This article appeared in the February 2014 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.
By Hamish Nairn, Taylor Collison
The Australian listed investment company (LIC) sector has experienced a significant resurgence, as shown by a tightening of discounts to LIC asset backings to historically low levels and by the largest amount of capital yet raised in the sector.
Why the extraordinary turnaround from 2009, when LICs were trading at record discounts?
A quick technical point: I value LICs on a going-concern basis, that is, pre-tax net tangible asset (NTA) backing, excluding any non-performing assets (usually tax-deferred losses). When I refer to asset backing, it is the LIC's pre-tax asset backing.
(Editor's note: LICs can trade at a premium or discount to their pre-tax Net Tangible Assets. For example, an LIC might have a share price of 80 cents and NTA per share of $1, meaning prospective investors can buy each dollar of assets in the LIC at a 20 per cent discount. The LIC might trade at a discount because of LIC's performance record or dividend history. Listed investment companies and trusts explains the features, benefits and risks of LICs. The ASX Managed Funds Market update shows whether LICs trade at a premium to discount to NTA.)
Reasons for a narrowing of the gap
Share price discounts to asset backing have tightened for a number of reasons.
Many of the companies have existed for more than 50 years and paid dividends for just as long; Whitefield was formed in 1923 and the Australian Foundation Investment Company (AFIC) in 1927.
Second, LICs are founded on quite basic and simple accounting principles, making them necessarily transparent to investors.
Third, the Australian sharemarket is trading around record levels, based upon the S&P/ASX 200 Accumulation Index (which assumes dividend reinvestment). In the past, LICs have underperformed during a market rally, but now they are embracing the rally, as I will discuss.
Low cash rates spur LIC demand
With interest rates low, investors have bought Australian shares for their higher dividend yield, with many investors diversifying their portfolios away from banks and Telstra into LICs. Indeed, the higher-yielding LICs in the sector are all trading at premiums to their asset backing. For example, Aberdeen Leaders (18 per cent premium), Australian Leaders (9 per cent), Djerriwarrh Investments (30 per cent +), Mirrabooka (9 per cent) and the three "WAM sisters".
Yet as recently as 2009 a number of LICs were unable to pay a dividend, discounts widened and some managers lost their investment mandate (e.g. HFA and India Equities).
LIC managers have learnt from 2009. Many have placed a greater emphasis on their accounting for profits by creating a profit reserve from which they can pay a dividend. Or, in this strong sharemarket, they harvest profits more actively, thus crystallising gains and paying tax, again boosting their franked dividend capacity.
LICs have embraced the investment community. The semi-monastic perception they may have had when an earlier generation owned them has been replaced by a troupe of managers who travel frequently. After seeing discounts widen and money pour into exchange-traded funds, LIC managers paid attention to their shareholders, found out who they were, and now engage with them, educate, market and find new distribution channels for their products.
Technology has been of enormous benefit in this.
Better promotion also helps
The AFIC-affiliated four LICs employ Geoff Driver; Contango has Boyd Peters; BKI Tom Millner, the "WAM sisters" have Geoff Wilson and his team; and Angus Gluskie is with Whitefield. These people have helped the LIC sector enormously by making it more transparent and available to investors through their marketing and education efforts.
They have used the internet and provided interactive websites, and by travelling the country to visit accounting practices and financial planning houses to talk about their company, the equity market and LICs generally. As Rob Patterson initiated at Argo Investments in 1983.
The LIC sector has benefited from proven successful investors such as Chris Mackay and Hamish Douglas forming Magellan Funds Management and subsequently launching a LIC. In addition to being skilled investors, they have developed an excellent distribution network and investor education program.
Magellan Flagship Fund invests in international stocks, adding to the diversity of investment strategies available from LICs. Twenty years ago the only derivation away from long-only Australian equities investment strategies (buying shares to profit from rising prices) from LICs was DUI's strategy to invest in a few international stocks, whereas today we have a China fund, long-short funds, absolute return, market neutral, high-yielding, international, and more.
The success of Magellan and the ability to launch new strategy funds has attracted some other successful investors to launch LICs, such as Sir Ron Brierley, Paul Moore and Alex Waislitz.
