICs, the current discounts appear extreme. The biggest LICs such as Australian Foundation Investment (ASX:AFI) and Argo Investments (ASX:ARG) are trading close to their widest discounts over the past three years. 


Source: Bell Potter

Reasons for the discounts

Why are LICs trading at such large discounts? There are many reasons, some of them self-inflicted, such as:

Underperformance. Many LICs have underperformed their benchmarks in recent years. Their jobs haven’t been made easy by the concentration of market gains in large caps. Yet, that’s not an excuse as good managers will find a way to outperform over an investment cycle.

High fees. A number of LICs still charge high fees even when they consistently underperform. A little-known fact is that LICs charge the fees against NTA not their market value.

Lack of scale. Among the 88 LICs, there are a lot under the $200 million market cap mark that lack scale. Scale brings marketing power, and potentially lower management expense ratios.

Liquidity. Lack of scale can also bring liquidity issues, especially for institutions wanting to buy and sell.

However, there are other reasons, little mentioned, that are likely behind the LIC underperformance too:

LICs typically underperform during stock bull markets. As markets run up, investors are more willing to trade out of LICs to play the market directly.

ETFs have acted as an accelerant to this trend. The inflows into ETFs in Australia over the past six months has been extraordinary. It’s led to 11 ETF products hitting the market in February alone, after a record for new ETFs in 2023.


Source: Morningstar

The ETF money has been flowing into the hottest areas of the market. Where once retail investors didn’t want to invest overseas, they are now piling in.


Source: Betashares

While ETFs have much going for them, including low costs, the above charts suggest that there is a lot of momentum trading happening as well.

LICs may offer value in a valueless world

What’s happening with LICs is akin to a normal business cycle of boom and bust. LICs were hot in the mid-2010s. In each of 2014, 2015, 2017, and 2018, there were 10 or more LIC IPOs. Many of the funds now delisting, or being taken over, were part of this wave.

Yet, like many industries, success brought oversupply and increased competition. The competition not only came from other LICs but ‘disruptors’ such as ETFs. That’s meant LICs have had to increase marketing and lower fees and costs, which have hit the small-scale funds especially hard.

We are now at the point in the cycle where savvy investors see value and are pushing for changes. That’s leading to increasing consolidation in the sector. From a business cycle perspective, these types of things typically happen at the bottom of cycles. It’s not unlike what’s starting to happen in the lithium and nickel sectors, though LICs are likely further along in the cycle.

There’s undoubtedly value in the sector. That’s why Geoff Wilson, Saba Capital, and Regal are diving into LICs. As retail investors chase momentum and growth stocks, LICs perhaps represent one of the few pockets of value left in the market.

 

James Gruber is an assistant editor at Firstlinks and Morningstar.com.au

 

20 Comments
John
April 03, 2024

For those interested in the Active / Passive Debate a couple of observations.

The 'S&P Dow Jones Indices Australian Scorecard' is the principal source of the 'proof' that Active Managers consistently underperform benchmarks. But the facts is that it assumes that investors naively (or randomly) invest in managed funds with retail fees. Having spent over 50 years working in institutional investing I can assure you that this in not the case fro Institutional Investors.
In reality institutional investors:
a) Pay only a small fraction of retail fees; and
b) Not investing with the average manager - due to the manager search that they carry out.

The net result of this can be seen in the performance of Australian Super's and Hostplus's actively managed and indexed products, which have been running for over 10 years.

Australian Super: Periods to June 2023
Option Investment Fees 1 Year 2 Years p.a. 3 Years p.a. 5 Years p.a. 7 Years p.a. 10 Years p.a.
Balanced (Active) 0.50% 8.22% 2.60% 8.23% 6.72% 8.14% 8.60%
Indexed Diversified 0.10% 11.56% 2.57% 7.44% 6.44% 7.18% 7.22%

Active Outperformance -3.34% 0.03% 0.79% 0.28% 0.96% 1.38%

i.e. The Actively Managed product has consistently outperformed after fees (by 1.38% p.a. over 10 years) even though active investment management fees have been 0.40% higher each year.
The equivalent Hostplus products show similar levels of consistent outperformance.

