By Emma Rapaport
Taking a punt on the underlying assets of some listed investment companies is a strategy that could pay off, but there are risks in premium and discount distortions.
While exchange traded funds (ETFs) are all the rage and are growing by billions of dollars, listed investment companies (LICs) are like the forgotten old-timers of the ASX.
The sector has been around for almost 100 years, but with new sales virtually ground to a halt and more investors turning their backs on the closed-end funds, there’s a big divergence.
While grand old ladies including Australian Foundation Investment Company (AFIC) are trading at premiums, the rest of the sector is in danger of being abandoned because of discounts as wide as 20 per cent. The discount is the gap between the listed price and the value of the underlying assets.
Even though the $50 billion sector is in the doghouse, analysts say there are opportunities for those willing to take advantage of the discounts, sweetened by yields that are higher than bank deposits.
After roaring back to life in 2021, listed investment companies had a pretty ordinary financial year in 2022.
August reporting season is just another month for LIC observers, with much of the year-end information published ahead of the annual reports, but it does give shareholders an opportunity to hear from the management teams directly and dig deeper into their holdings.
While some delivered strong net tangible asset (NTA) growth, many did not. Managers opened up on the difficulties they faced in a torrid year for markets, as equities slumped alongside a dramatic shift in monetary policy.
Data from Bell Potter shows NTA declines of just over 7 per cent for domestic equity LICs, on a weighted average basis, and 13.5 per cent NTA declines for global equity LICs, with many skewed towards underperforming mega caps.
Still, LIC boards hoping to retain and attract investors who crave stable income in a volatile environment delivered the goods, passing on income or dipping into reserved profits from previous years to smooth payouts.
“Most LICs either maintained or increased the dividend, which was good to see,” says Bell Potter listed investment specialist Hayden Nicholson.
Aussie equities-focused WAM Leaders (WLE) dodged the carnage on markets, reporting a 3.8 per cent increase in the pre-tax NTA, according to Bell Potter, compared to a 6.5 per cent decline from the S&P/ASX 200 Accumulation index.
But the investment team had to work hard to deliver returns, turning over the portfolio more than three times during the year. WLE equity analyst Anna Milne says they rode the cyclical wave through the first half of the financial year alongside the unleashing of pent-up demand.
As inflation jitters entered the market, WLE bet that interest rates were going to shoot up and aggressively shifted the portfolio into defensive consumer staples and healthcare. Now they’re reducing their defensive positions and edging back into cyclical names like Santos and the banks.
Not everyone is crowing about exceptional returns.
Global long/short LIC Tribeca Global Natural Resources (TGF) posted a pre-tax NTA loss of negative 11.9 per cent, according to Bell Potter, and won’t pay a dividend, after its fortunes fell dramatically in the final three months of the financial year. The portfolio is weighted towards commodity producers and explorers and includes a large allocation to base metals businesses.
It’s also been a tough 12 months for Hearts and Minds Investments, whose pre-tax NTA slid 35.9 per cent. The fund was created on the back of the Sohn Hearts & Minds Investment Leaders Conference, in which the top fund managers in Australia and the world pitch their best investment ideas.
“Last year we had a lot of managers who liked tech growth, and obviously that got slammed fairly hard,” chairman Chris Cuffe told The Australian Financial Review.
Understanding LIC discounts
With reporting season done and dusted, Bell Potter data shows that LIC discounts widened over the second half of the financial year, with most companies across all market capitalisation bands trading at a discount.
Discounts for LICs with a market cap between $50 million and $100 million steepened and trade at an average discount of close to 20 per cent.
The question for analysts is whether any of these discounts represent an opportunity?
First, it pays to understand what a LIC is and how it differs from popular ETFs.
LICs are closed-end funds. A fund manager sets up a listed company by raising money in the form of an initial public offering (and follow-on capital raisings). The capital raised is invested in securities, such as shares and bonds, that gain or fall in value, and that is reflected in the reported net asset value of the company.
If an investor wants their money back, the only way to do so is to sell shares in the LIC. The value that is realised depends on the market price.
If there’s strong demand to invest in the LIC, the investor might sell out at a premium (a price above the net asset value). But if the demand is weak, that investor may have to accept a discount (a price below the value of the assets).
Fund managers like the LIC structure because once they have raised the money, it’s captive and cannot be redeemed. For investors, it’s mixed. Investors don’t like selling at a price that is below the value of the assets they’re invested in. But buyers can take advantage of sellers that want to or need to get out.
