The attraction of listed investment companies

With his van Eyk Three Pillars Listed Investment Company being targeted by Dixon Advisory, van Eyk’s Mark Thomas explains what makes LICs an attractive proposition despite the naysayers.

In the wake of the global financial crisis, many listed investment companies (or LICs as they are better known) have traded at hefty discounts to their net tangible assets (NTAs).

Indeed, in some cases these discounts have become so pronounced that it has prompted calls for LICs to go the way of the dodo bird.

But are exponents of such a view of LICs missing the point? Do these investment vehicles still offer value? On balance, the answer would appear to be yes.

The LIC sector, which represents more than $18 billion of shareholder funds, is diversified. It appeals to different types of investors, from someone looking for steady income to the more speculative end of the market.

There are the traditional buy and hold dividend harvesters (Australian Foundation Investment Company), sector specialists such as international equities (Platinum Capital) and biotech (Biotech Capital), as well as hedge funds (Cadence Capital).

What this diversity means is that it is difficult to compare LICs — it’s rarely an apples and apples comparison. How investors view the Australian Foundation Investment Company will differ to Biotech Capital or Cadence Capital.

It’s not just a question of the asset base that underpins the LIC, important as that is. Other issues come into play, such as whether an investor’s focus should be on the pre-tax NTA or post-tax NTA of an LIC.

The answer to this question, often posed by investors, depends on whether the LIC is a long-term investor or trader for tax purposes.

If the LIC is a long-term investor, pre-tax NTA is the most appropriate measure. Why? LICs that invest in this vein trade infrequently. As a consequence, it’s unlikely they will have to pay out their deferred tax liability on unrealised capital gains.

If, however, the LIC is a trader, they will be active managers, turning over their portfolio more frequently than the buy and hold LICs. In this event their tax liability obviously becomes an issue, so it will pay investors to focus on the after-tax figure.

For investors, a sound rule of thumb to apply when comparing LICs is to either compare all LICs on a pre-tax basis (don’t forget to inquire into the tax treatment of the companies in the LIC) or split the universe into the two camps and compare them separately.

This comment began by noting the most frequently heard criticism of LICs, the fact they often trade at discounts to their NTAs. Even the venerable Australian Foundation Investment Company has spent some time in the red compared with its NTA over the past two decades.

No LIC wants to be at a discount to its NTA — it signifies market disapproval. But it also represents an opportunity: buying assets at a discount.

Astute investors are always on the lookout for a bargain, a stock that is overlooked by the rest of the market and can be bought at a discount to its intrinsic value. LICs often fit this bill.

For example, take Commonwealth Bank (CBA) shares that are trading at $46 and expected to pay $2.28 in dividends over the next year. If bought directly, these shares will yield 4.96 per cent.

However, if you buy an investment company that holds CBA shares, Brickworks Investment Company for example, and trades at a 10 per cent discount to NTA, you could buy those same CBA shares for the equivalent of $41.40.

Importantly, those shares will pay the same $2.28 in dividends, but will yield the equivalent of 5.51 per cent (an 11 per cent increase in income, all other things being equal).

However, when it comes time to sell, what if the shares are still trading at a discount?

Assuming they trade at the same discount, and that the shares have appreciated by 5 per cent over the year, the total return over a year is 10.5 per cent compared with buying the shares directly, which delivers a 9.9 per cent return.

In all likelihood, the discount is likely to be different, either higher or lower, because of other assets in the portfolio. But the example still remains valid.

There are three other factors that should be considered in relations to LICs.

First, they offer investors liquidity. As the name suggests, the asset pools are incorporated as public companies.

This means they have a fixed asset base, with no redemptions or applications. The advantage of this is that portfolio managers can invest having regard to investment merits alone, without the need to worry about short-term inflows and outflows, as happens with managed funds.

Second, LICs are competitive in terms of cost in relation to giving investors access to professional investment management. The traditional buy and hold LICs have the lowest costs (some are less than 0.20 per cent a year).

The actively managed LICs and specialist managers have higher fees, ranging from 1 per cent to 2.5 per cent and possibly including performance fees.

But even at the higher fee levels, their costs compare favorably with retail managed funds, whose fees are generally higher and may also have entry fees of up to 4 per cent. In addition, LICs don’t pay trailing commissions.

Third, in the past LICs were open to the valid criticism that they were less efficient after tax than trusts. These days, with cash refunds of franking credits, LICs and trusts are on an equal footing when it comes to post-tax returns (excluding the timing difference on the refund). LICs that are investors for tax purposes can even pass on capital gains tax discounts where applicable.

LICs will not suit every investor, but that makes them no different to any other asset. However, for long-term investors in particular, who are looking for a steady income, LICs remain a viable option.

Mark Thomas is managing director of the LIC van Eyk Three Pillars.