Unlike the S&P Scorecard (and recall that S&P are in the business of selling index data to index managers) the Australian Super and Hostplus products are real funds that real investors have had investments in over the last decade.

Michael
March 30, 2024

It's complicated.

1. I see the "retained funds to guarantee dividend" argument as a negative. Some LIC's have many years worth of dividends sitting in an account, being charged fees. Why doesn't the manager reinvest it, to increase dividend? Why not pay it out, so the investor can reinvest? When will shareholders actually receive value from these parked profits?

2. Some of the big old LIC's, like AFI, used to pay above market dividends. Good time to buy & hold. But now they pay below market dividends. Why should anybody buy now?

3. likewise with NTA calculations. Why should a new investor buy a tax debt? I can buy the underlying shares without a tax liability.

4. I have flirted with LIC's. I like the concept, but reality is often different. I currently own GVF, D2O & VG1. All were purchased at significant discount to NTA, pay strong dividends in a timely manner. But mostly they do things I can't do directly, and this is the essential factor, for me. It helps tolerate the inherent deficiencies, knowing I don't have a better alternative.

5. Buybacks are rife, and don't work.
Wilson's & Plato seem to have shown that paying a strong dividend does more for the share price than a buyback

JM
March 31, 2024

1) Sounds like a bit of a misunderstanding of what retained earnings is about. Can you name a LIC that holds this in cash purely as a reserve and not for some other reason?

I suggest reading the comments on this previous post which highlight retained earnings as purely an accounting measure that measures whether franking can be applied to a dividend: https://www.firstlinks.com.au/lic-dividend-coverage

Regarding buybacks, you're right that they don't often have the desired impact, though the recent buybacks from AUI and DUI seem to be having some effect already. And it's worth noting they don't just support the immediate share price but are also NTA accretive.

Michael
April 03, 2024

Thank You, JM.
I had no idea the concept of retained earnings was so arbitrary. I am naive enough to have thought it a real quantity of funds, in the LIC's possession.

Paul
April 03, 2024

You are spot on about retained earnings being an accounting measure that measures dividends that can be paid out. I am not sure retained earnings or dividend coverage in an LIC (perhaps these are different things?) necessarily indicates that there are sufficient franking credits to pay franked dividends.

I know Wilson Asset Management regularly publishes the amount of dividend coverage on the LIC’s they run but recently they have had to pay only partially franked dividends in some of these companies because they had insufficient franking credits.

Jim Lane
March 29, 2024

I've never understood the regular bagging of LIC's, nor investor dislike of buying a share at a cheaper price than its true value, or management embarrassment about their higher yielding portfolio.
Let's assume an LIC is trading on a Market Cap. of $80,000,000, but at a (not uncommon) discount of 20% to the NTA of its underlying portfolio, $100,000,000.
If the underlying portfolio is generating a net return of 10% - that is, $10,000,000 .... then the LIC's yield is a very heathy 12.5%, being $10million on its (purchasable) trading value of $80,000,000.
Now, I'm no rocket scientist, but what that (and the performance of my portfolio) tells me, is that I'm getting something for which I'm not paying full price. I'm still able to assess the holdings in the portfolio as well as the calibre of the investment team, who are often similar personnel as for a comparable ETF - where you'll get NO discount and usually NO franking credits.
But as long there are those in the market willing to suppress the price of well managed and performing LIC's, on the basis of changing fads, I remain delighted to accept their money.

CC
March 29, 2024

Jim, show me a well performing LIC that is yielding 12.5% ?

Jim Lane
March 29, 2024

CC, the numbers used were to simplify the point being made. The principle remains.

