These are interesting times for bargain hunters in listed investment companies (LICs) as share prices for some of our biggest and oldest LICs languish under weak investor demand.
Even the stalwarts of the sector – companies like Argo Investments, Australian Foundation Investment Company and Milton Corp – are trading at discounts to their underlying investment portfolios, which doesn’t happen all that often.
Normally, the big, high-quality LICs trade at or above their pre-tax net tangible assets (NTA). So is now a good time to jump on board?
How LICs work
If you’re not all too familiar with the acronym, here’s a quick rundown. LICs are like managed funds that trade on the ASX in the same manner as shares. So effectively, when you buy an LIC you’re purchasing a bundle of stocks in one go.
Argo Investments, for example, holds shares in about 120 Australian companies, with its largest holdings at 30 June 2012 comprising BHP Billiton, Westpac, ANZ, Wesfarmers and CBA. Argo has no debt and a market capitalisation of $3.2 billion, which places it among Australia’s top 100 listed companies. And to top it off, the company has paid dividends to shareholders every year since 1946.
However, due to jittery sentiment, the entire LIC sector has been sold off along with the rest of the market. On a weighted sector average basis, LICs are trading at a 11.22 per cent discount to their pre-tax net tangible assets (NTA), based on ASX data at 30 June 2012. A whopping 88 per cent of LICs – those that specialise in Australian shares – were trading at a discount to pre-tax NTA at the end of June.
The biggest LICs mentioned above are also wallowing under hefty discounts. Argo Investments, for example, was trading at a 6.4 per cent discount at the end of June.
Australian Foundation Investment Company (AFI) is another goliath of the LIC sector. With a track record spanning 80 years, AFI holds shares in 75 Australian companies. AFI has also been sold off, with the stock trading at a 4.4 per cent discount to pre-tax NTA at the end of June.
According to Bell Potter’s March 2012 LIC report, AFI and Argo Investments have traded at a 1.3 per cent average premium to pre-tax NTA over the past five years – so current discounts are fairly unusual.
The share price of the third-largest LIC in the market, Milton Corp, has also dipped below the value of its investment portfolio and is trading at an 7.4 per cent discount.
Milton targets companies that pay dividends as part of its investment strategy; it also buys fixed-interest securities, including mortgages and real property. At 30 June, Milton’s biggest holdings included Westpac, Commonwealth Bank, Campbell Brothers and Washington H Soul Pattinson.
Normally, LICs get a lift in popularity when markets are bearish. In bull markets when everyone is chasing high returns, LICs tend to get overlooked in favour of individual stock picking. LICs, with their focus on broad conservative portfolios and dividend streams, are hardly as enticing as getting on the back of the next hot stock.
Typically, it’s in subdued, more cautious markets that LICs come to the fore. But that doesn’t seem to be playing out this time around. Regardless of the LIC’s investment focus – Australian shares, international stocks or resources – the vast majority of LICs today are trading at significant discounts to pre-tax NTA.
So what’s causing the fallout?
The sharemarket downturn is definitely one factor scaring off investors. As you can see by yearly returns at 30 June 2012, the big LICs were hardly blowing the lights out. Milton returned 3.0 per cent for the year; Argo Investments posted -3.6 per cent and AFI -1.1 per cent, ASX data shows.
Although in theory LICs can pick and choose which shares they hold in their investment portfolios, the big LICs like Argo, Milton and AFI have such large holdings across our biggest blue chips that performance numbers become vulnerable to underlying sharemarket conditions, more so than the specialist LICs that restrict purchases to sector-specific stocks.
In its June annual report, AFI Chairman Bruce Teele argued that the big LICs were trading at historically high discounts because of ‘less interest in Australian equities across the board.’ Investors are choosing to stash their cash in less volatile investments such as term deposits rather than equities, he wrote. The sovereign debt crisis in Europe and general investor nervousness has seen equities sold off across the board.
These short-term events happen from time to time across the market cycle, Teele continued: ‘however, over the longer term, history suggests the share price and portfolio returns of AFI tend to match each other.’
Reforms help LICs
Investors should note there are a couple of events that could see LICs return to favour. The Financial Planning reform that came into effect last month is one example: the reform bans trailing commissions on investment products like managed funds, which have dominated the financial planning product pool in past years.
Essentially, the reform means financial planners are more likely to increase the scope of investments they recommend – and LICs, being low-cost, conservative products, could fit the bill quite nicely.
Another growth area for LICs is the boom in self-managed super funds. The big LICs are low-cost vehicles – much cheaper than managed funds, for example – and attract no performance fees. For example, AFI charges a management expense ratio of 0.17 per cent which compares very favourably with between 1 per cent and 2 per cent on actively managed funds (Note that some of the newer, more actively managed LICs can charge higher fees and even performance fees, so do your research).
The other handy feature is that LICs pay out fully franked dividends – a clear plus for SMSF investors who can pocket the 30 per cent tax credit. For example AFI, Argo Investments and Milton Corp have delivered yields of over 5 per cent before franking over the past 12 months.
Clearly, it’s tempting to get excited by the prospect of buying an LIC for less than its holdings are worth. If CBA shares could be snapped up for 10 per cent less than their market price there would surely be takers. However the risk for investors is that these discounts could get worse.
The medium to long-term outlook for the sharemarket will affect returns gleaned from LICs, so if you’re decidedly bearish, then snapping up an LIC at a discount might not be the best move.
If, however, you think equity returns will gradually improve, then do some research on the myriad LICs on the market before jumping in. LICs should be compared across such factors as long-term returns, fees, management expertise, track record, and yield and stock holdings.
The ASX has provided a full list of the discounts and premiums to NTA on LICs as at June 30 2012, you can click here to access that list.