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The catalyst for a LICs rebound

Australian Foundation Investment Company (AFIC) is the largest Listed Investment Company (LIC) or Trust (LIT) on the ASX (ASX:AFI), with a market cap of around $9 billion. It’s also the most liquid and oldest (listed in 1936!).

The fund has an enviable, very-long-term outperformance track record.

Since the late 1980s, AFIC has traded on an average premium to Net Tangible Assets (NTA) of +1.8%. That premium reached nearly +20% in 2022.

Yet AFIC now trades at a 7-7.5% discount to NTA, putting it in the lowest 5-10% of its discount-premium range in AFIC’s history.

So, what gives? Why such a historically big discount? And what does that mean for the outlook for other listed funds?

An alternative explanation

Investors give several reasons for LIC/LIT premiums and discounts, including:

  1. Supply and demand
  2. Size of the LIC or LIT
  3. Liquidity of the fund
  4. Investor sentiment
  5. Market direction
  6. Investment performance

But so many of these reasons fail to explain AFIC’s historically large discount.

AFIC is a large, liquid fund, with good recent one- and five-year performance. The Australian large-cap-dominated index (ASX200) is within a whisker of all-time highs, so we have a fairly bullish market.

What else could explain AFIC’s historically high discount?

We think it’s interest rates.

Below, you can see the premium and discount of AFIC on a monthly (orange line), and six-month moving average basis (black line), since the early 1990s.

We have added a red line, which is the average of the US Federal Reserve’s Fed Fund Rate and the Reserve Bank of Australia’s Cash Rate, inverted.

Chart 1: LIC/LIT premiums/discounts move with rate hikes/cuts

Source: Bloomberg

It’s clear: lower interest rates (a higher red line) have been associated with higher premiums to NTA … and higher interest rates (a lower red line) have been associated with higher discounts to NTA.

Managing OPH’s big discount

Our Ophir High Conviction Fund (ASX:OPH) has been listed on the ASX as a LIT since late 2018.

It has traded as high as a +20% premium, and as low as an -18% discount to NTA. Overall, it has traded close to par with an average discount of -2.2%.

However, like AFIC, it currently trades at a larger-than-average discount, in OPH’s case circa -11% at writing.

We, of course, are working hard to help manage the discount, including:

  1. Enhanced marketing to make investors aware of the value on offer to investors if they buy the fund at a discount, particularly given it has an attractive +13.1% (net) p.a. NAV investment total return since inception in 2015, versus its benchmark of +9.1% p.a.;
  2. Signalling to investors the value we see on offer through us (Andrew and Steven) personally buying units in the Fund recently; and
  3. Using the buyback mechanism to buy OPH units in the Fund when we see compelling value on offer.

We have used all three of these since the Fund was listed.

Do interest rates affect discount/premiums for the broader pool of LIC/LITs?

It’s important, however, to understand whether other factors that are out of our control, such as interest rates, influence the cyclical nature of the premium and discount for OPH.

OPH has only been listed for a little over five years, so we need to look to longer-running LIC/LITs to see if our ‘rates relationship’ hypothesis holds, and not just for AFIC.

The evidence strongly suggests it does hold.

Below, we show the relationship between interest rates and the 38 long-only Australian and Global Equity LIC and LITs on the ASX. Though not a perfect relationship, the black line – the average premium or discount on these funds – has broadly moved inversely with interest rates in both the US and Australia[1].

Chart 2: LIC/LIT premiums/discounts move with rate hikes/cuts

Source: Bloomberg

Another way to view this is through the average and median premiums or discounts that have prevailed in the equity LIC/LIT market on the ASX for different Fed/RBA interest rate ranges. We show this below for all 38 equity LIC/LITs from the chart above:

While premiums are rarer on average for the full contingent of equity LIC and LITs, it is clear, larger discounts do tend to be associated with higher interest rates.

From TINA to TIARA

This is certainly the case today, with the Fed Funds Rate the highest since the year 2000 and the RBA Cash Rate the highest since 2011.

We think it’s fair to say that the highest interest rates seen in 10-20+ years in the US and Australia is weighing on LIC/LIT premiums and discounts. That’s because higher rates are likely providing an alternative investment to LIC/LITs for some investors, which is impacting demand.