Garry B
March 28, 2024

Firstly, if you invest in an initial float of a new LIC, you will likely find that the price often dips into a discount-solution do not put your money into floats. Buy shares in a well run LIC trading at a discount. Avoid any LIC with an out- performance fee, since it introduces an incentive to take excessive risks-bad managers have destroyed LIC's, by gambling.
Secondly. Not all the published NTA's are quoted on the same basis. Is it proper to regard the pre-tax NTA as the standard, if liquidation would mean much of the capital gain may end up being paid to the ATO. Should franking credits be treated as an asset?
Thirdly. Market volatility. If you are patient, and buy at a meaningful discount, you can collect your dividends, and when price rises above NTA sell and buy a different LIC, that is trading at a discount. I recall that many of the LIC's that later became Australian Foundation, in the 1960's, were regularly trading at 20% discount. The cumulative rewards over time, for those who grasped the opportunity have been great.
For people, who read the prospectus for a new float, and then send their money in, you are likely paying an excessive price, and all the whining about discount to NTA, is because you paid too much. Learn. See the discounts as an opportunity, and not a negative.

Graham Wright
March 28, 2024

My comments on the 2 most persistent negative issues re LICs:
1. FEES: So many investors object to performance and management fees associated with LICs. The LICs state these fees up front so they are obvious. We do not hear criticism of the management and performance returns received by various levels of management in our listed companies. That is because they do not receive fees as such. But the higher salaries, annual bonuses and performance bonuses paid in cash and share options can grossly exceed the rates available to LIC (and other fund) managers. Which investors reject investing in our largest companies because of exorbitant salaries and bonuses of various types?
2. NTA premiums and discounts: Many see this variation between shareprice and NTA as a reason to avoid investing in LICs. They are quickly and easily aware of this at any time because the LICs are required to publish their NTA values at least monthly. Are these wary investors aware of the NTA for major listed companies and would such awareness change their behaviour? This morning I found on Market Index, the NTA for WOW (latest 06/23) was $0.06 while todays shareprice is $33.2. Similarly, the CBA NTA is 0 while the sharprice is $120. The premiums being paid for these are massive. Who is complaining about all these? In case of a fire sale, these companies yield nothing to shareholders. At least one would expect better than nothing from a firesale of an LIC if such an event were to happen.
I'm just grateful I can see value in LICs after considering what others see as negatives and in the process I hope to profit from other investors fears,

Michael
March 30, 2024

Most of the LIC's are invested in those companies with tiny NTA.

James
March 28, 2024

Great article. Fundamentally, active managers have shown to consistently underperform the index. You can’t have over 80% failing to meet the benchmark and expect people to flock towards the investment. Despite the proclamations of active managers, they fail across bull and bear markets.

Terry Hills
April 02, 2024

An Index doesn't pay tax. That "pre NTA" number is_after_tax has been paid on those realise gains remember.

Want a franked dividend? Well, your NTA needs to pay that tax then. Add tax paid to LIC returns and a much higher % of them will be outperforming that no dee and no tax index return

JM
March 28, 2024

Regarding your point that "LICs can also be useful for income investors as they have the ability to smooth dividend payments via their profit reserves."

I'd also add for an income investor, if you're buying a LIC at a discount you're getting more income for your dollar, ie: you're getting the income from the full portfolio value without having to pay that full value.

Steve
March 28, 2024

Underperformance was it for me. Large LIC's continually not meeting the index is not good enough. End of.

Neil
March 28, 2024

A significant reason (not covered explicitly in the article) is the passive vs active investment debate. The fees favour passives / indexers when the market is hot, but when the market goes cold, will this still be the case as the passive investors "run for the hills"?

James
March 28, 2024

Neil, respectfully, there is now over 35 years of data showing this is never the case. All it has ever shown is persistent outperformance from passive over active. The tagline of, wait til the market turns, has been the ruse of active managers for years.

John
March 28, 2024

James, respectfully, the 'data' you quote is based on paying full retail fees and being a naive retail investor, which investors in institutional vehicles such as Super Funds and Large LIC's do not pay.
If you allow for institutional fees and the value added by institutional level research, then the 'data' that you refer to demonstrates that active significantly outperforms passive.

Gerald W
March 28, 2024

John,

Where's the data or evidence that active funds outperform post institutional fees?

Steve
March 28, 2024

SMA Managed Account Portfolios have rendered LICs pretty much redundant, unfortunately.
Not having to deal with NTAs is one less BID risk for advisers.

 

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