The Australian listed investment company (LIC) industry is almost 100 years old and has experienced many cycles since Whitefield Limited was first incorporated in 1923.
In 2002, I welcomed a “golden decade” which has now extended to almost two decades and more than 50 LICs have listed on the ASX since then. In the current environment, I believe the LIC structure provides significant opportunities for investors.
LICs are listed on the stock exchange and governed by a board of directors, adopt a long-term investment horizon because they are not influenced by inflows or outflows of capital, and provide a compelling retirement income solution.
In recent times, some fund managers without previous experience in managing LICs have chosen to adopt the structure, attracted to the closed-end nature under the mistaken belief that it represents “permanent capital”.
Many investment managers have learnt this lesson the hard way, as they have either performed poorly over the period or treated shareholders without due respect as owners of the LIC, such as conducting capital raisings at a discount to the company’s net tangible assets or by failing to engage with shareholders.
How LICs tick
I have been passionate about the LIC structure since reading a mid-nineties Morgan Stanley report that found closed-end funds outperformed open-end funds over a 50-year period.
The logic is clear: open-end funds buy and sell in line with investors’ inflows and outflows and this leads to them being a forced buyer when asset prices are high and a forced seller when they are low.
Investment managers of a LIC do not face this dynamic and they are able to invest according to their investment process rather than fluctuations in sentiment. LICs also have the ability to smooth and grow dividends paid over time and distribute franking credits which can be beneficial to shareholders.
LICs allow an equity fund to convert its total return into a combination of fully franked dividends and capital appreciation, this is ideal for SMSFs looking for retirement income. Unit trusts must distribute all profits each year, so income is unpredictable and can result in unexpected tax consequences.
LIC share prices are dictated by the market. Due to this fact, and additional complexities arising from structural differences between trusts and companies, we believe there are three important measures of performance that LIC investors need to assess.
These are: performance of the investment portfolio versus performance of the benchmark; growth in NTA per share and fully franked dividends; and total shareholder return.
The first enables a shareholder to assess whether an active manager can outperform on a like-for-like basis with the benchmark, before expenses, fees and taxes.
The second demonstrates the value of that portfolio performance after fees, expenses and taxes and quantifies the impact of capital management decisions (for example, dividends paid, options exercised, new shares issued at a premium or discount to NTA) under the direction of the LIC’s board of directors, which can increase or decrease the value of a LIC’s NTA separate to the performance of the investment portfolio.
The franking credits generated by corporate tax payments, which reduce a LIC’s pre-tax NTA when the cash outflow is paid, are available for distribution to shareholders through fully franked dividends.
Finally, total shareholder return measures the tangible value gained by the shareholding measured by dividend income and share price growth. This measure does not value the potential benefit of franking credits distributed to shareholders through fully franked dividends unless it is reported as a ‘grossed up’ figure, which some LIC managers choose to present.
Emotions hold sway
A LIC’s share price ebbs and flows with the emotion in the market, which can occasionally provide investors with opportunities to buy $1 of assets for 80¢ and even sell $1 of assets for $1.20, as the shares can trade at different values to the reported NTA.
Discount opportunities can be realised through events such as a return of capital, wind-up, or closure of the share price discount over time, as the investment manager or board of directors acts. The average premium/discount across the LIC sector is currently minus 10.1 per cent.
Many of the LICs trading at discounts will cease to exist in coming years and others will see their fortunes reversed. For investors who love buying $1 for 80¢, the opportunities have only just begun.
Geoff Wilson AO is Chairman and Chief Investment Officer of Wilson Asset Management. Wilson Asset Management has an investment management agreement with six LICs.