Basically, we have shifted from an interest rate world of 0% during COVID in 2020 and 2021 where the ‘TINA’ (There Is No Alternative to equities) moniker was in play and many saw shares as the only investment choice to “TIARA” (There Is A Reasonable Alternative) where fixed income and even cash investments have become more attractive again.

The OPH premium and discount has not been immune, as you can see by the yellow line in the chart above.

In the chart below, we have zoomed into the period since OPH listed in December 2018.

Chart 3: LIC/LIT premiums/discounts move with rate hikes/cuts

Source: Bloomberg

It traded at a premium for a few months after listing, but then fell to a discount in 2019 following recent rate hikes in the US[2].

However, when the Fed and RBA cut rates in early 2020, in response to the outbreak of COVID, OPH shot back to a premium, and the average discount for equity LIC/LITs as a whole shrunk.

Later in early-to-mid 2022 both the Fed and RBA (along with other developed economy central banks) starting hiking interest rates in response to ‘sticky’ inflation pressures.

In some of the fastest rate hiking cycles seen in decades, the OPH premium became a discount, and the average LIC/LIT market discount also began to widen again.

Springtime for LIC/LITs?

So where to from here?

We have made the case that LIC/LIT premiums and discounts in general across the market tend to be cyclical. And that cycle is heavily influenced by the direction and level of interest rates. Rates are by no means the only factor, and other factors can be more meaningful for individual LIC/LITs.

But if history is any guide, interest rate cuts are likely to be a catalyst for LIC/LIT discounts to shrink in general and premiums to widen.

Which begs the question: when is the rate-cutting cycle currently forecast by markets likely to start?

Currently, there is a greater-than-50% chance the Fed will start its cutting cycle in just over three months’ time in September. While for the RBA, rate cuts look likely to start in either very late 2024, or early 2025.

It has been a frosty winter for discounts for many LICs and LITs on the ASX in the last year or two.

But summer may be just around the corner.

 

[1] Policy interest rates in both the U.S. and Australia have broadly moved in line with each other since the early 1990s with coordinated hiking and cutting cycles. The exception is the U.S. Federal Reserve hiking cycle from late 2015 to late 2018 – a period over which the only change by the RBA was 0.5% of rate cuts over six months in 2016.
[2] Proposed franking credit changes by the Opposition Government in Australia in 2019 and arguably an oversupply of LIC/LITs to market also likely contributed to bigger discounts for LIC/LITs during this period.

 

Andrew Mitchell and Steven Ng are co-founders and Senior Portfolio Managers at Ophir Asset Management, a sponsor of Firstlinks. This article is general information and does not consider the circumstances of any investor.

Read more articles and papers from Ophir here.

 

35 Comments
Andrew
June 24, 2024

Peter Thornhill says he’d never buy an ETF.

Why? Because they have to distribute all of their capital gains and income every year. A LIC has the flexibility to hold back profits and smooth distribution returns.

I own both for different reasons.

James
June 24, 2024

"Peter Thornhill says he’d never buy an ETF." "Why? Because they have to distribute all of their capital gains and income every year."

Not all ETF's are bad. Take VAS or IVV. Very low turn over (so low capital gains liability) and extremely low fees. Often less sure or variable dividends sure, but usually better capital growth and hence total return. Yet at times some LIC's have also reduced dividends or failed to increase with inflation too. Jack Bogle was no fool!

PJ
June 24, 2024

People in LIC land miss the point. New and younger investors prefer ETF's because it's easy and they're dirt cheap. I understand why Peter Thornhill prefers LIC's over ETF's. He was once quoted as saying that he didn't like the fact that he received a $7000 distribution payment from an ETF that he held that wasn't tax effective. Easy to say for a guy who earns 400k per year in dividends and seemingly made a motza during the GFC.

Is it any wonder that LIC's are trading at discounts during a booming period of ETF investment? And strangely enough, most of these LIC's have large allocations to banks and bank stocks have been soaring of late. Meanwhile, LIC's are languishing. The last time I looked, AFIC was trading at a trailing PE of 28. That's expensive.

Times and sentiment are changing. In time, ETF's will continue to dominate. It's a simple equation in my mind. More money going into ETF's means less money going into LIC's. Look at DUI who so far this morning having 16 trades is highly illiquid. I think it's a good LIC - that ironically also utilises ETF's for good measure for diversity and growth. And whilst DUI do that, they've been able to increase their dividends consistently. Unlike AFIC who've failed to increase their final dividend since 2013. Talk about opportunity cost.

