LICs offer opportunities amid the market mood swings

One of the areas where the cycle of pessimism and optimism offers regular interesting opportunities is listed investment companies, writes Dominic McCormick.

Following the share market rally of early 2012 and some move away from the extreme pessimism of late 2011, it has become more challenging to identify high conviction investment ideas, particularly with markets once again focused on the major global macroeconomic risks including European debt issues, the pace of US recovery and the Chinese (and Australian) economic slowdown.

The tendency for markets to swing within large ranges from pessimism to optimism and back, but without developing any convincing long-term trend, looks set to continue for some time yet.

In such an environment I believe that being prepared and positioned to take advantage of such sentiment swings is an important component of successful investing.

One of the areas where the cycle of pessimism and optimism offers regular interesting opportunities is listed investment companies (LICs). LICs are listed, closed-end, managed funds usually in a company tax structure. 

VIEW ALL

View all

There are around 60 listed in Australia with a combined market capitalisation of around $16 billion.

Unlike exchange traded funds (ETFs) or unlisted trusts, LICs do not have to, and typically do not, trade at their underlying net tangible asset value (NTA).

Indeed, the level of discount or premium to NTA can fluctuate quite markedly over time, creating potential opportunities for disciplined and patient investors.

On the other hand, this dynamic also creates the risk of additional losses, particularly for overly emotional and impatient investors.

LICs have had their share of criticism over the years and not just because they tend to trade at a discount to NTA. (The tendency to move to a discount to NTA is usually a negative for those who buy into an LIC float at a premium to NTA, but an opportunity for those that buy when discounts widen, as discussed below).

However, some of the other criticisms directed at LICs are well deserved. Some LICs, particularly amongst the smaller and more specialist vehicles, have had particularly poor investment performance coupled with poor board governance and capital management.

A number of these vehicles arguably shouldn’t exist, or at least shouldn’t be listed on the Australian Securities Exchange (ASX).

Having said that, at a large enough discount to NTA, where there are future catalysts for change, even these can occasionally offer an interesting investment opportunity.

The additional opportunity and risk of LICs, compared to unlisted managed funds, come primarily from the dynamics of the price divergence from NTA.

While some critics focus only on the risk and potential loss from buying a fund where the discount widens (or premium shrinks), they fail to properly understand and consider the various ways that the discount to NTA dynamics can help to produce better returns than an equivalent unlisted fund over time. 

These include:

1. The ability to pay dividends to shareholders – effectively a partial return to investors at full NTA – that can then be reinvested at a discount to NTA, thereby allowing shareholders to benefit from compounding these dividends at a higher rate. 
2. The ability of the board/manager to increase NTA per share over time by buying back shares at a discount and cancelling those shares. 
3. The ability of investors to opportunistically purchase shares when they are trading at larger discounts to NTA than average and benefit from “mean reversion”, i.e, a narrowing of the discount to more normal levels over time. 
4. The existence of catalysts for discounts to narrow or even disappear through such mechanisms as better fund marketing/positioning, higher dividends/capital returns, on- and -off market buybacks or fund restructurings. 

While the mechanisms listed above have the potential to boost returns from LICs versus unlisted managed funds, which only ever trade at NTA, we must remember they will not usually be enough to offset extremely poor investment performance.

Discounts are just one element of the investment equation. The asset class, investment strategy, management team and costs all need to be considered as well, as they would with an unlisted managed fund.

Tax differences also need to be considered.

Nevertheless, often what is happening with the NTA discount will be a key additional driver to returns, particularly in the short- to -medium term. 

There are some interesting recent examples in the Australian market where some of these mechanisms have been at play, and have provided some rewarding investment opportunities for active, contrarian investors. 

Global Mining Investments (ASX code GMI) was a fund set up locally by stockbroker Bell Financial Services with investments managed by BlackRock' London-based global resources team.

It invests in listed large and mid cap companies across the mining spectrum and has around $200m in assets.

Despite good relative performance since inception, the fund has traded at a discount to NTA of between 15 per cent and 30 per cent over recent years.

The fund has sporadically implemented on market share buybacks, which were accretive to NTA, but had little long-term impact on the discount.

Interestingly, around the end of April when the fund was trading at a 25 per cent discount to NTA, a bigger UK-listed resources fund – Blackrock World Mining – with essentially the same portfolio and managed by the same team as GMI, was trading at a discount of around 10 per cent. (And markets are supposedly efficient!)

GMI has since announced a significant restructure (including announcing the winding up of the LIC at a later date) involving the creation of a new unlisted unit trust, with a proposal to switch GMI shareholders across to the new trust, and then allow investors to redeem money at NTA as required.

