How to use LICs/LITs for income (and 3 we like)
Many investors look to ASX Listed Investment Companies (LICs) for their ability to pay regular income. Given the incredibly strong market since April 2020, many LICs have banked huge profit reserves that can cover dividends for many years. Over the past couple of months, we have seen increased dividends, and some LICs increase the frequency of dividend payments. This can help to attract new investors, and, where LICs are trading at below their net asset value, to close those discount gaps.
The result of this recent positive performance is that the sector is starting to look healthy again. Investors are returning in droves, and many LICs are yielding 4%, 5% or even more. This can make LICs an attractive proposition for those looking for income. But let us give you a word of warning up front. We don’t believe anyone should buy an LIC based just on its dividend yield. There are many other attributes we look for before purchasing, and in our view some of them are much more important than today’s yield.
LICs vs LITs and smoothing income
While we often refer to the sector collectively as LICs, it is important to understand the differences between a Listed Investment Company and a Listed Investment Trust (LIT).
LICs pay dividends
As the name suggests, LICs are companies, and they must pay tax on net income and on realised capital gains. When an LIC pays that tax, it reduces the NTA. However, shareholders of the LIC will eventually get the benefit of the franking credits that this creates, when the LIC pays dividends. When an LIC pays a fully franked dividend, shareholders receive the cash plus the benefit of any attached franking credits. The investor can then use this credit to help offset their own taxable income, or even get it refunded to them if their tax rate is lower.
The amount of dividends an LIC can pay out is usually limited by its profit reserve, which is effectively made up of income and capital gains. When an LIC does not have a profit reserve (for example soon after listing, before significant investment profits have been accrued), then its ability to pay dividends is more limited. So, in the early years, LICs usually pay no/very low dividends. But once they’re up and running, and have built some profit reserves, it’s easier for them to pay a consistent dividend.
LITs pay distributions
LITs are trusts. That makes them very similar to ETFs and unlisted managed funds. LITs don’t pay any tax on income or capital gains. Instead, they pass through taxable income (and any tax obligations) to their unitholders. LITs pay distributions rather than dividends and they are franked in the same way. However, LITs can still receive and distribute out any franking credits they have received during a year (for example, from investing in companies that pay franked dividends).
LITs are not limited by the profit reserve concept. That means they can potentially start paying distributions straight away. But there’s a catch. LITs must usually distribute all taxable income, including realised capital gains, every year. This means they can be forced to pay a large one-off distribution in year where they make exceptional gains. And while this is very good at the time if you’re an investor, it is not predictable, and very likely won’t be repeated every year. Examples of LITs that paid outsized “special” distributions in the 2021 tax year include Regal (RF1) and Ophir (OPH).
Assessing income levels
Recent buoyant market conditions have boosted the profit reserves of many LICs. Pleasingly, LIC managers have mostly taken this opportunity to increase payout levels, while staying within the bounds of what is sustainable. When assessing an LIC on its potential yield, we consider several factors.
How often they pay
The timing of payments is important to some investors. The most common payment period for LICs is twice per year. An increasing number are moving to quarterly payments, which we applaud. Many debt LITs pay monthly, which has proven popular. Examples of monthly payers include Metrics Income Trust (MXT), Perpetual’s Credit Income Trust (PCI) and the Qualitas Real Estate Income Fund (QRI).
What’s a fair income level?
Understanding the prospective returns a manager can deliver can help to work out what level of dividends is reasonable, and identify “value traps”. For example, a good quality active equity manager should back themselves to achieve total returns of 8-10% per annum. Some years may be terrible and some outstanding. However, if on average you are paying out half as income, a 4-5% income yield seems very maintainable, particularly if the LIC has amassed a profit reserve that covers the next few years. Debt LITs may achieve lower returns from their portfolios. But those assets tend to be less volatile, and the income from them more dependable. Thus, many debt LITs can pay sustainable income in that same 4-5% range.
Profit reserves and franking
Always check the level of profit reserves the LIC holds. Most LIC managers are now very transparent about how many years dividend coverage they have. If they’re not, make contact and ask them.
For LICs, the level of franking credits can also be a factor. Some LIC managers are reluctant to pay dividends if they can’t be fully franked. There are many situations where the LIC may hold an adequate profit reserve, but not have enough franking credits to match. This is particularly the case for LICs that invest offshore, as they are not receiving franked dividends from their investments. Information of franking credits can be harder to find, but it’s usually contained within the annual report.
Can the dividend grow?
An important factor for us is not so much the current yield for an LIC, but how much that dividend or distribution can grow in the next few years. A growing dividend yield can assist is closing NTA discounts, or even see the LIC trading at a premium. You may want to consider LICs that are currently paying a lower dividend but have the potential to it over the medium term.
What else really matters?
When selecting LICs, we never purchase based only on the dividend. Here are three key criteria we always look at before purchasing.
