What attracts us to the LIC sector is the opportunity not only to access a range of very good investment managers, but also to potentially buy some LICs at very attractive discounts to NTA value.

If you get that right, it can provide two sources of returns for patient investors – the returns from the LIC portfolio and the extra from buying at a discount and seeing that discount narrow or even turn into a premium over time.

Here we look at some things to look for, and some mistakes to avoid, and nominate our favourite LIC right now. We also discuss the implications of Labor's proposal around franking credits, and a change LIC providers could respond with if needed. 

Significant discounts on offer right now

A reasonable proportion of LICs have always traded at a discount; The current level is slightly higher than normal, but is not unusual.

What is interesting right now though is that the size of the discounts in many cases is quite a bit higher than usual. The current opportunity seems to have been caused mostly by the large market falls late last year, which has scared off a few LIC investors.

As the markets have recovered, most LICs have lagged that recovery. While the NTA’s have increased somewhat, LIC prices have not increased by nearly as much and the discount has widened.

Market indigestion passing and market improving

We have certainly seen signs of caution after the large IPO's of last year, and that’s part of the reason for the current “soft” LIC market. But over time market conditions will improve and investors will return in force.

We are already seeing signs of a recovery in the IPO market. There are at least three new LICs on the way, all of which we think will successfully list.

That’s part of the reason we like LICs. Poor market conditions lead to poor performance, which leads to bigger discounts. For contrarian investors like us, that seems a good time to buy more. When we see the opposite conditions, we’ll sell some.

As an example of that, last September we increased the cash weighting in our LIC portfolio to over 20%. Right now, it’s down below 10% and we recently also increased our total allocation to LICs. As the number of opportunities increased, we topped up.

We’ve recently seen a couple of the Watermark LICs announce they will delist and effectively offer investors an exit at NTA after a long period of underperformance. This is good in that it has set the market a precedent. We would expect pressure on serial underperformers (including the remaining Watermark managed LIC) to increase in the future as a result.

But if an incumbent manager is determined to stay, despite lacklustre performance, they can be hard for shareholders to dislodge. So it’s difficult to see too much consolidation, but even with some consolidation, we would expect the total number of LICs to continue to grow over time, as new managers continue to come to market. 

Things to watch for and mistakes to avoid

The two big factors we assess when looking at any LIC are the ability of the manager to outperform their investment market and the current discount to NTA compared to the average over time.

There are many other factors that matter, but those are the two biggest. In our view, if you’re not thinking about these things, LICs are not for you.

Also, in LIC land as with many other types of investments, bigger is not necessarily better. The three largest LICs, which account for around one third of all money in LICs offer little in the way of diversification. We think they are unlikely to outperform their market by a meaningful amount over the long term. Indeed, all three have delivered total shareholder returns (change in share price plus dividends) of less than the ASX200 index over 3, 5 and 10 years to 31 January 2019.

Despite the recommendation of one well-known investor who doesn’t wear any shoes (and who we usually agree with), you may well be better off owning a low-cost ASX200 ETF than Australia’s largest LIC, particularly if you’re worried about franking credit refunds.

It’s easy to get LICs wrong. Buying based on dividend yield alone is the single biggest mistake we see from LIC investors. Another common mistake is that too often for individual LICs, we see a vicious cycle where last year's outperformers or high dividend payers trade at premiums as new investors pile in. Sooner or later they underperform, and the reverse happens. If you’re going to invest in an LIC, you must do enough work to understand what you’re getting.

We have a range of factors we look at, and our LIC Guide explains a lot of them. One example of a great situation for us is an LIC trading at an unnaturally large discount, where the manager has a very good long term track record, and poor recent short term performance (they all have one eventually).

While we are able to buy LICs at a premium, it’s very rare for us to do so. Buying at a premium assumes the LIC manager is going to deliver outperformance in the future, and that as an investor you’re happy to pay for that up front. Depending on how high a premium you pay, those odds are probably not in your favour.

There is a wide range of attractive opportunities out there right now. We currently hold over 30 LICs in our portfolio. We recently wrote on Livewire about three of our favourites. 

If we had to pick just one, it would be Spheria Emerging Companies (ASX:SEC). We think this provides a good blend of a quality manager, an underlying portfolio with real value and a 10%+ discount. It’s just one example of the many mid-sized LICs that can be readily accessed at a good price.

One way around Labor's proposals?

Australian investors are addicted to franking credits. But in fact, an LIC is a very poor investment structure compared to a listed investment trust (LIT). If every LIC was able to be converted to an LIT tomorrow, here’s what would happen:

• The LIT would pay no tax, leaving more cash profits available for distribution to investors;
• Distributions would be higher than current dividends, as the retained cash not used to pay tax could be distributed;
• Franking credits received by the LIT from underlying investments in shares could still be passed through to investors;
• CGT concessions from selling investments held by the LIT for more than 12 months could be passed through to investors, making the whole structure more tax efficient; and
• Less franking credits, but more cash in the hands of investors, means that if you will lose franking credits under Labor’s policy, you would probably be better off under an LIT structure. This is because you will effectively get a higher cash distribution and have fewer franking credits to lose.

So, if Labor’s changes look like coming through, expect every LIC manager out there to look at converting.

It’s not always easy, particularly for older LICs with large franking balances and a lot of unrealised gains. But if the proposed changes are legislated we would expect quite a few to take the leap, and for most new IPOs in the sector to elect to use an LIT structure.

Before you invest, read this!

We encourage you to do your own research before investing in any LIC. Remember, a great LIC and a great 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. 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.