Last month, we set out why the worst performing funds in recent times can be amongst the winners in the future. In summary, Research Affiliates showed that the top 10% of US managed funds over a three year period went on to underperform over the next three years by 0.6% per annum (9.7% vs 10.3%). The 10% of worst performing funds over each prior period, produced returns of 11.7% per annum, a significant 1.4% per annum above the average.
While this is counterintuitive, it makes sense to us. One of the things we like to see when we're looking for exceptional fund managers is a great long term track record, coupled with not so great short term performance. As a follow up to last month’s story, we look to apply this theory to the LIC sector.
This is an interesting time to undertake this exercise, as investment markets, and the LIC sector in particular, are in the middle of some unusual conditions. As has been well reported through the investment media, growth and momentum strategies have been performing exceptionally well, and value strategies have largely been the opposite.
In addition to this, current investor sentiment towards LICs seems to be at a low point. Since the start of this calendar year, there has been a notable lack of buying support right across the sector, almost irrespective of market capitalisation, performance, and manager quality.
The result of these soft conditions has been a marked increase in the discount to NTA across the sector. We suspect fear from Labor’s franking credit proposal may be a big factor. Regardless of the cause, the effects are very clear. Discounts to NTA in many LICs are at levels not seen for 5 years or longer. We believe this represents a good opportunity.
The following table highlights some of the poorer performing LICs over the past 3 years (or shorter if not listed for that period) in alphabetical order. Because we’ve looked at performance in terms of total shareholder returns, the poor performance could be due to poor underlying portfolio performance, an increase in the discount to NTA, or a combination of both.
We’ve reviewed the poor performers and specifically focused on those where the manager has a very good long term track record.
Below are three examples where we believe there is potential for future upside. As with any underperforming strategy, there can be no certainty that we are yet at the bottom. Regardless, we believe that current prices represent an attractive entry point, and we hold all three LICs in our Affluence LIC Fund.
L1 Long Short Fund (ASX: LSF)
Some would argue that this LIC is part of the reason for the current sector woes. L1 Capital created headlines in April 2018 when they undertook the IPO for LSF. After extraordinary demand, the team ended up raising over $1.3 billion. Then, in what we believe was largely just a matter of coincidence, virtually as soon as the IPO had settled, the underlying performance plummeted. From trading at a premium for the first few months, the share price fell from a high of $2.09, to a low of $1.27 in December 2018, a loss of 39% in value. It has since recovered to around $1.44.
It is important to remember why the IPO caused so much excitement to start with. It was on the back of the performance of their very similar unlisted fund which had returned nearly 40% per annum for the three years before the IPO. No manager can outperform forever, and even the best managers go through tough patches. After this incredible performance, we were sceptical of investor expectations for LSF. Did the average investor expect 40% per annum returns consistently forever? We hoped not.
L1 describe their investment style as ‘value’ and ‘contrarian’. To us, this alone could explain a lot of the poor performance in 2018. Value style managers have hugely underperformed both growth and momentum styles recently. We believe, as does L1 Capital, that the recent obsession with growth and momentum is a fad which will revert to the mean over the medium term. If you believe that as well, then LSF may now be worth a look.
The performance history for LSF is only 12 months old. During that time, the underlying portfolio lost 16% and total shareholder returns were -23%. Compared to the ASX 200 Index return of +10%, this was obviously disappointing. However, that’s only part of the story. We have also reviewed the performance of the underlying L1 investment strategies that have been available via unlisted funds for some time. The long only strategy commenced in 2007 and the performance track record is exceptional, with the team outperforming by more than 3% per annum net of fees over an almost 12 year period. The L1 long short strategy commenced in 2014 and even including the poor 2018, has delivered net returns of over 20% per annum.
To be clear, we don’t expect LSF to deliver 20% per annum returns over the long term. However, we do believe L1 can outperform the market significantly over a full cycle. As at today, you can purchase LSF at an 11% discount to NTA.
NAOS Small Cap Opportunities (ASX: NSC)
NSC is one of three LICs managed by the NAOS team. While all three have a very similar investment philosophy, they concentrate on different market cap sectors. NCC focuses on micro-cap stocks, NSC focuses on small-cap stocks, and NAC focuses on mid-cap stocks. All the NAOS LICs have quite concentrated portfolios, with a strong value bias to industrial equities. They take a genuine long term view with their positions and are quite prepared to hold their nerve during inevitable periods of poor performance.
NSC was previously known as Contango Microcap Limited and is one of the older specialised small cap LICs trading on the ASX. NAOS acquired the management rights from Contango in November 2017, renamed it and adopted the NAOS investment strategy. Since taking control of NSC, performance has been poor. While only a relatively short time, the NSC portfolio has lost 12% per annum over this period. NSC shareholders have seen even worse returns of -20% per annum, as the discount to NTA has widened in concert with the underwhelming investment performance.
