Listed investment companies: shopping for a discount

Boyd Peters considers the listed investment company (LIC) market and the effect investor behaviour has on the share price of LICs.

Listed investment companies (LICs) are not overly complicated vehicles. They raise money in order to make money. Sometimes the share price of an LIC trades at a premium to its net tangible assets (NTA), and other times at a premium.

Ask around and you may hear that all LICs always trade at a discount (apart from those that are well-managed and successful — apparently you have to pay a premium to own them, even if they don’t actually perform that well).

Discounts exist for structural and behavioural reasons. Structures evolve, and behaviour is slow to change. Often discounts exist for no other reason than people have been conditioned by the idea ‘LICs always trade at a discount’. But that will change.

So is a share price discount to NTA an opportunity, or a sign of failure? Is buying $1 worth of working assets for 70c a risky investment, or the trade of the century?

The answer to that is the determination of whether the company — and its latent discount — will generate a greater return than can otherwise be obtained elsewhere.

Unfortunately with regard to discounts there are too many questions and too little empirical data to answer them. Of the 60 plus LICs trading on the Australia Stock Exchange, about half commenced since 2000 — and the bulk trade at a discount to NTA.

Much has been written about why LICs trade at a discount. Often the talk is of bad management and poor performance. Typically an aggressive buy-back is presented as the only solution, usually accompanied by the statement: ‘And any managers who won’t are fee gouging’.

While the merits of that and of buy-backs can be left for another article, the effect of aggressive activism and spilled boards can nonetheless be recognised.

Consider disunited boards, portfolio managers with reducing capital bases to invest and funds with proportionately higher fees and costs.

The resulting company would likely have reduced scale and profitability, and the increased shareholder uncertainty would be likely to damage the share price.

Do we want LICs second-guessing their short and mid-term development plans, conscious of being the next target of corporate raiders?

Is a quick bump in the share price in the best long-term interest of investors in the LIC?

The investors and employees of India Equities Fund and van Eyk Three Pillars will never know the answer to that — never mind the distraction in other LICs anxious about being similarly targeted.

The reason shareholders invested in the company (long-term growth and dividends, tax efficiency, diversification, asset allocation, risk management, alpha) can be lost in the noise.

The soul of a company can be destroyed and its performance compromised for the sake of narrowing the share price by a cent or two.

Very rarely is it considered that discounts may not necessarily be a bad thing. Take the example of a recently listed LIC.

Assume it lists with 100 million shares on issue at $1 with the NTA of $1 per share and has a 12 million performance of 50 per cent. So all things being equal, its NTA is now $1.50 while its share price trades at $1.45 as investors are factoring in a market fall.

It then pays a 10c dividend, reducing the NTA by 10c and share price falling by the equivalent amount. As you can see a 5c differential on an NTA of $1.40 is greater as a percentage than it is on an NTA of $1.50. Observers of ratios might express alarm that the discount in this company is growing.

Let’s say it then honours its prospectus and shareholders are offered one-for-one options at $1. It now has 200 million shares, a portfolio size of $240m ($100m + $50m - $10m + $100m) and an NTA of $1.20. Ouch.

Not only did the NTA just fall off a cliff by 14 per cent, but that same 5c discount to NTA has now grown as a percentage. It is time to sell quickly.

Quick, buy-back, do something.

Never mind the 50 per cent performance and 10c dividend. Granted, there are many assumptions here, however it does draw attention that one simply cannot look at a discount and read too much into it.

In this example, were shareholders disadvantaged when they bought more shares at $1? How about when they undertake the next rights issue, or dividend reinvestment plan, which will likewise extend the discount?

Too rarely is it recognised that the beneficiaries of discounted share issues are often the shareholders themselves.

Notwithstanding the fixation with the discount, advisers are better suited to the consideration not so much where it has been, but how will it perform in the future.

If they identify a suitable investment, and are able to secure $1 worth of assets for say 85c, then all the better.

In regards to future performance, this class of new LICs is maturing and poised to pass on the bulk of portfolio performance into their NTAs.

They are increasingly issuing statements they do not foresee the need to raise additional capital, and the options overhang has cleared.

In addition many provide dividend certainty thanks to new legislation enabling them to pay dividends regardless of fund performance.

Finally, increasing profile through active salespeople and admission to Approved Product Lists helps funds to grow, providing the scale to reduce their indirect cost ratios.

The image of an uphill march into the wind carrying a heavy pack has been overtaken by a downhill gallop with a tailwind and lighter load. This should auger well for improved share price performance in most LICs relative to their underlying portfolio performance.

Nonetheless, irrespective of strong performances, increasing profile and strong management, in the short term LICs may continue to trade at slim discounts for no other reason than investors may choose to believe that they are meant to.

It is possible that the historic, and false, perception that the newer LICs should trade at a discount simply became self-fulfilling at one point.

As such, have too many investors framed their buy and sell expectations around the misconception that new LICs only trade at a discount while old LICs only trade at a premium?

This could explain why some discounts are stubborn to budge, while some premiums are nothing less than fascinating.

Thus why some investors perceive a safety floor sufficient to buy say an AFIC at a premium of 17 per cent to its NTA, while equally happy to sell a Contango — with six years at 24 per cent per annum portfolio performance — at a 35 per cent discount to NTA believing it has hit its resistance point.

Investors can continue this strategy but at their own risk. At some point in the past the Argos of the world also traded at discounts and at some point in the very near future investors will revisit the newer breed of LICs and recognise the structural changes within.

Generally, if investors are happy with their long term performance and dividends, then strong consideration should be given to buying now.

History suggests they will not be getting any cheaper. This may be further accentuated, in that if we enter a period of low growth investors will be looking for to lock in every cent of value they can find.

Boyd Peters is the national distribution manager at Contango Microcap.