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Why LICs trade at premiums or discounts

With a surge of Listed Investment Companies (LICs) coming to market recently in Australia, there are now over 60 LICs listed on the ASX with a combined market capitalisation of more $25 billion – up 15.1% over the last 12 months and a remarkable 52.1% over the last 24 months. A key feature of this investment vehicle is that, unlike unlisted managed funds, it can trade at a premium or a discount to its underlying asset value. Over the last ten years, Australian LICs have traded at an average discount to net tangible assets (NTA) of 6%. Today the median discount is 4%, with some LICs  trading at significant premiums to NTA including Djerriwarrh Investments Limited (ASX:DJW) and WAM Active Limited (ASX:WAA) with share price premiums of 24.0% and 34.0% respectively (as at 10 October 2014).

Increasing profile of LICs

This trend of reducing price discounts has been driven by a number of factors including the increased popularity of LICs following the introduction last year of the FOFA (Future of Financial Advice) reforms banning upfront and trailing commissions payable by other managed funds to investment advisers and financial planners. This development helped raise the profile of LICs and their benefits. In addition, while valuations of LICs traditionally focused on their discount/premium to NTA, in their ‘hunt for yield’ investors are now more focused on fully franked dividends, an important feature of LICs.

In this article, I look at the factors that may cause an individual LIC to trade at a premium or a discount to its NTA.

CS Chart1 171014

CS Chart1 171014

Source: Patersons ‘Listed Investment Companies’ Quantitative Research report – 27 June 2014

Trading at a discount to NTA

There are a number of reasons why a LIC may trade at a discount to its NTA including:

  • Poor investment portfolio performance, or for newer LICs, having no established past performance.
  • Lack of fully franked dividends, a poor track record of paying them, or a perceived inability by the market to pay fully franked dividends in the future.
  • Ineffective marketing and communications resulting in the failure of the LIC to raise its profile amongst prospective investors or build an understanding relationship with existing shareholders.

The consequences for a LIC and its shareholders when it consistently trades at a discount to its NTA are generally negative.

Shareholders are likely to become disgruntled, particularly if they bought their shares when the LIC was trading at or around its NTA. Consider a shareholder who bought when the underlying assets were worth $1.00 per share which later trade at 80c each. Trading at a discount means a LIC’s ability to raise capital is constrained and its growth is stunted. The LIC may then be forced into a share buyback or to undertake other capital management initiatives. Attempts to grow by raising capital at a discount are often highly dilutive to existing shareholders, further exacerbating or causing shareholder frustration. As a publicly listed company, disgruntled shareholders have the ability to call for the company to be wound-up, as with India Equities Fund Ltd (ASX: INE) and Van Eyk Three Pillars (ASX: VTP) in recent years.

Over time, if shares consistently trade at a discount, it can attract agitators or activists to the share register who may take a short term approach to their investment. For example, during the GFC, investors Weiss and Carousel Capital took positions in discounted LICs and then cashed-out as soon as they were trading closer to their NTA.

However, this does provide upside for prospective investors who want the opportunity to gain exposure to the LIC’s underlying securities for less than their value. Also, investors can exploit occasions where a LIC’s shares trade at a discount to its NTA, creating the potential for some gain.

Trading at a premium to NTA

In our view, there are some common factors that contribute to a LIC trading at a premium to its underlying asset value including:

  • Experienced management – in recent years, newer LICs have traded at discounts (or more significant discounts) than their older counterparts, such as AFIC (ASX: AFI), founded in 1927, and Argo Investments (ASX: ARG), founded in 1946, suggesting investors value companies with long term experience trading through various market cycles.
  • Solid investment portfolio performance – a track record of consistently good performance of the LIC’s investment portfolio in absolute or relative terms to a benchmark.
  • Stream of dividends – the LIC’s track record of paying a regular stream of fully franked dividends over time.
  • Effective marketing and communications initiatives that raise the profile and improve the reputation of the LIC and its manager. For example, investor presentations, regular market updates and media appearances.

For a LIC trading at a premium to its NTA, its ability to raise capital in order to grow the company is enhanced. Over the last year, we have seen numerous LICs raise capital through placements (in addition to Share Purchase Plans and Dividend Reinvestment Plans) such as Cadence Capital (ASX: CDM) and WAM Capital Limited (ASX: WAM). Last calendar year, almost $1 billion was raised by LICs (including Initial Public Offerings) – a record for the sector.

Existing shareholders generally welcome an increase in the value of the shares relative to the LIC’s assets as it increases the value of their investment. For example, a shareholder may have bought their shares when the LIC’s underlying assets were worth $1.00 per share and they later trade at $1.20 per share. In the shorter term, this may translate into larger than usual gains, however, this is often short-lived with history showing that LICs normally return to trade at or around their NTA. The downside is for prospective investors who must pay in excess of the value of a LIC’s NTA.

In general, the premium to NTA trend has contributed to attracting considerable capital to the LIC sector over the past year with more LICs listing in the last 12 months than over the previous decade.

Chris Stott is Chief Investment Officer at Wilson Asset Management. His views are general in nature and readers should seek their own professional advice before making any financial decisions. Wilson Asset Management is a major manager of LICs.

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8 Comments

john

January 30, 2015

There is no incentive for managers to fix the discount issue. They care about the size of assets under management as this drives the fee they receive.

The only real problem for the managers is when activist investors buy up force them to close the discount.