Andrew Mitchell
June 24, 2024

An important benefit Andrew for certain investors who rely on particular LICs for their stable income.

Jerry
June 23, 2024

What defines LIC performance primarily is stock selection and portfolio allocation choices - this article briefly acknowledges this but understates its importance . Even taking the information presented from the table containing average Fed/RBA policy rates let's say rates come down to the 2-4% range the average price of LIC's would rise by less than 2% - hardly a reason to back up the truck. I am a holder of OPH and the reason I purchased is that a fund manager friend of mine spoke highly about Ophir - so far the dividends have been good but the fund performance is lagging somewhat - you can view a chart of OPH to see that price has gone nowhere. I'm waiting for market beta to lift it over time rather then 2% uplift from any Fed rate discounting.

Andrew Mitchell
June 24, 2024

Thanks for the support in OPH Jerry. 100% agree majority of return over long term can expected to be generated by stock selection and portfolio management. The article was deliberately about just premiums and discounts in LIC/LITs given they are near historic/cyclical lows for many/most and what might be the catalyst for discounts to close/premiums to increase.

Tim
June 23, 2024

Interesting article.
As a net buyer, I'd prefer LICs trading at a discount.
Don't have to worry if you never sell..

Andrew Mitchell
June 24, 2024

Discounts are certainly where I do all my personal buying of our vehicle (ASX:OPH). Whether it is stocks in our funds or our own vehicle I like buying when we see good value Tim.

Ramon Vasquez
June 22, 2024

Thanks Guys for your thoughts on this topic . Best wishes , Ramon .

Andrew Mitchell
June 26, 2024

Thanks Ramon. Cheers, Andrew

Martin
June 21, 2024

I've been put off buying AFI as a result of their dividend barely increasing over the last 15 years, from a grossed up 30 cents in 2009 to 35.71 cents in 2023. If the dividend can't keep up with inflation, I'm not sure what the point is. There are more attractive places to park money at the moment.

Geoff
June 21, 2024

That's selective endpoint analysis. Try mine...

From 2004 to 2018 AFI dividend increased by 60%, whilst CPI increased only 40%. Over the same period the share price rose 80%. (round numbers)

That better?

Pick your end and start points and you can make the numbers say whatever you want...

michael
June 21, 2024

If I buy into an LIC that's been around a long time, it comes with a tax liability should its holdings be sold. Assuming it is sitting on a profit.
Why should I buy that?

Luke
June 26, 2024

Totally agree. I would not buy ARG or AFI for that very reason even trading at a discount.

Alex
July 06, 2024

The tax liability is at the LIC level, not at the investor level. Any capital gains (net of the CGT) can be retained by the LIC to be reinvested, or distributed to you as a franked dividend. I'm surprised you are not aware of this.

Pete
June 21, 2024

A great article Andrew and Steven, thanks.
As a holder of AFI, ARG ( index's ) and VAS (ETF) I've seen that stark performance difference between them!
I've uncomfortably watched AFI and ARG's share prices whittle away ( over the past 2 years they're both down by around -3% ) while VAS's share price has increased +18% !
Don't know what you think, but it looks like atleast another year until interest rates have fallen enough to trigger enough of a behavioural change with investors to move back to LIC's and reduce the discount to NTA.
For the past 18 months I've wanted to cash out of some of my LIC's, but I feel trapped.
I don't think I'm the only one.

Andrew Mitchell
June 21, 2024

Hi Pete - it looks like discounts shrink when rates start moving down - so that’s the point historically when it starts adding to NAV returns. Of course there can be other factors at play at the same time.

Lawson
June 21, 2024

The big LIC's AFI and ARG also generally trade at premiums during uncertain times like 2008/2009 GFC as investors deem the dividends safer due to dividend reserves.......They also go to discounts in bullish times like 2010/2012 as they are light on tech and small mining which leads the bulls.......Sure ETF's are making inroads to their base at present but at the current discounts I would be reluctant to bail just yet specially as dividends going forward are uncertain again and the comfort of the reserve can't be found in ETF's.......should they return to a 5% premium again bailing then might be a better option

Andrew Mitchell
June 21, 2024

Agree re the certainty of dividends in uncertain times being an attractive feature Lawson. And rate cuts being another catalyst.

