Through LICs you can access many different managers, asset classes, geographies and investment strategies. One of our funds invests only in LICs, so we spend a lot of time looking for investment opportunities in the sector. Here are ten things you need to consider before making any LIC investment.
1.The biggest opportunity in LICs
There are several differences between LICs and other investment structures, such as managed funds and ETFs. The most important one is that unlike managed funds and ETFs, an LIC can, and usually does trade on the ASX at a price which is different to the net tangible asset value of its investments (referred to as NTA). The NTA is calculated by dividing the value of all the investments and other assets the LIC holds (less any liabilities) by the number of shares on issue.
That difference between NTA and share price (known as the premium if the share price is higher than NTA or discount if it is lower) provides both the biggest risk and the biggest opportunity. It means there are two ways to make money on LICs. You can benefit from the performance of the investments the LIC holds. And you can win (or lose) by selling at discount or premium to NTA that is different to the one you bought at. Buying and selling well can be just as important as the performance of the investments an LIC holds.
2. Know what you're investing in
Before you invest in any LIC, make sure you understand the type of underlying assets you will be getting exposure to. Are they stocks, bonds, property or a mixture? What markets and sectors is the LIC concentrating on? Is there value in those markets - are they cheap, expensive or fair value?
Once you understand that, think about how those investments might fit into your existing portfolio. For example, it may not be very helpful investing in an LIC that focuses on the larger ASX companies if you already have exposure to a lot of those same investments in your portfolio.
3.Understand the investment strategy
Take some time to research the philosophy of the investment manager and the investment strategy the LIC uses. Do you understand that investment strategy? Does it fit well in your portfolio?
Pay extra attention to strategies which use shorting (e.g. long/short or market neutral) or LICs which use gearing.
Strategies involving shorting can mean the performance of the investments can differ quite a lot from the underlying market they invest in. Often, it means they are more likely to perform better in poor market conditions, but they may lag in a rising market.
Gearing in an LIC (or any investment) is likely to amplify both wins and losses. They may outperform easier in positive market conditions, but the opposite may well be true in poor markets.
4.Assess manager performance
It is said that historical performance is no guide to the future. While that is true – historical performance can be a great indicator of the potential for future performance.
You should assess portfolio performance on an annualised basis, after all fees to the manager and costs, but before tax. Most LIC managers publish this data. Compare this result to an appropriate benchmark. Check the fine print, and make sure performance is stated net of fees and costs (or adjust for it yourself).
The longer the period you have data for, the better. Good managers can have bad periods and asset prices move in cycles, so you should never assume the last 1 or 2 years’ performance will be repeated. If fact, we are usually wary of an LIC that has had exceptional short-term performance. It’s likely to be reflected in the LIC trading at a premium to NTA, which may not be a good entry point.
Sometimes our favourite LICs are those which have exceptional long-term performance, but have lagged recently. This scenario can provide some of the best buying opportunities.
5.Consider volatility of returns
While most LICs are less volatile than the ASX, the risky period is when markets suffer large corrections. In 2009 and 2010, it was common to find LICs trading at NTA discounts of 20%+. These days that’s rare, but that doesn’t mean it can’t happen again.
Look at a chart of the LIC's share price against an appropriate benchmark and focus on times when the market has corrected. Did the LIC move down more, less or about the same as the benchmark? Some LICs may outperform over the long term, but underperform in negative markets. If you are uncomfortable with that, you may be susceptible to selling at the worst possible time.
6.Avoid LICs trading at very large premiums to NTA
Currently, there are a few LICs trading at premiums of between 10% and 30% to NTA. We almost always avoid LICs trading these sorts of premiums. By buying at a large premium, you are paying now, for the potential of the manager to outperform in the future. That’s risky.
Even great managers have bad periods. When that happens, that big premium might well disappear. In our view, that’s worth waiting for, and might give you a much better entry point.