As a result of this announcement on the 10 May, the share price rose 14 per cent on the way to the likely full elimination of the recent 25 per cent discount, assuming this proposal is fully implemented in coming months. (In practice the elimination of a 25 per cent discount, all other things being equal, provides a 33 per cent return boost: i.e, 25/75).

Clearly, this means that investors who have been recently using/buying this discounted LIC as a way to gain exposure to global resources have received a significant boost in return, relative to an unlisted managed fund holding similar assets. 

I am not suggesting that all LICs trading at large discounts to NTA need to implement such a significant restructure to address large discounts.

As indicated above, there can be some significant benefits that fluctuating discounts on LICs can deliver to savvy investors on an ongoing basis over the long term.

Another LIC that has seen some interesting moves in recent times is Platinum Capital Limited (PMC).

Ironically, in contrast to most LICs, PMC has spent much of its life since inception (until recently) trading at a premium to NTA, reflecting the high regard for the manager and good underlying performance through much of this period.

However, following a period of poor NTA performance and the resultant elimination of the dividend in 2011, the fund drifted out to a discount as high as 15 per cent in late 2011 and early 2012.

We believed these levels provided a very attractive entry level, given the likelihood of better investment performance going forward, the historical average 8 per cent premium to NTA since inception, and the introduction of an on-market share buyback by the board.

Since then, underlying NTA performance has improved and the discount has again narrowed to single-digit levels, providing a double performance benefit to investors.

There are a range of LICs trading at larger than normal discounts to NTA, where investors can benefit from the dynamics of these discounts, and/or where there are catalysts for discounts to narrow over time.

These range from those simply prepared to enhance NTA growth by aggressively buying back shares on-market, to the other extreme such as GMI, which have fully embraced a restructure that will provide investors with full access to NTA.

Meanwhile, however, there are still numerous LICs that have done very little to make their fund attractive or narrow their NTA discount, even when underlying investment performance has been poor.

Many managers and boards are still living the myth that they are managing “permanent” capital, with resultant permanent management (and director) fees.

These are the vehicles that ultimately attract activist investors and an increasingly disgruntled shareholder base that eventually puts pressure on boards and management to properly focus on delivering shareholder value.

In some cases, it is the poorest investment performers who are letting their funds languish at discounts as high as 25-50 per cent and, in a few cases, even more.

The market is clearly providing a vote of no confidence in their investment and/or their capital management ability. It is time LIC shareholders got more demanding of their boards and managers.

The job of a director on an LIC board is actually not that difficult. A good board will have a focus on reducing costs and enhancing returns.

They are usually not required to make investment decisions, as these are either outsourced to a manager or to an internal investment team.

Instead, one way an LIC board can enhance returns is to buy back and cancel its shares when the fund trades at a discount.

A company can buy back up to 10 per cent of its shares in a 12-month period without needing shareholder approval, and if this is done at a 20 per cent discount, the board will have effectively added 2 per cent of risk-free excess return over a year.

Shareholders in LICs trading at a discount to NTA, which do not have an active on-market buyback program, should engage with their board and encourage them to start one.

Often directors will talk about wanting to grow the LIC, but this is misguided. Their job is to enhance shareholder returns, and this is achieved by growing the NTA per share, not by growing the size of the fund itself.

The growth of ETFs is already providing increased competition that is putting pressure on LICs to justify their existence and returns.

When investors can use ETFs to get passive exposure to a range of asset classes at very low cost, boards and management of LICs need to do a better job convincing investors that active management and the benefits of the listed closed-end structure are worth the additional cost. 

Another development that may provide some additional pressure for LICs is the launch of Aqua II – the ASX’s Managed Funds Service.

This arrangement – to be launched by the ASX this year – will bring a range of mainstream and specialist unlisted managed funds into the ASX Chess settlement system and within easy access for many retail investors who have typically supported LICs in the past.

As the opportunity set of easily accessible active managed investments grows for such investors, I suspect they may more closely scrutinise and become more demanding of their LIC investments.

I don’t think these various developments will undermine the case for well-managed and governed LICs, but I do think they will further isolate and highlight the poorer performing and badly structured ones, and place pressure on them to make appropriate changes.

It’s clearly time for the boards and management of such LICs to either raise their game or give some or all of the funds back to investors. It’s their money, after all. 

Dominic McCormick is the chief investment officer at Select Asset Management.

Disclaimer: Select Asset management holds shares in both GMI and PMC.