How to profit from liquidity provision in LICs
There was an excellent article on Livewire last week looking at some Listed Investment Companies (LIC) trading at a discount that offer good chances to profit for investors. Today, I offer another way that investors may not always consider: IPO investors to offer liquidity on the stock exchange.
Here at Morphic we recently undertook the listing on the stock exchange of an Ethical version of our Fund called the Morphic Ethical Equites Fund (ASX:MEC). The Fund doesn’t invest in a number of types of stocks, such as tobacco, armaments and coal and also seeks to short those stocks if we think shareholders can profit from the demise of those industries.
But this article isn’t about our Fund, it’s about helping investors understand how they can profit from the way markets work.
LIC Options – dividing the market
When we launched, we made the decision to attach options to the issue of shares. Now options and LICs have divided people, with some like Forager Funds, coming out against them and others like Geoff Wilson supporting them.
The reality is that options remain very popular with LIC investors and one thing I have learnt over the years is that markets are pretty efficient so if something exists, there is usually a reason.
Understanding the float process, options and liquidity
So what I want to talk about today is “liquidity provision”. What this means is the role and profit paid to be a “middle man”. The most common example is someone who exchanges foreign exchange on a corner that you may see on holidays. If you want to access the currency you need on holidays but haven’t got enough for whatever reason, they “provide liquidity” to you by acting as a middle man.. at a price of course – that being an exchange rate lower than normal!
If we return to looking at an LIC, the IPO process essentially offers unlimited liquidity. The price, though, is the listing cost of the IPO.
Now once the IPO is complete and the LIC is trading on the stock exchange, there are no new shares available. So if you want to buy some, you have to convince a shareholder to sell to you. For investors who just put money in for the long term, a lot of them may be unwilling to sell just yet. In this case, the price of the shares would then trade to a premium to try and “bring out sellers” to make supply and demand equalise.
This brings me to the second part of LIC IPOs from above – options. Options provide a valuable role in liquidity provision.
Profiting from providing liquidity – how does it work?
Holders of stocks in most LIC IPOs hold options granted to them on day 1. These options represent the natural providers of liquidity. If you are an owner of options from an IPO, there is a relatively easy way to profit from providing liquidity. The steps of an example are below:
- Step 1: LIC floats and a shareholder paid $1.10 for 1 share and 1 option.
- Step 2: the stock trades up to $1.20 through a combination of rising asset values and more buyers than sellers creating a premium.
- Step 3: The shareholder goes on market and sells the stock on the ASX at say, $1.20 with the NAV being worth $1.12.
- Step 4: The options were issued at $1.10, so the shareholder, who still owns the options, then convert those options at $1.10 and pays for them using the money received from the sale of the shares ($1.20).
- Step 5: The shareholder still owns 1 share trading at $1.20 and keeps the 10c difference as the profit.
This is a case where both parties are happy: the buyer is trying to buy more stock than would be normally available on the market and if there were no options, they would force up the share price. The seller is happy as they have been paid a profit for providing liquidity to the market.
By converting at this stage and reinvesting the proceeds, investors are able to “lock in” profits that can’t be lost.
But what about LICs that trade at a discount?
In this case, liquidity provision isn’t needed as there are more sellers than buyers, so new buyers would be better off going onto the share market and buying the shares there until there was discount. And for owners of the options, since the options can be converted at the discretion of the owner, not converting hasn’t cost the owner.
So where are these opportunities for LIC Investors who bought in at the floats of some LICs?
The largest listed fund with options outstanding is the Antipodes Global Investment LINC (ASX:APL), which trades at a small premium to NAV (~2%) and options (ASX:APLO) are in the money.
Our Fund (ASX:MEC) is also trading at a premium with a NAV of $1.09 versus $1.14 for the last price and options exercisable at $1.10.
If you are a holder of some options and LIC shares in either of these, but don’t have a stock broking account and are interested in locking in some profits, then Taylor Collision and Morgans Stockbroking offer competitive rates. Please contact us if you want their details.
2 stocks mentioned
Chad co-founded Morphic Asset Management in 2012. As a stock picker Chad is also a generalist but has strong regional knowledge of Europe and the Americas. He has also been awarded the CFA Charter.