Daryl Wilson

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.

 



Comments

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Carlos Cobelas

unfortunately very few LICs are outperforming the markets. certainly not the larger Australian share LICs like AFIC, Argo and Milton which do not ever deserve to trade at a premium in my opinion although they often do.

Rodney Forrest

Good write up. The URB:ASX LIC is worth looking at Daryl with c20% discount to NTA as per 1 March ASX release.

Robert Brechin

Yes, Daryl, I'm caught in a trap. As a big fan of the WAM group, I've got the ticklish situation of a healthy stream of dividends reasonably well into the future (WAX, WAA). But the share prices have fallen, so that it will take a good two to three years of divvies to balance the capital losses. Trying to get out near the top as dividend season looms is hazardous, as if you sell, you lose all those dividends and possibly still make an overall loss. And if I jump into a new LIC, as you suggest, I could end up in the same bent over position! Cheers, Robbie (BTW I take it you're no relation to Geoff Wilson)

John Gates

John Gates Under "One way around Labor's proposals? Para 5 "Less franking credits......you would be better off than under an LIT structure." Please explain.AFIC has referred to the possibility of issue of LITs which I feel is the answer to Labor grabbing of retirees" ATO refund cheques.Shorten preaches "a fair go to all Australians" but acts "blow you jack, I'm all right!" Franking credits would be better called Tax credits for better understanding.

John GRAHAM

Daryl, is there an extraneous "than" in the 5th bullet point? Removing it makes a more logical sentence.

JOHN BIRD

Hi Daryl, re LITs - is it correct to assume that, in principle, when a LIT receives a franked dividend from an investment then the cash part of the dividend is passed to unit holders following year 1 and subsequently the cash from the rebated franking credit is passed to unit holders in year 2. Note: I ask this from the perspective of a zero tax rate self funded retiree

Ed Fung

Converting from a LIC to LIT would also mean losing those dividend reserves that is one of the selling points for the LIC structure eg WMI has a few years worth of dividend reserves which would help smooth out dividends over lean times. This would put more pressure on the fund manager each year to consistently have enough to pay out each and every year rather than have a "bank" of them so that they can afford to go longer term with some investments.

Neil Hampton

The more info ppl like me in smsf pension phase the better. Of course the guidance re picking the right LICs is great. The info regarding LITs and LICs converting to them potentially is valuable too. I don't understand how the LIT gets to effectively cash out its Franking Credit, and thus be able to pay as cash, as part of its distribution, to holder. Can anyone explain that, or have I got it completely wrong?

Neil Hampton

Ps, on a re-read, I understand that the FCs from the companies held in trust are NOT passed through at all, but there is no tax therefore no FC passed from the Trust itself. So in the end, the FCs that are issued by the companies invested in by the trust are sill lost by those with $zero tax liability. Yes, that 5th dot point has an extraneous "than" or should say "be better off than under an LIC structure", not "LIT structure". Ed F, I would imagine that those dividend reserves would be paid out prior to the start date of the new policy, along with the attached franking credits. Otherwise, the purpose is not achieved if they are held into the trust and then paid out along with the attached FCs, after the policy start date. This would not suit many who are not in low tax bracket. Will be interesting to see how it plays out. GWilson has been vocal as we know and mentioned conversions to Trust structure. Doesn't seem like it is a panacea though. Investing in growth companies, reinvesting divs, and cashing out as needed might be a strategy. As always it is the TSR that should be kept in mind with the cashed out FC line from your spreadsheet removed if you are in pension phase smsf, and not a pensioner on 28 March 2018, or an individual who is not also a pensioner but on a low tax base.

Ed Fung

RE; Neil H I would expect that the reserve of FC's would be paid out prior to the LIC to LIT conversion but it still means that post LIT conversion the holding of dividend reserves is now not possible. That was one thing that I liked about LICs - the ability to pay a consistent dividend during poor market conditions for as long as the reserves can hold out.

