Top LIC picks and a different perspective

Top investment picks

Sandon Capital Investments (SNC): Deep value with lowly correlated alpha

Investment Manager Sandon Capital is an Australian-based activist investment firm that regularly engages with misunderstood companies in seeking to promote positive changes, aiming to transform these businesses so that their intrinsic value is better appreciated by the market. Influencing the direction of a company is a long-term focus. Returns from activist investment approaches often follow the shape of a j-curve, with an initial loss immediately followed by dramatic gains, similar to private equity. The result is a long duration, highly concentrated portfolio with a much greater likelihood for company-specific factors to drive the return outcomes.

Qualitas Real Estate Income Fund (QRI): No impairments and competitively placed

QRI aims to provide investors with monthly cash income and capital preservation through a portfolio of Australian originated Commercial Real Estate (CRE) loans, secured by real property mortgages that are diversified by borrower, loan type, property sector and location by specialist Manager Qualitas. The Trust seeks to achieve a Target Return equal to the prevailing RBA Cash Rate plus a margin of 5.0-6.5% p.a. net of fees and expenses, where it has consistently performed at the upper end of this scale, with a trailing 12 month distribution return of 6.2% based on the $1.60 IPO price for 30 September. There have been no impairments or interest arrears across the loan portfolio, resulting in a stable NAV position since the float. Growth in borrower demand for alternate financiers and a pull-back from the banks in the c. $355bn Australian CRE debt market as a result of increased regulatory and capital requirements also bodes well for Qualitas.

Future Generation Global (FGG): Pro-bono expertise plus look through positives

FGG was Australia’s first internationally focused LIC with the dual objective of providing shareholders with diversified exposure to a select pool of prominent global fund managers, in lieu of management fees, while supporting children and youth mental health charities. An increase in socially responsible investing makes this seem attractive at a discount. FGG also currently distributes income on an annual basis, while it’s domestic-focused sibling has a semi-annual payout frequency. During the half-year ended 30 June 2021, the Board reassessed the accounting classification for investments. As a result of this change, the company’s distributable profit reserve to shareholders has increased, providing additional flexibility on dividend and capital management decisions.

Tax implications for LIC accounts

A deferred tax liability is an accounting recognition created when periodic income tax expense is greater than taxes payable, due to temporary differences between the tax base and carrying amount, where it is probable that future amounts will require settlement to the relevant taxation authority. Deferred tax is calculated at the tax rates that are expected to apply to the period when the asset is realised, or liability is settled.

Deferred tax assets arise when provisions and expenses have been charged but are not yet tax deductible and/or where there are unused tax losses. These assets are later realised when the relevant items become tax deductible, provided that enough taxable income has been generated to claim the assets against, and where there are no changes to the tax regime that affect the LIC’s ability to claim a deduction.

Australian Accounting Standards actually require liabilities for all LICs to be recorded for provisions of tax on realised income and gains (current tax), provisions for declared but unpaid dividends/distributions, provision for accrued but unpaid management and/or performance fees; and finally provisions for the estimated tax on unrealised income and gains (deferred tax). Assets for a fund are straightforward, being typically just cash and shares. Net tangible assets, or NTA, is therefore the difference between the total assets of a Company less any intangibles, such as goodwill, and minus liabilities. LICs will typically differentiate between these tiers of provisions in their monthly updates, quoting NTA before all taxes, NTA after current tax liabilities; and NTA after current tax liabilities and deferred tax liabilities, regardless of whether these deferred tax liabilities are theoretical or genuine based on the implicit investment style.

Current tax assets and liabilities are offset where a legally enforceable right of off-set exists, and it is intended that net settlement or simultaneous realisation and settlement of the pairing asset and liability will occur. For example, this benefit may be recognised as a tangible when deferred tax assets can be used to offset current and deferred tax liabilities. A LIC may have both tax assets and tax liabilities at any given point in time. The end treatment of pre-tax and post-tax net effects will effect a LIC’s NTA backing and the determined premium/discount to which the Company’s prevailing share price trades. Selecting an inappropriate NTA figure may therefore produce a misleading assessment of the perceived imbalance between a LIC’s supply and demand dynamics.

The turnover ratio and NTA suitability

Portfolio Turnover is a measure of how frequently securities in a LIC are either bought or sold over a given period of time (note that we have used public information relating to financial year 2021 in our analysis). The turnover is given by the minimum dollar value amount of proceeds from the sale of investments, or payments for the purchase of investments; divided by the average NTA.

