As the share prices of listed investment companies (LICs) have traded closer to their true underlying values or net tangible assets (NTA), a flood of money has poured into the sector.
The Australian Securities Exchange (ASX) reports the total number of LICs has jumped from 51 to 87 over the past three years with their combined market capitalisation increasing more than 40 per cent to nearly $30 billion.
For prospective investors, a discount provides the opportunity to get exposure to the LICs’ underlying assets for less than their value. It can also represent a great buying opportunity for investors.
Distinct from an unlisted managed fund, LICs can trade at a premium or a discount to the value of their underlying assets. Historically, Australian LICs have traded at an average discount to their NTA of about 5 per cent.
According to Patersons Securities, five years ago the average discount was 11.4 per cent and three years ago it was 7 per cent.
Currently, the mean discount has narrowed to just 1.9 per cent with some LICs trading at significant premiums to their NTA such as Djerriwarrh Investments Limited (DJW), which trades with a share price premium of 36.8 per cent (as at April 21 this year).
Narrowing discount trend
This reducing price discount trend is due to several factors including the surge in popularity of LICs as an investment vehicle following the introduction of the 2013 FOFA (Future of Financial Advice) reforms that banned upfront and trailing commissions paid by other managed funds to financial planners and advisers.
The FOFA reforms helped raise the profile of LICs and their advantages. In addition, while in the past LIC valuations focused on their discount/premium to NTA, investors motivated by yield are more focused on fully franked dividends – an important benefit of LICs not offered by ETFs or managed funds.
Chief among the yield hunters in the current low interest rate environment are self directed superannuation funds that now account for 32 per cent of all superannuation assets in Australia.
With interest rates forecast to remain low for the foreseeable future, SMSFs’ appetite for dividends shows no signs of abating.
LICs trading at a discount to NTA
There are a range of factors that may cause a LIC to trade at a discount including the poor performance of its investment portfolio and a poor track record of paying fully franked dividends (or a perceived inability by the market to pay fully franked dividends in future).
In addition, ineffective or inadequate marketing and communication initiatives may limit the profile of a LIC amongst potential investors and prevent it from engaging with existing shareholders and building an understanding relationship.
When a LIC trades at a discount to its NTA for a prolonged period, the consequences are generally negative. Shareholders are likely to become disgruntled, particularly if they bought their shares when the LIC was trading close to or above its NTA.
There are several instances of LICs that listed in the early 2000s and then languished at discounts before being either wound-up or taken over.
Trading at a discount constrains a LIC’s ability to raise capital and stunts its growth. This may force the LIC into a share buyback or undertaking other capital management initiatives.
Raising capital at a discount is often highly dilutive to existing shareholders, which may frustrate them. As a publicly listed company, frustrated shareholders have the ability to call for a LIC to be wound-up or the investment manager to be changed.
If a LIC’s shares consistently trade at a discount, this can attract to its share register agitators or activists who take a short-term investment approach, for example taking a position in a discounted LIC and then selling as soon as they are trading at or closer to their NTA.
LICs trading at a premium to NTA
There are various factors that contribute to a LIC trading at a premium, including the consistently good performance of its investment portfolio (in absolute terms or relative to a benchmark) and a track record of paying a regular stream of fully franked dividends over time.
An experienced management team is also key as investors value investment managers with long term experience trading through various market cycles.
Another important factor is proactive marketing and communication initiatives (such as presentations and regular market updates) that can raise the profile and improve the reputation of the LIC and its investment manager and can potentially improve shareholder wealth over the long term.
Trading at a premium to its NTA enhances a LIC’s ability to raise capital. 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.
This may lead to larger than usual gains in the performance of the investment portfolio in the short term although it is often short-lived with LICs trading at premiums and discounts over the various market cycles.
This is because historically, LICs are more popular when the market is falling. Conversely, they are less popular when markets are rising as investors are keen to manage their own investments.