While the level of disclosure around LIC performance ranges from excellent to incredibly poor, it is important to assess whether the manager can provide competitive risk adjusted returns. One of our preferred methods is to compare the net performance history (after fees, but before tax) against the relevant benchmark for as long a period as possible. We also like to understand how the manager performs when markets fall.
Discount/premium to NTA.
This is probably the single most important aspect for us when investing in LICs. You might come across an excellent quality LIC that ticks all the boxes and is paying a strong dividend yield. But if it is trading at a large premium, it may be much more difficult to achieve a satisfactory total return. There is no one right discount/premium level for LICs, but we prefer to purchase an LIC when it is trading at a greater discount than its long-term average.
Underlying portfolio value.
Investors need to assess the attractiveness of the LIC’s underlying investment portfolio. If the LIC invests in Australian shares, is it a good time to invest in that asset class? Is it cheap, or expensive? How does this LIC fit within your existing portfolio?
Is the LIC investment philosophy similar to yours? It can be hard to back a manager that invests contrary to your normal style. But then again, this is one way to diversify your portfolio.
These types of questions can lead to difficult decisions. For example, even with the recent market blip, most equity markets remain near all time highs, and appear quite expensive. Are you comfortable investing in such markets, or will that have an impact of the weighting of a particular LIC within your portfolio?
Some LICs we like
Here’s a few examples we currently hold in our Affluence LIC Fund portfolio that may also suit investors looking for a reasonable yield. All prices and statistics are as at 31 August 2021 unless otherwise stated, and please do your own work on them or consult your financial adviser before making an investment decision.
Sandon Capital (SNC)
SNC declared a 2.75 cent fully franked dividend in August and stated their intention to pay the same amount for the next half year. This translates to a 5.5 cent annual franked dividend. They are also paying a special dividend of 1 cent for the full year, however as this is one-off, we have excluded it for this analysis.
Based on the 31 August NTA of $1.19, this reflects a 4.6% net yield and 6.2% grossed up for franking credits. Based on the closing share price of $1.05, the dividend yield is 5.2% net and 7.0% grossed up for franking credits. SNC was trading at a 12% discount to NTA on 31 August, which is similar to its long-term average. They have 32 cents in profit reserves and have advised that this represents four years of fully franked dividend paying capacity.
They are currently in the final stages of a capital raising, so this may have a short-term impact on the share price. But in general, we like the management team, the portfolio and the yield and the discount is OK.
Djerriwarrh Investments (DJW)
The history of DJW is a very good example of why it can be dangerous to purchase LICs based on the dividend yield alone. The DJW investment strategy is to sell call options to receive the premiums, which increases the amount of income they can distribute. The downside is it reduces potential capital growth. For many years DJW paid a well above market level of dividends, and investors responded by bidding DJW up to a 40% premium to NTA.
Dividends started reducing in 2016, and the premium to NTA also gradually reduced. In 2020 the pace of reductions increased, and after 10 years of trading at a premium it finally fell to a discount to NTA. For investors who purchased DJW during the period of high dividends and high premiums, they have either lost money or substantially underperformed as the premium normalised.
That’s the history. But the future looks brighter. The latest declared dividend was 5.75 cents for the half year, which is 11.5 cents annualised. Based on the 31 August NTA of $3.50 it reflects a 3.3% net dividend yield and 4.7% grossed up for franking credits. The closing share price was $3.12, with a 3.7% net yield and 5.3% grossed up for franking credits. We believe the dividends can grow further.
DJW was trading at a 11% discount to NTA at the end of August, which is unprecedented. As a comparison, stablemate Australian Foundation Investment Company (AFI) was trading at a 9% premium to NTA despite offering a lower dividend yield.
WAM Alternative Assets (WMA)
Unlike the previous two examples, WMA does not invest in listed equities. Instead, WMA owns alternative assets including water rights, private equity, agriculture and some real estate. This provides a different risk/reward profile and may help to diversify investment portfolios.
WMA declared a dividend of 2 cents recently and stated they intend to copy that for the next dividend. Based on the 31 August NTA of $1.17 it reflects a 3.4% net dividend yield and 4.6% grossed up for franking credits. The closing share price was $1.03, with a 3.9% net yield and 5.2% grossed up for franking credits.
At the end of August, WMA was trading at a 12% discount to NTA. Under the management agreement, if WMA does not trade at a premium to NTA at various time during the initial 5 year period, shareholders will have an opportunity to vote to wind up the LIC and return the proceeds to investors. This provides a clear catalyst for management to close the share price/NTA gap over the next few years, adding some potential further upside for investors.
Want to learn more?
In this wire from a few months ago, we took a look at which LIC managers added value during the Covid market correction and this wire from Livewire’s Glenn Freeman includes 10 LICs that we think can grow dividends over the next few years.
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Daryl has over 25 years’ experience in finance and investing. He formed Affluence to provide investors with regular income and long-term capital growth by investing with some of the best fund managers available in Australia.