Opportunities in sight from the top of the LIC cycle

The Australian LIC industry is almost 100 years old and it has experienced many cycles since Whitefield Limited was first incorporated in 1923. The current environment for LICs provides patient and discerning investors with significant opportunities. In 2002, I welcomed a “golden decade” which has extended to almost two decades and 122 LICs and listed investment trusts (LITs) have listed on the ASX during this period.

Evidence that we were approaching the “top” in this cycle included investment managers absorbing listing fees, options ceasing to be attached to initial public offering (IPO) shares and investment managers attaching additional incentives to encourage uptake in new IPO capital raisings. We have seen these “innovations” before.

Notably, during this cycle, fund managers without expertise in managing LICs have chosen to adopt the structure in large numbers. Some have chosen to utilise the closed-end nature of a LIC structure under the false belief that it is “permanent capital”. It is not. Many investment managers have learnt this the hard way as they have either performed poorly over a long period or treated shareholders without their due respect as owners of the LIC, such as conducting capital raisings at a discount to the company’s NTA or by failing to engage with shareholders.

Taking the emotion out of investment decisions

I have been passionate about the LIC structure since reading a mid-nineties Morgan Stanley report that found closed-end funds outperformed open-end funds over a 50-year period. The logic is clear, open-end funds buy and sell in line with investors’ inflows and outflows and this leads to buying when asset prices are high and selling when they are low. Investment managers of a LIC do not face this dynamic and they are able to invest according to their investment process rather than fluctuations in sentiment.

In addition, LICs also have the ability to smooth and grow dividends paid over time and distribute franking credits which can be beneficial to shareholders. Open-end funds like unit trusts must distribute all profits each year, so income is unpredictable.

Buying a dollar for 80 cents

As an investor who is focused on value, I also love the fact that LICs can offer investors the opportunity to invest $1 of assets for 80c and sell $1 of assets for $1.20, as the shares can trade at different values to the reported NTA. Discount opportunities can be realised through events such as a return of capital following a wind-up, or closure of the share price discount over time, as the investment manager or Board of Directors takes action.

I have taken advantage of countless opportunities like these over four decades as a professional investor, Premium Investors, Wealth Defender Equities and Century Australia Investments are just a few examples. The industry cycle plays an important part in these opportunities.

"The average premium/discount across the LIC sector is currently -10.1%. Many of the LICs trading at discounts will cease to exist in coming years and others will see their fortunes reversed. Investors who see the opportunity will be able to benefit as this plays out."

3 measures of performance

The nuances of reporting LIC performance have evaded some newer industry participants and observers. Unlike a managed fund, which can be redeemed at the available unit price, LIC share prices are dictated by the market. Due to this fact, and additional complexities arising from structural differences between trusts and companies, we believe there are three important measures of performance that LIC investors need to assess. These are:

1. performance of the investment portfolio versus performance of the benchmark;
2. growth in NTA per share and fully franked dividends; and
3. total shareholder return.

The first enables a shareholder to assess whether an active manager can outperform on a like-for-like basis with the benchmark, before expenses, fees and taxes.

The second demonstrates the value of that portfolio performance after fees, expenses and taxes and quantifies the impact of capital management decisions (for example, dividends paid, options exercised, new shares issued at a premium or discount to NTA) under the direction of the LIC’s Board of Directors, which can increase or decrease the value of a LIC's NTA separate to the performance of the investment portfolio. The franking credits generated by corporate tax payments, which reduce a LIC's pre-tax NTA when the cash outflow is paid, are available for distribution to shareholders through fully franked dividends.

Finally, total shareholder return measures the tangible value gained by the shareholding measured by dividend income and share price growth. This measure does not value the potential benefit of franking credits distributed to shareholders through fully franked dividends unless it is reported as a ‘grossed up’ figure - we provide this measure to shareholders without the benefit of franking credits distributed.

Every six months Wilson Asset Management  provide these three measures of performance together and with context. The ASX recently adopted our method of reporting the reconciliation of the growth in NTA as the industry standard, requiring LICs to report this measure in their annual reports.