To help interpret this ratio, a Portfolio Turnover of 5% would imply that on average, 5% of a LIC’s holdings changed during the observed time period. Similarly, a Portfolio Turnover of 100% would suggest that the entire portfolio has been changed, once over, for that duration. Tax is payable on all realised gains from investments. The difference between an underlying investment’s tax base and the capital proceeds, as well as the Manager’s likelihood of incurring turnover costs, will help to determine the importance and timing of tax liabilities; and whether or not the pre-tax or post-tax NTA should be considered when setting the current net position of a LIC. 

Figure 1 - Turnover ratios for global equity LIC/LITs

Classifying and linking the turnover ratio to NTA

We see two equally viable methods for differentiating between LICs more concerned with pre-tax over post-tax and vice versa:

1. Divide the entire sector into camps with reference to the Company’s mandate and investment objective, consistent with the three broad categories that have been identified in this report: Domestic Equity, Global Equity and Alternative Strategy; or
2. Define intervals for Portfolio Turnover ratios and group similar asset churning LICs into: Low Turnover and High Turnover.

For the purposes of this report, we believe that managerial styles extend beyond the individual asset classes and risk-adjusted return objectives set by Investment Managers, and have therefore chosen the latter approach when assessing the LIC/LITs under Bell Potter coverage.

Trimming the data for severe outliers… the range in Portfolio Turnover ratios for financial year 2021 is approximately 375%. Portfolio Turnover ratios have been bucketed into 15 equal intervals, each with a width of 25%, starting from 0-25% and finishing at 350-375%. We have then counted the number of Portfolio Turnover ratios falling within each mutually exclusive interval to calculate a relative and cumulative frequency.

Figures 2&3 - LIC/LIT portfolio turnover, relative and cumulative frequency

Despite the tumultuous financial year, many LICs actually changed their entire portfolio quite minimally, and in most cases entered into new positions or supplemented old ones (with payments for investments exceeding proceeds from investments), confirming what many cite to be high conviction prospects for their featured investments.

The arithmetic average Portfolio Turnover ratio for financial year 2021 was 76.9%. Rounding off for neatness, we have set 75% as the threshold Portfolio Turnover ratio for classifying either Low or High Turnover vehicles. A Portfolio Turnover ratio of 75% would imply that on average, 75% of a LIC’s holdings have changed throughout the financial year, which should give cause to look at the post-tax NTA, as the likelihood of deferred tax liabilities becoming current tax liabilities is high.

Note that this was an extremely volatile period, and that turnover ratios may not be consistent for all strategies from year to year, but is based on the dislocation between fair value and a Manager’s fundamental assessment of intrinsic value for investments.

Reimagining premiums and discounts

The following charts depict both blended sector premiums and discounts using pre-tax and post-tax NTAs from our Low (<75%) and High (≥75%) Portfolio Turnover ratios, along with the more conventional calculation using just pre-tax NTA.

Figure 4 - Equally weighted sector premium/discount

Figure 5 - Market cap weighted sector premium/discount

Concluding thoughts

• The collective lived experience of investors fluctuates around par value (net tangible assets), with pockets of more adverse negative dislocations arising from systemic events, including the then prospective Labor government tax reforms and an indiscriminate Covid-19 sell-off.
• “Undervalued” investments still exist in this landscape, where much of the attention has been pessimistic, with arithmetic average discounts now approaching an asymptote of ~5%, particularly due to the inclusion of smaller Companies and Trusts with thin liquidity and brief historical performance, albeit which benefit in terms of returns from information asymmetry and inferior notoriety and;
• Accounting for a mix of pre-tax and post-tax NTAs tends to produce a more positive assessment of demand when prices are rising (i.e. greater deferred tax liabilities and lower NTA), and exacerbate the disconnect when prices are falling (i.e. greater deferred tax assets and higher NTA). This becomes more pronounced as more post-tax NTAs are added.
• LICs and LITs are very different from one another, hence the breadth of opportunities, competitive positions and mandates; which can make drawing broad like-for-like comparisons difficult and presumptuous.
• LICs could report both NTA before and after deferred tax, as well as an explanation attached to this, detailing which figure is considered to be more meaningful and why, in helping to better inform investors and researchers.
• LIC NTA submissions could be standardised in a regimented way, and with identical terminology when disclosing these figures, helping to remove any confusion or uncertainty.
• LICs could provide better guidance and commentary on what defines an intangibility and where tax assets are recognised.

Click below for a copy of the full 108-page Bell Potter September Quarterly report which also contains a market update, sector summary and profiles for 68 LICs and LITs .