Steve Martin

November 08, 2014

Certainly there are mispricings in the market and these can affect LICs as much as the shares the LICs invest in. The inexplicable wild fluctuations from day to day in some quality LICs (e.g. MIR) seems to be simply a reflection of low trading levels I suspect. Certainly buying a dollars worth of assets for 80cents is a good reason to buy in, but I want to be confident that there is not something more amiss than I, as a mug investor might know about. Why would an informed investor sell at 80 cents? Somewhere in the complexity of seeking value when making a decision to buy a LIC share, an informed investor has regard to many things, including past performance of the LIC, past performance of the manager, the current portfolio the LIC holds and why it has that portfolio - i.e. the investment strategy of the LIC - and a sense is formed about whether I have confidence about the future performance of the fund. Less sophisticated than a more formal analysis of future maintainable earnings as a percentage of a current price, but the driver is the same - it looks good now but will it still look good in a year? Yes, there are mispricings but sometimes when something looks to good to be true, it often is.

These days of course there is another significant factor in looking at the high surpluses on some LICs other than a perception of future performance, it is the never ending period of low interest rates.

Chris (the author) refers specifically to the premiums for DJW and WAA. As a matter of disclosure I hold the latter and sold the former some months ago. Overall, I could not see the justification for the high premium in DJW. Don't get me wrong, I like the manager, the portfolios and the option strategy seems perfect for a conservative investor, that is why I bought in to start with, but the past performance and the yield simply led me to conclude that it was overpriced at a 30% or so premium (at the time I sold). I think the factor I missed, was the ability of that fund to manage share market volatility through its options strategy and the perception many investors may have formed that it could continue to generate earnings in a higher risk environment. It then has a great appeal as an investment producing better yields than many bonds but be able to weather the market volatility (as we have had over recent months).

I am proceeding on the assumption that the market is also treating WAA as a substitute for a bond, not simply as a well managed LIC. I am keeping an eye on interest rates, when rates increase, I suspect many stocks that are yield plays will lose their premiums as investors rebalance their portfolios to interest bearing investments. For me, if WAA holds its yield and interest rates remain on hold, I cannot see any reason why the premium in the price should not also hold, so I will hang in there for now.

I think as I get older, I will just find quality LICs to invest in, as well as other investments, and just put them in the bottom drawer and forget about the premiums and discounts in share prices.

robert

October 18, 2014

Yes, a suitable discount will inspire me to accumulate more of a satisfactory (performance wise) LIC. The yield will be better compensation than share price growth (after inflation).

I think over-expectation of manager performance blinds some ... it is rare the fund that can be all things (styles) to all investors.

Maybe the over-usage of comparisons (v. rivals/peers and v.indexes) also distracts from clear thinking.

Please don't make LICs look all the same (please managers), it is the differences that appeal to me at suitable times, and it is up to me (the investor) to buy the correct focus/style at an advantageous time for me.

Graham Hand

October 18, 2014

Geoff, on your comment about discounts always being with us, I think some of the techniques to manage these LIC discounts have improved. For example, one LIC has made a commitment to offer a repurchase at NAV this financial year and at least once every three years thereafter. I expect this will trigger buying if a decent discount opens.

robert

October 18, 2014

Depending on the (LIC) style you chose, sometimes "fashion" and timing counts. I bought WIC and OZG when WA was still considered an investment "backwater", and at MY entry share prices are doing very well, considering the portfolio focus.

Others can suffer from "management style". A very conservative LIC can get "lost in the crowd" in a strongly rising market (but for long term holders present attractive prices to accumulate at).

I like the smaller LICS that cover shares I am very unlikely to invest in as a solo holding. An interesting investment sector all by itself. For shorter term holds/trading, I normally chose ETFs (for their easy to liquidate ability).

For LICs I aim to buy at a discount, and focus on the yield after that. After all, when you by into a LIC you are in essence hiring an investment manager. Would you pick an investment manager solely on "popularity " (premium to NTA)??

Geoff Walker

October 18, 2014

One key discount driver not mentioned is the cost of management, particularly if paid by way of a fee payable to an external party often closely related to the sponsor of the LIC's listing.

To the extent that such fees exceed those of long-established internally-managed LICs, such as Argo, the net dividends per dollar of NTA received by the new LIC and available for on-payment to the LIC's investors will be less than in traditional LICs.

Therefore, income-focused LIC investors, of whom there are many, will shun the new LIC, thereby reducing demand. Reduced demand will lead to a discount that will grow until it is sufficient to compensate for the lower net dividends.

Such discounts can be quite substantial. For example, were Argo paying a dividend of, say, 5%pa, then a similarly-invested LIC paying an additional 1%pa in external management fees would need to suffer a discount of 20% in relation to Argo in order to become equally attractive to income-focused investors.

Of course there will be other supply and demand factors that gain strength from time to time and for a while disguise the quantum of the fee-driven discount.

Finally, speaking as an investor for more than 25 years in LICs, the comment in this article about the "... trend of reducing price discounts ..." has been repeated by LIC managers every few years over the whole of that 25 years. I confidently predict that in 25 years time discounts will still be with us and we will still be reading similar comments!

Chris

October 18, 2014

I thought there were also a couple of other reasons for the discounts.....
1) because of the options that are usually issued, and 2) the present value of the management fees in fixed period management agreements.

BDC

October 17, 2014

The one point that is often overlooked for investors that invest into LICs is that they never actually receive the performance of the underlying portfolio. Their own performance is driven by the price that they buy in at and then the price that they eventually sell out at plus any dividends they receive along the way. The fluctuations of the premiums and discounts to NTA can often override the performance of the underlying portfolio!


 

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