Alternatively, some managers may also have a managed fund doing almost the same as the LIC. Buying the managed fund at NTA might be a much better opportunity than buying the LIC at a large premium.
7. Be aware of LIC options
Many LICs, particularly when they first list on ASX, also have options. You should check to see if this is the case, and what the terms of the options are. Options can be both a blessing and a curse for LIC investors. They can provide the potential for upside with a low entry cost. But they can also expire worthless if the LIC manager can’t deliver good performance reasonably quickly.
We’ve found that in many cases, having options on issue will hold back the price of the LIC until those options expire. Presumably this is because investors are conscious of the possible dilution in NTA if the options are converted to shares. The opposite can quite often occur when options expire. A small rally in the price of the LIC can occur in subsequent weeks or months as this uncertainty is removed.
The effort and consistency that an LIC manager puts into investor service, communication and marketing can have a very big impact on the price. A regular, useful flow of information and opportunities to meet the manager can make a big difference.
It doesn’t mean we don’t buy LICs that aren’t good at investor relations – but we demand a bigger discount when this is the case.
9. Buying at the right price
Once we’ve found an LIC we like, we assess its value by estimating of the NTA and comparing it to the share price.
ASX requires all LICs to publish the NTA per share within 14 days after the end of every month. Sometimes an LIC will publish more than one NTA. Usually, the most appropriate is the NTA before tax on unrealised gains/losses. This includes an allowance for tax on current year earnings and realised capital gains, but before any unrealised gains on the remaining investment portfolio.
Consider market movements since the last NTA date. For example, if the LIC invests in ASX stocks and the ASX has fallen 5% since the date of the last reported NTA, it is likely the NTA of the LIC will also have fallen during this period. It may be difficult to know with certainty the exact NTA between reporting dates, but you should be able to make a reasonable estimate.
Once you know the NTA per share and the Share Price, calculate the discount or premium by subtracting the current share price from the NTA, and dividing the result by the NTA. A positive number is a premium. A negative number is a discount. For example, if the share price is $0.90 and the NTA is $1.00, the discount is 10%.
There is no one rule which determines the right price to pay. Of course, we prefer to buy LICs at a discount to NTA but there is a whole range of factors to consider. We believe the most important factor is the current premium/discount, compared to the long-term average for that LIC. This can be a good indicator of value.
Other factors which impact our preferred buy price are historical performance, size, liquidity of underlying assets and the LIC itself, portfolio concentration, market value and the prices of other similar LICs.
10.The biggest mistake
The first question most LIC investors ask is “What’s the dividend yield?” While that can be an important piece of information, and there’s no doubt it does influence the price, it should never be the only thing you consider when buying an LIC.
Dividends can come and go – at the end of the day they’re dependent on the manager’s performance over time. Buying an LIC based on dividend yield alone, without considering many of the other factors we’ve mentioned, can turn out badly.
Like all investments, it’s best to do your homework before buying any LIC.
Buy those LIC’s holding assets you like and using an investment strategy you understand. Consider the quality and long-term performance of the LIC and its manager, how it might fit into your portfolio and other relevant factors.
Most importantly, buy at a fair price, relative to the NTA.
And don’t buy based only on a dividend yield.
Hi Daryl - thanks for your article. Have, or are, ETFs now becoming the substitute as there seems to be a smorgasboard of choices amongst them. "True value" is better reflected with daily MtM without the discount/premium issues. Regards, Michael
Michael, I think there's merit in both. Both ETFs and LICs continue to grow strongly. We like LICs because of the price inefficiencies we can exploit. But you're right about ETFs - there's more choice and price/NTA certainty. We sometimes use ETF's as an alternative if we just want pure market exposure. Each investor will have their own preferences and it's good to have a choice.
Daryl, is there a place for an LIC of LICs for the Australian domestic space? How small would it need to be/ how large could it be? Would liquidity be an issue for it? Do't you do something similar?