Both NCC and NAC have been operating for much longer under NAOS stewardship and can provide a fuller perspective of the managers performance. NCC has been listed for just over 6 years and the manager has reported gross (before fees) portfolio performance over this period of 11.6% per annum. This is 6.4% per annum better than the ASX Small Ordinaries Index. Like NSC, over shorter time periods the portfolio has significantly underperformed. NAC has just over a 4 year track record. During this time the gross portfolio returns have been 12.1% per annum, 4.5% above that of the ASX 300 Industrials Accumulation Index. Again, the portfolio has underperformed over shorter time periods. As an aside, we are always disappointed to see a manager report performance before fees as NAOS do, unless they are proposing to manage our money for free. Notwithstanding this, long term performance still appears to be very good, even after adjusting for fees.
So once again, NSC provides access to a manager with a good long term track record, currently experiencing a rough patch. We believe small cap value is one of the most unloved sectors at the moment. So, while we don’t find this recent underperformance surprising, we do see a lot of potential value in the portfolio. NSC is currently trading at around a 17% discount to NTA and we are excited about its long term potential from here.
By the way, stablemate NAC is trading at around a 20% discount to NTA, which also looks like good value. NCC trades at around NTA, which makes no sense on a comparative basis.
Australian Leaders Fund (ASX: ALF)
Rather than pick from a number of other value-focused LICs which have been beaten up over the past year, ALF represents something a little different.
ALF is an absolute return fund managed by Watermark Funds Management. While the strategy is described as ‘variable beta’, it has been market neutral since 2015. ALF has a market capitalisation of approximately $220 million and was the largest of three LICs managed by Watermark. The other two LICs, Watermark Market Neutral (ASX: WMK) and Watermark Global Leaders (ASX: WGF) have recently been delisted and converted into an unlisted trust. This has both eliminated the discount to NTA and allowed investors the ability to redeem their investment at NTA.
Essentially all three LICs suffered from the same issue in recent times. They have not made profits for investors at a portfolio level for quite a while, and all ended up trading at substantial discounts to NTA. While WMK and WGF have now been dealt with, that still leaves ALF trading in limbo.
Unlike the other two Watermark LICs, ALF can adjust the level of net market exposure depending on market conditions. When equity valuations are cheap it may be fully invested. When equity valuations are expensive (as the manager has believed they have been for the past few years) then it may be market neutral or even net short.
On a portfolio level, ALF has posted negative annual returns over 1 and 3 year periods and just 1.2% per annum over 5 years. Unsurprisingly, this LIC now trades at a discount to NTA of approximately 20%. What makes this worse for some shareholders is that between 2014 and 2016, ALF traded at a substantial premium (over 20% at one point). If you bought around that time, you’ve suffered the additional pain of seeing a substantial premium turn into a substantial discount. Total shareholder returns over 3 years are approximately -11% per annum, and over 5 years approximately -7% per annum.
So why do we think ALF is a good buy now? Firstly, we don’t believe it will get drastically worse from here. As the vehicle is currently market neutral, it is unlikely to suffer a large drawdown in a market fall. Of course, it could certainly continue to make losses, as its 1 year performance of -4.5% shows. It is also very possible for the discount to NTA to blow out even further. But in our opinion, the larger the discount gets from here, the greater the chance of a shareholder revolt. Given the 5 year returns, pressure is continuing to build for a resolution. Any more losses to shareholders from here, in our opinion, increases the chance of a WMK/WGF type transaction occurring.
ALF is far from a standard LIC, but one which could deliver a reasonable return over the next year or two, regardless of how markets behave.
There are always risks in investing but buying cheaper than average can be a good way to reduce them. We believe now is an excellent time to be deploying some cash into the LIC sector, while demand is soft and we’re seeing limited bids on the buy-side.
We encourage you to do your own research before making any investment. A great LIC, investment fund or manager is only part of the story. We also like to make sure they’re trading at the right price and that the assets they are investing in are not themselves overvalued. We explain how we do this in our LIC Guide and our Managed Funds Guide, but in the end, it’s up to you to make the investment decision that’s right for you, in conjunction with your financial advisor if you have one.
Take care and all the best with your investing.
Disclaimer: This article is prepared by Affluence Funds Management Limited ABN 68 604 406 297 AFS licence no. 475940 (Affluence) to enable investors in Affluence Funds to understand the underlying investments of the funds in more detail. It is not an investment recommendation. Prospective investors are not to construe the contents of this article as tax, legal or investment advice. Neither the information nor any opinion expressed constitutes an offer by Affluence, its subsidiaries, associates or any of their respective officers, employees, agents or advisers to buy or sell any financial products nor the provision of any financial product advice or service. The content has been prepared without considering your objectives, financial situation or needs. In deciding whether to acquire or continue to hold an investment in any financial product, you should consider the relevant disclosure documents for that product which are available from the product provider. Affluence recommends you consult your professional adviser to determine whether a financial product meets your objectives, financial situation or needs before making any decision to invest.