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Using LICs to own small-caps

This article appeared in the March 2013 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.

Listed Investment Companies are a convenient way to gain exposure to small stocks.

Photo of Boyd Peters By Boyd Peters, Contango

To their own detriment, many investors refuse to look further afield than the largest 100 stocks on ASX and miss out on some of the best candidates for portfolio selection.

Reasons for this myopia include elements of both Pride and Prejudice. Pride - in that some investors choose not to "slum it" by buying smaller, often unproven, companies - and Prejudice, in having a narrow-mindedness as to the benefits small companies can provide.

But experienced investors recognise that including smaller companies in portfolios provides diversification, opportunity, performance and freedom.

ThereĀ  are about 1900 companies listed on ASX, but most large-cap fund managers hold the same 50 or 60, which represent the bulk of the market capitalisation overall.

Incorporating a small-cap allocation reduces the blue-chip risk factor of being overexposed to ASX 100 companies and provides investors' portfolios with diversification.

Allocating to small-caps

However, with so many factors affecting the share price, most investors only invest a modest part of their overall portfolio in small-caps. While not offering an investment recommendation, Chart 1 below demonstrates how some investors might allocate between large and small equities. (Editor's note: It shows how conservative investors will have far less exposure to small stocks, compared to large ones).

Chart one - Sample asset allocations

Chart one - Sample asset allocations

Source: Contango

The good news is that there are ways to reduce some of the risks of investing in small-cap stocks. One way is by using an investment manager to provide you with a diversified portfolio of companies (hence minimising the risk of one or two poorly performing stocks wrecking a portfolio).

The value of an investment manager

A Listed Investment Company (LIC) is a portfolio of companies managed by a professional fund manager that trades on a stock exchange. Some Australian LICs that invest in smaller and micro-cap companies include Contango MicroCap, Mirabooka, WestOz and the WAM stable of companies.

Being professionally managed, these funds give investors exposure to potentially fast-growing companies and the upside of any market bounce. As LICs themselves trade on ASX, their shares can be bought and sold easily, cheaply and in real time.

Another benefit is many LICs offer clear dividend policies, which can help investors plan reliable income streams to fund their lifestyle needs. For instance, Contango has a dividend policy to pay annual dividends totalling 6 per cent per annum of the fund's July 1 net tangible assets, paid twice annually.

Dividends are also important to enable shareholders to enjoy share price growth without having to sell shares and potentially realise capital gains tax. Also, many LICs offer dividend reinvestment plans, where shares are issued to them at a slight discount to the most recent share price.

Another upside is an LIC's share price can trade below the value of the investment portfolio, enabling investors to buy $100 worth of assets for, say, $95.

Other advantages to recognise are that companies are committed to transparency in their operations and in the investment portfolio. Being governed by ASIC and ASX regulations, their boards ensure the best interests of shareholders are always maintained, with many committing resources to promote the company and be accessible to shareholders.

Outlook

Investment managers are always asked if "now" is the time to invest in smaller companies. Generally the stock answer refers to the staples of diversification, opportunity and performance, rather than making predictions.

However, it is fair to say that the doomsday scenarios of 2012 did not materialise and investors are recognising that the fundamentals in the Australian economy are quite compelling.

On possibly the most simplistic basis, price and earnings (PE), we can see in Chart 2 below that by no stretch can either small or large-cap stocks be considered to be expensive, with small-caps appearing to offer particular good value.

Chart 2 - ASX 100 vs Small Ordinaries PE

Chart 2 - ASX 100 vs Small Ordinaries PE

Source: Contango

Traditional indicators beyond PE, such as earnings per share (EPS) and dividend yield, also suggest upside to the market, while increases in share prices and market turnover indicate that investors are returning to the market, which overall is looking attractive again.

About the author

Boyd Peters is National Distribution Manager at Contango MicroCap (CTN), an investment company investing in a diversified portfolio of 60 to 100 Australian micro-cap companies listed on ASX, with a market capitalisation generally between $10 million and $350 million. There are more than 1000 companies in this category. CTN produces a free Quarterly MicroCap Investment Commentary.

From ASX

Listed Investment Companies provide a wealth of information on LICs. Use ASX Market Update information to review LIC premiums and discounts to NTA since 2004. View the monthly sector update to see overall LIC performance. Examine quarterly performance returns to gauge a LIC's investment performance against others.


The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

© Copyright 2013 ASX Limited ABN 98 008 624 691. All rights reserved 2014.

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