For income-focused investors, the traded discounts can actually boost the yield, as the purchase price is below the value of the fund’s assets while the distribution are a function of the actual value of the assets, not the quoted price.
For instance, if a LIC intends to pay a $4 distribution for each $100 of assets it owns, but the discount allows an investor to buy in at $85, the yield goes up from 4 per cent to 4.7 per cent.
But are they worth investing in? While there are plenty of naysayers who rightly point to the distortions that manifest themselves in premiums and discounts, experts say there can be compelling opportunities for individual investors prepared to take a view on the underlying assets in a LIC.
If that LIC has a track record of paying consistent distributions and income, those opportunities are even more enticing as a high discount (just like a depressed share price) has the effect of boosting the yield on the invested capital.
There are risks for the investor if the asset value falls and/or the discount widens. LICs can trade at perpetual discounts because the market is worried about the manager’s performance, stocks in its portfolio, a patchy dividend record or low underlying liquidity in its investments. Narrowing the discount is easier said than done, with some managers giving up on the structure altogether.
Daryl Wilson manages the Affluence LIC Fund which targets LICs trading at attractive discounts to NTA.
Wilson says he looks for three things when assessing potential LIC prospects: good management teams; the prospects for the investment universe; and the discount/premium to NTA.
“If we can get a good management team, an attractive investment set and a better-than-average discount, that’s the holy grail of LICs for us,” he says.
Wilson says he’s not necessarily looking for the discount gap to close completely. However, reductions can mean additional returns above portfolio performance.
“If we buy something at a 20 per cent discount, which goes to 10 per cent over the next three years, that’s about 3 per cent per annum of extra returns we’ve had just from that discount closing,” he adds. “We just want to buy it at a discount bigger than it should be.”
Wilson sees good value in mid-smaller sized LICs where the discounts are larger than average, particularly those that focus on small-cap and global equity markets. Conversely, he’s less excited about many of the larger ASX-focused LICs, like AFIC and WAM Capital, noting they trade at significant premiums of 10 per cent and 13 per cent.
WAM Alternative Assets, Sandon Capital Investments and Perpetual Equity Investment Company appear on Wilson’s list of LICs with good total return prospects and good yields. The fund also holds Alex Waislitz’s small-cap value LIC Thorney Opportunities (trading at a 29 per cent discount), TGF and Platinum Capital.
“Value investing has been on the nose for almost 10 years now, so they’ve [Platinum] underperformed for quite a while, but if you look forward it’s a much better environment for value investors,” he says.
Wilson also has his eye on the debt-focused listed investment trusts, saying “they may start to look attractive again later this year, particularly as interest rates increase and flows through to their underlying loan portfolios”.
Among Bell Potter’s top picks are Whitefield, TGF and Qualitas Real Estate Income Fund, but for different reasons. It describes Whitefield as a “one-stop stalwart”, offering exposure to a highly diversified portfolio of industrial securities and income certainty. TGF is more of a bet on commodity markets, while Qualitas is an income play via its portfolio of commercial real estate loans.
Bell Potter’s Nicholson also likes the alternatives space, noting Bailador Technology Investments’ strong performance and a discount of around 22 per cent.
“A lot of investors just look to Australian equities and magnify their exposures to materials, financials, whereas there’s a lot of really nice lowly correlated assets in the alternatives space that are yielding quite healthy amounts,” he says.
Financial commentator and author Peter Thornhill is not interested in tracking the LIC market from month to month or keeping a close eye on premiums and discounts. Rather, he focuses on the larger LICs with unbroken dividend histories.
Thornhill’s rules of thumb: LICs have been investing for at least 30 years, saying many of the newer funds charge “absolutely disgraceful fees”; consistency and simplicity in the investment process; and consistent dividends. He notes that many continued dividends through COVID-19 despite the underlying companies reducing or cutting dividends.
“Stuff that’s come into the market more recently, I wouldn’t touch with a barge pole,” he says.
“One of the LICs that I invest in just celebrated 55 years of consecutive dividends payments – do I need to know anything else?”
Thornhill is not a fan of ETFs, noting that the structure forces them to distribute all realised capital gains, along with any income, which means the dividends can be “erratic”.
Wilson warns investors to be careful when seeking out the highest dividend payers, saying they tend to have some of the poorest total return prospects. Total returns matter more, he says.
“It’s the old story of a value trap – it’s its paying too high a dividend, that could be a red flag or an orange flag at least,” he says.
“We would never just chase yield – you’ve got to look at the whole package. Unfortunately, some of the lower-quality LICs are paying the best yields.”
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