This article appeared in the May 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Learn why the outlook for listed investment companies is the best in decades.
By Geoff Wilson, WAM
When I first discovered an investor could buy $1 worth of shares for 80 cents I didn’t believe it was possible. That’s what the sharemarket allows you to do every day. At times people sell things for below what they are worth – it seems illogical, but it’s true.
The entities listed on the sharemarket that currently give you these opportunities are Listed Investment Companies (LICs). A LIC is a listed equity fund, a managed share investment fund that is itself a listed share. In Australia, 59 are listed on ASX with a combined value of $19.1 billion. Currently at least 49 of them are trading below the value of the shares they own, creating a lot of opportunities for great value investing.
Evolution of LICs
The first investment trust was launched in Britain in 1868 by Foreign & Colonial. It was the world’s first collective investment vehicle and planned to raise £1 million to invest in government stock of foreign countries and colonial territories. The prospectus said it aimed “to give the investor of moderate means the same advantages as the large capitalist in diminishing the risk of investing in foreign and colonial government stocks, but spreading the investment over a number of different stocks”.
This principle is still the same today. Like unit trusts, LICs are pooled funds invested in a diverse range of shares that are listed on the sharemarket. But, unlike unit trusts, LICs are incorporated as quoted companies, and instead of buying units in a fund, investors buy shares in that company.
LICs are closed-end funds with a fixed amount of capital. No one can buy shares in a LIC unless someone else is willing to sell. Therefore, the share price moves according to the rules of supply and demand rather than as a direct reflection of the movement in the underlying assets of the LIC. Thus LICs often trade at either a premium or a discount to the value of the assets they own, namely their net tangible assets (NTA).
It is this premium or discount that makes LICs appear complicated. Most investors are familiar with unit trusts, which quote their unit values every day. Investors can buy or sell those units at the stated NTA daily. With LICs, the variance between the value of the LIC’s assets and its share price is a complication for some, but provides an incredible opportunity for others. Research has shown that the closed-end structure enables LICs to invest more efficiently and to outperform unit trusts or other managed funds over time.
In a market downturn, such as the Global Financial Crisis, investors in a managed fund are likely to sell their units to get cash, forcing the managed fund manager to liquidate some of its holdings to repay unitholders. The manager is selling into a market that has fallen and may be forced to sell assets they believe are cheap. In a bull market, when money is rapidly flowing into managed funds, the reverse is the case: the manager may be forced to buy shares they know are over-valued as money pours in from investors.
This is never the case with LICs. The LIC manager can continue to hold the same portfolio and is never forced to sell or buy any shares. The total focus is on managing money for the benefit of all shareholders; the manager’s investment strategy is not dictated by market sentiment or flow of funds. The manager may start buying in a downturn and pick up some bargains, or sell shares that become overvalued in a bull market.
The origins of the LIC sector in Australia go back to the 1920s. The oldest investment company that is now listed is Whitefield Ltd (WHF), which was incorporated in 1923, originally as an investor in mortgage loans. Its business has been solely focused on equity investment since 1949, although it did not list on ASX until August 1971.
The largest Australian LIC started life in 1928 as Were’s Investment Trust Ltd. In 1936 it changed its name to Australian Foundation Investment Trust Ltd and adopted its present name, Australian Foundation Investment Company Ltd (AFIC), in 1938.
It listed on June 30, 1962. In 1973 it was used to amalgamate the Capel Court group, which resulted in the takeover of Capel Court Investments, Breton Investments, Clonmore Investments, Haliburton Investments, Jason Investments, Jonathan Investments, National Reliance Investments and Shelbourne Investments. AFIC now has assets of $5 billion.
The second-largest LIC, Argo Investments Ltd (ARG), was established in 1946 and listed in 1950. It currently has assets of $3.9 billion.
Over the years, new LICs have been floated on the stock exchange. Some have grown and prospered, such as Milton Group (MLT), Kerr Nielson’s Platinum Capital (PMC), and our group, WAM Capital Ltd (WAM), WAM Research Ltd (WAX) and WAM Active Ltd (WAA). Others have been taken over or returned their capital to shareholders. LICs are excellent investment vehicles and can give exposure to a range of different investment opportunities from Australia to China.
Outlook for LICs
The outlook for LICs in Australia is the brightest I have seen in my 31 years working in the securities industry. The sector is currently benefiting from two major structural changes.
The first is the change to the Corporations Act in June 2010, allowing companies to pay dividends as long as they are solvent. Previously they could only pay a dividend if they had an accounting profit, so the company might have had the cash flow, the cash and the franking credits, but if its assets had fallen in value (as happened during the GFC) it could not pay a dividend. The change in legislation gives companies greater flexibility with dividend payments. As for the three LICs we manage – WAM, WAX and WAA – we have planned a growing stream of dividends that can be paid over the next 20 years.
The second significant structural change is the reform of the financial planning industry. From July 1, 2012 commissions on managed funds will be banned. This will remove a significant impediment for financial planners looking at LICs or other investment products listed on the sharemarket – for example, exchange traded funds (ETFs).
LICs do not pay trailing commissions. For years, financial planners have had a significant financial incentive to recommend managed funds over LICs. Thus LICs have not fully benefited from the significant growth in the funds management industry. The Australian managed fund industry has grown from $157 billion in 1990 to $1,199 billion today. Finally the playing field will be level. We are already seeing an increased level of interest from financial planners in LICs.
Since these changes were first discussed, the discount to NTA of a number of LICs has decreased. I believe this will continue and may well result in a large number of LICs trading at a premium to their asset value.
About the author
Geoff Wilson is the Chairman of Wilson Asset Management, WAM, WAX and WAA, and will give a presentation on this topic at the AIA National Investors Conference from September 1-3 at the Sofitel Sydney Wentworth Hotel.
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