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This article appeared in the October 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.

Why large listed investment companies can be a good source of yield.

Photo of Toni Case By Toni Case, thebull.com.au

To make profits in this market you need darn good stock-picking skills combined with a modicum of good luck. Or you need a well-diversified portfolio - and listed investment companies (LICs) are one way to achieve this. They are diversified, cheap, and the oldest LICs have track records spanning back to the early 1900s.

There has even been some talk that LICs could experience a comeback of sorts because of forthcoming regulatory changes in the financial planning industry. More about that later.

First, for those who don't know much about LICs, here's a quick rundown. LICs trade on ASX just like any share, which means they have a three-letter code as well as a bid and ask price. But LICs are companies that invest in other shares on ASX and the selection is actively managed by a professional manager (either in-house or outsourced). So the LIC may hold shares in Telstra, as well as in Westpac and Woodside Petroleum, for example, and will actively manage the portfolio in an effort to outperform the index. Most LICs will own shares in as many as 70 ASX-listed companies, so buying shares in an LIC means you are indirectly buying shares in a whole range of companies.

LICs work in the same manner as any company listed on ASX: the LIC raises capital from investors via an initial public offering (IPO) and its shares are traded. When investors want to sell their shares in the LIC they do so on the market by selling to other investors who want to buy in. This feature of LICs is very handy in nervous sharemarkets, and is one reason LICs find favour in times such as this.

The problem with unlisted managed funds, such as the majority of retail managed funds, is that when investors want to redeem units in the fund, the assets of the fund must be sold down to meet these requests. This can be troublesome in bear markets when share prices are falling, and a flood of redemptions cause a fund manager to sell at lows.

However, the manager of an LIC is never under pressure to sell assets to meet redemptions. They can invest with an eye on the long term, as well as in less liquid assets such as microcaps. The manager need not worry if investors suddenly pull out.

Another plus is that unlike managed funds, LICs do not charge entry or exit fees, there are no buy or sell spreads, or upfront and trailing commissions to financial advisers. Basically, the only cost is brokerage to buy shares in the LIC in the first place and a comparatively low management expense ratio (MER).

The biggest criticism

So what happens in the event that investors do exit an LIC in tranches? When investors sell BHP Billiton shares in droves its share price drops, and this is exactly what happens to an LIC from time to time. If its popularity wanes, its share price can sink below the value of its investment portfolio. This is probably the most talked about criticism of LICs - the problem when LICs trade significantly above or above net asset value. (This is simply fund assets less fund liabilities expressed on a per share basis.)

For contrarian investors, the opportunity to buy an LIC for less than its worth and sell for more than its worth is a bonus. Other investors feel ripped off when they purchase shares in an LIC that is temporarily trading above its net tangible asset (NTA). LICs publish their NTA values as regularly as weekly so investors should check this before buying.

A comparable investment to LICs is the exchange-traded fund (ETF), which offers the broadest possible diversification by investing in the entire index of shares. While LICs are actively managed, ETFs are passive. They simply buy the index in totality and ride the highs and lows of the overall market. LICs, in contrast, aim to beat the market by selecting the best shares to achieve this end.

ETFs tend not to experience the problem of trading above or below NTA, because they are open-ended funds. If an ETF experiences a surge in demand for units, the ETF provider can simply issue new units without the share price being affected. Similarly, if the ETF is trading at a discount, market-makers can come in and buy ETFs, closing any gap in market price to NAV.

Cycles of popularity

The popularity of LICs tends to move with the cycles. LICs come into favour in bear markets, but often get lost in the wash when bull markets turn everyone into an avid stock-picker. Some LICs are perennially popular because of the manager's track record and enjoy strong demand, such as the country's largest LIC, Australian Foundation Investment Company, and the second largest, Argo Investments. Both often trade around a 4-6 per cent premium to their NTA.

The good news for LICs is the Federal Government's regulatory changes that should come into effect by July 1, 2012. The proposed changes mean that financial advisers will be prohibited from receiving commissions and payments from investment product providers, fund managers and investment platforms, in exchange for recommending particular products. Happily for LICs, it means that financial advisers will be less inclined to favour commission-based products, such as unlisted managed funds, compared to listed products that do not pay commissions, such as LICs.LICs are user friendly because you access a diversified portfolio of shares via the single purchase of a share. This can be handy for advisers monitoring multiple client portfolios. Rather than managing individual share portfolios for each client, a one-off investment in an LIC can do the job.

For these reasons, we could see a rise in popularity for LICs and an end to the gripe of recent years that LICs often trade at a discount to NTA.

Another growing market segment for LICs is private client businesses advising self-managed super fund (SMSF) investors. Because LICs are structured as a company, they are required to pay company tax on income and realised capital gains made in the portfolio. Management has the choice of either retaining profits or paying them out to investors as dividends. Investors pay tax on any dividend income, and franking credits can be used to offset the tax already paid. SMSFs benefit from franked income as it helps to reduce their tax.

What to look for

When researching LICs to buy, the best LICs tend to beat the market indices over the medium to long term, are liquid, have a solid management track record, and a history of increasing dividend payments. Riskier LICs are newer, smaller in size (measured by market capitalisation) and are less liquid. LICs that use gearing can heighten both share gains and losses; and LICs that invest in microcaps or Asian markets, for example, are more difficult to research than those invested in popular Australian industrial shares.

If you are looking to buy an LIC for yield, then one that invests in large Australian industrials will be more appropriate than one invested heavily in Australian microcaps. LICs will list individual shareholdings on their website, so look at the types of companies chosen as well as the investment objective behind the choice.

You also need to compare LIC management expense ratios. Some LICs will outsource portfolio management to an external fund manager, which tends to increase costs. And lastly, compare the market price of the LIC to its underlying asset value, preferably its pre-tax figure, because the post-tax figure measures the fund's value if all investments were sold and all capital gains paid. In other words, if the fund was wound up.

Every month ASX publishes reports detailing all LICs, including current share price, market size as well as NAV, both pre-tax and post-tax. The reports also calculate whether the LIC is currently trading at a discount or premium to NTA. In August 2011, out of a total of 63 LICs, just nine were trading at a premium to pre-tax NTA, with the rest trading at a discount.

About the author

Toni Case is the editor of TheBull.com.au, a trading and investing site. Each week TheBull's free newsletter offers 18 share tips from more than a dozen leading brokers, tailored share portfolios for income and capital growth, plus investing, super and property strategies.

From ASX

Listed Investment Companies on the ASX website has more information about the features, benefit and risks of LICs.


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