Consistency the key
Consistent and growing dividends (due to a buoyant sharemarket), strong performance returns throughout the sector (ditto buoyant sharemarkets), marketing and education, have been the keys. Managers have capitalised on this period of low discounts in LICs by issuing more stock. Almost $1 billion was raised in LICs in 2013, a record.
For the externally managed LICs, size does matter. Obviously, the manager benefits from an increase in his or her management fee, and the larger the capital base, so too potentially the opportunity for a far greater performance fee.
Investors are currently not discerning about managers' fees, nor indeed that some LICs really should remain quite small or concentrated, if their own investment strategy (e.g. micro-caps) has a limited investment universe.
A brief history of LICs
In Australia, LICs came to the fore as a pooled savings vehicle akin today to an industry superannuation fund. In days past, LICs were favoured by public trustees and charities. Sir Donald Bradman even chaired one.
After World War Two the dominant investment vehicle was a company structure, generally owned by a series of family trusts, albeit father (or mother) held the one Class A "Governors" share.
This structure has become very tax-inefficient, thanks in the main to the Honourable Paul Keating who, frankly, via his introduction of dividend imputation should have a Lenin or Stalin-like statue in Martin Place or, even better, on the lawns of Kirribilli.
Imagine receiving a $100 dividend and when it is banked and processed by the tax office it is actually worth $130! Well, since 1987 this has been the case, as franked dividends received by superannuation funds are, in my experience, like discovering heaven.
The realisation by investors and the wealth advisory industry (that is, financial planners) that they could enhance their income (or their clients' income) via franked dividends, has seen a far greater interest in direct shares.
And at the very time the hobbyists and do-it-yourself types have plonked more of their superannuation into Australian equities, the Federal Government has assisted via the Future of Financial Advice (FOFA) legislation, which, as you work your way through it as an adviser practitioner, forces you to look at direct shares, and via your duty of care to your client you arrive at LICs.
Record number of investors
In 2012 and 2013 the wealth advisory industry advised a record number of clients into buying LICs on market. They squeezed out the 2009 and 2010 fringe institutional buyers. In 2013 the demand for LICs came from both the wealth advisory industry and from old-fashioned stockbroking desks, the almost forgotten paragon of "my word is my bond", the private client stockbroker.
The 50 and 60-year-old grumpy private client stockbroker (who had probably missed the market rally) stood aside from lunch, stopped longing for the days of the family investment company, and has emerged by forging new links with the superannuated savers and by advising them to buy LICs.
In short, the advice industry is advising on LICs and is providing generally quite reasonable research.
Can the LIC sector go pear-shaped?
Well of course it can, but having said that we are still yet to see family offices, the major banks or indeed the Future Fund or university endowments participate in the sector.
Your best armoury? I go back to where I began: investors coming into LICs must focus on the asset backing. Be wary of investing $1.20 to buy $1 of assets (e.g. buying a LIC at a substantial premium to NTA) just because the historical yield is 6 or 7 per cent. Identify the LICs you like and be patient. Opportunities always arise, especially among the smaller and more illiquid LICs.
With research and sound advice you should be able to buy a dollar of assets at a discount, or at least parity, that if properly managed will provide a greater income stream and thus returns over the longer term.
While there are clear signs of some froth in the LIC sector, if you focus on the asset backing, historical performance, the history of dividends, fees, costs and what exactly the LIC invests in, you will be streets ahead.
About the author
Taylor Collison Limited is an Australian based stockbroker, formed in 1928, and is equally owned by each of its eight directors. In 2013 it was lead manager on around $400 million of new LIC capital raisings. Any reference to NTA premiums or discounts in this article is based upon the author's own work.
Disclosure: In 2013 Taylor Collison received corporate fees from Australian Leaders Fund Limited, BKI Limited and WAM Research Limited; it facilitated the WAM Capital Limited on-market ASX Bookbuild (for no fee) and underwrote the final WAM Active Limited dividend (no fee). It was a co-lead manager to the PM Global Opportunities Limited IPO (received fees) and has a broking relationship with all the LICs mentioned in the article. It is a corporate adviser to Magellan Financial Group, and is an on-market buyback broker for the Magellan Flagship Fund Limited (joint) and Whitefield Limited.
Listed Investment companies and trusts provides information the features, benefits and risks of ASX-listed LICs.
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