Luke Sampson

I’m not sure why you’ve singled out Spheria Emerging Companies (SEC) as your preferred pick based on good management, they’ve only been listed for 15 months and have underperformed the benchmark over a 1, 3 & 12 month period. They also charge 1% management fee and a 20% fee on outperformance of the benchmark. They appear cheap for a reason and it ain’t due to good management...

Simon

We could do with someone like yourself or Affluence FM to co-ordinate the action against these serial underperformers to either liquidate or become LITs. The remaining Watermark LIC already has a First Strike from the AGM so pressure is mounting....

Daryl Wilson

Hi all. Some great comments here. It's clear that LICs and franking credits are hotly debated topics. I'll respond to a few questions briefly. Rodney, yes we agree URB has been good value recently. It's one of our top 10 holdings at the moment because of the discount. We expect the manager is in a good position to do something about this over time. We're less sold on their potential as investors to outperform the market, but time will tell. Robbie, no not related to Geoff Wilson, but we are big fans of the WAM team - exceptionally talented managers. To the John's and Neil - thanks for pointing out the extra "than" in the article - it was a mistake and has been corrected. To John Bird and Neil - essentially any franking credits received in a year by an LIT can be passed through in that year (they are included as a tax credit available for the investor in the tax statement sent to all holders at the end of each tax year). The LIT manager has some flexibility as to when the cash from a dividend received can be distributed by the LIT - see the comment below. The tax benefit arises from the LIT not having to pay tax on profits. I'll look to write more about how this happens, perhaps with an example in a future article. To Ed, I'm not a tax expert, but as I understand it, converting to an LIT means the LIC effectively sells everything for tax purposes and unrealised gains turn into realised gains, tax is paid and franking credits distributed. So this can be a problem for LICs with a large amount of unrealised gains or losses. The gains cause tax to be paid in order to convert (probably offset to a degree by a franking credit paid out to investors). Any tax losses are likely to be lost on conversion, so that can be a negative. As an LIT, the idea of a profit reserve is irrelevant. One of the benefits of an LIT is the manager is essentially free to determine the level and timing of distributions, which makes it easier to smooth them over time. Luke, there are quite a few LICs we could have chosen from for this article. SEC stands out partly because of the discount and partly because of the excellent long term track record of the team (including a long period before forming Spheria) despite fairly average short term performance. You are right in that they do not come cheap, but in our experience, very few managers who have a genuine chance of outperforming by a reasonable amount, ever charge a low fee. Of course, you never know exectly when a better performance period will come along, or when a discount will start to close up, and we may well just end up being wrong. To Simon, while activism is not our style, we try to encourage and talk with managers where we think there are things they can do better. We think we will see more examples of activist investors entering the space if these discounts persist. Thanks for all your comments. Keep them coming.

Emma Davidson

Wow, excellent comments from everyone and great responses from you Daryl, thanks for offering your knowledge and experience!

Mr T

daryl fyi, i vaguely recall that there was no benefit (and i think disadvantages) from the really old LICs (eg AFIC) changing to a LIT. Although i cant remember the exact details for this, i think there was a specific bit of dated legislation that meant the older LICs were unlikely to change to a LIT, but for the newer LICs, it could be done without too many dramas. If you care, someone like Steve from Forager would be able to tell you the specifics of this (as i remember it was a raised as a possible issue for investors in his unlisted fund when it converted to a LIT (turned out it was a non-issue as Forager unlisted was a newer fund)). Broadly though i agree with your LIT/ LIC comments - a LIT is now generally a better and more tax effective vehicle than the newer LICs. ps - historically i suppose, the current crop of LITs have really been 'copied' from the basic investment trust structure used for unlisted funds. Steve at Forager was the groundbreaker for this i think, and deserves full credit for this market change (and changing to daily NAV reporting). There are some even more tax effective structures available for unlisted vehicles, but no-one i know has yet worked out how to make these vehicles workable for a publicly listed market.

Arthur Kingsland

• 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 than under an LIT structure. This is because you will effectively get a higher cash distribution and have fewer franking credits to lose. In the last bullet point should the be "than under an LIC structure"?