Don McKinnon
June 21, 2024

LICs are products left over from a time long past. The only reason that these investment dinosaurs exist and command so much discussion is that way to many people were shepherded into them by advisors getting hefty commissions. There are plenty of other products where you don't have to be concerned if they're valued correctly.

cb
June 21, 2024

Also add incentive for fund managers getting captive fum! To be fair there is also lots of benefits to good LICs/Ts, but this interest rate impact on prices discussion is a bit of academic banter without discussing a lot of the issues included in comments ETF flows etc

Damien Hunt
June 21, 2024

Interesting commentary. I am pleased to see the authors' fund includes buy backs in their tool kit for managing share price discounts.
Too often I think LIC Boards fail to manage share price discounts, and thus fail their shareholders. This may be deliberate due to fee structures that typically reference NTA rather than realizable shareholder returns, or it may be because the Board lacks the appropriate risk management acumen to establish an effective approach for managing the risk.
When LICs publish their Corporate Governance Statements, the document will typically state that the Board has developed a register of material / significant risks to the company's objectives, a risk appetite has been defined for such risks and the control environment for the risk defined and monitored. Periodic reporting is received in relation to the risk (versus appetite) and the effectiveness of the control environment. All good in theory.
AT AGMs I have started to question whether the Board recognizes a share price discount as a material risk to the company’s objectives. I am generally told yes. So where an LIC’s share price is trading at a significant discount to NTA, I query what is the status of the risk versus the Board’s risk appetite and what was the rating of the effectiveness of the control environment for the risk at the last periodic review. I have yet to receive a satisfactory answer.
The Banking Sector has been required by APRA to develop risk management approaches for dealing with risks similar to the LIC share price discount for some years. The risk management knowledge therefore exists to more effectively manage share price discounts, the LIC sector needs to be both willing and able to come up to speed.

PJ
June 20, 2024

How does a new generation of investors see any value at all in LIC's? Younger investors don't particularly have franking credits high on the list of priorities. Retail investors can just buy the market and pay an MER of 0.03%. They can still receive partially franked dividends and reinvest every quarter via a DRP. It's a no brainer. Who cares about buying at a premium or discount when nowadays it's all about dollar cost averaging. I invest in LIC's but I would never invest in a LIC on behalf of my children. ETF's are far more efficient and simple to invest in. I believe that it's because of ETF's and the ease of gaining exposure to different markets, sectors, themes and geograhies at low cost, is the real reason that LIC's are trading at discounts. Inflows into ETF's are soaring and LIC's will languish in the passing of time.

Andrew Mitchell
June 24, 2024

We like the closed end structure of LITs for managing capital in the small cap part of the market we invest in as it means we don't have to fire sales less liquid stocks to fund redemptions during market sell offs/dislocations that can seriously negatively impact performance. Appreciate your thoughts in general though PJ - rate cuts look not far away for RBA/Fed so we will see!

PJ
June 24, 2024

Thanks Andrew

John Derry
June 20, 2024

Thank you for the interesting analysis.

I think the link can be explained by the equity risk premium - where the marginal investor assesses the return offered by a bubbly stock market and aren't that excited by it compared to a reasonable risk-free interest rate currently available.

Andrew Mitchell
June 20, 2024

Agree John. That alternative of cash has become more attractive. Maybe as attractive as it’ll be this cycle!

Brian
June 20, 2024

That’s a v useful article.
The broad hook up over time between interest rates and disc/prem was - being a bit thick - a ‘penny drop’ moment for me!

Andrew Mitchell
June 20, 2024

Happy to help Brian. Yes a useful framework to keep in mind

Neil
June 20, 2024

One factor not discussed is a significant change in competition over the last few years: the emergence of low cost index ETF's. What mgmt fees do LICs charge and if greater than what ETFs charge, is their performance better than ETFs?

Andrew Mitchell
June 20, 2024

Lots of variety in fees for LIC/LITs. AFIC at 0.14% is low. ETF diverting away demand could be a contributing factor Neil.

Jim Simpson
June 20, 2024

The effect of interest rates could be covered by the "supply and demand" category.

Andrew Mitchell
June 20, 2024

Yes agreed. As do many other forces under that category. Just trying to point out how much of an influence rates have.

Doug Hill
June 20, 2024

I have been thinking along the same lines for some time. A timely reminder!

Andrew Mitchell
June 20, 2024

Yes I haven’t seen much about it before so thought we put it out there!

 

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