Observer (2-Jun-2005): Investors LICked by markdowns

In late 2003, I wrote an article that pointed out some of the flaws in the new listed investment companies (LICs) floating at the time, and predicted that investors’ high expectations were unlikely to be met (Money Management, December 11, 2003).

Specifically, I said: “I expect the majority of the LICs coming to market now will trade at discounts to net tangible assets (NTA) of 10 to 20 per cent in the next two years.”

It seemed a controversial call at the time, particularly as most of the existing LICs (Argo, AFIC and so on) were trading at premiums to NTA of around 5 to 10 per cent at that time.

The piece was criticised by a number of proponents of the LIC floats with one fund manager responding with a letter arguing why I was wrong.

Performance

The table (page 20) shows the situation 18 months on with current discount to NTA and total performance since listing across the LIC floats over the past two years.

Also shown is the performance of the All Ordinaries Accumulation Index since each float. Of those that listed up until April 2004 (many of which were mooted by late 2003), the average discount to (pre tax) NTA was around 12 per cent at April 30, 2005. Apart from two recent floats, all the funds listed in the past two years were trading at discounts.

As a result of the move from premiums to NTA at their float dates (because of float costs) to this level of discounts, investors have done poorly compared to the All Ordinaries Accumulation Index. Note that these returns include dividends and the value (if any) of ‘free’ options at April 30, 2005.

Clearly it is the move to discounts to NTA that has been key to the poor returns, although high levels of cash have been a contributor in a few cases.

Why are all these funds trading at discounts? Does this provide an investment opportunity today?

A discount

There has been considerable academic debate about why listed investment funds tend to trade at discounts on average (with most work based on the US experience).

Early explanations tried to fit the phenomenon into the efficient market view of the world citing management fees, illiquid holdings and taxes as the driving factors.

However, these failed to explain the magnitude of the average discount observed over time and also failed to explain why some funds trade at premiums and why the level of discounts and premiums fluctuated so much among individual funds.

It also failed to discover why funds were ever successfully floated to rational investors in the first place.

Better explanations have relied on behavioural factors. Even Burton G Malkiel, author of A Random Walk down Wall Street and champion of the efficient market hypothesis reached this view.

In an article written for the summer 1978 issue of Journal of Portfolio Management, Malkiel and co-author Paul Firstenberg wrote: “In our judgement, the most reasonable possibility is that, on average, closed-end companies sell at discounts because they are not supported by an active marketing campaign”.

Investor behaviour

The simple fact is LICs are sold to most investors, not bought.

The marketing buzz around most LIC floats quickly dissipates and there is limited ongoing market support for many of the funds.

The use of free options in the recent floats that inhibits after market support can accentuate this situation.

Meanwhile, investors end up selling because they (or their advisers) get bored, disappointed or simply need the money. A self-perpetuating cycle involving disappointed investors selling, thereby further increasing the discount and accentuating further disappointment and selling, is common in the first few years. Only those with exceptional investment/NTA performance from early on can overcome this cycle.

Lee, Shleifer & Thaler wrote in the March 1991 issue of the Journal of Finance: “Like casinos and snake oil, closed end funds are a device by which smart entrepreneurs take advantage of a less sophisticated public.”

Of course, not all funds trade at discounts and the level of the discount can vary over time.

Better performing funds tend to trade closer to NTA or at a premium, although the problem is identifying these in advance. Too often, paying a premium leaves one vulnerable to disappointment.

Platinum Capital (PMC), for example, still trades at a premium to asset backing of over 20 per cent, albeit that is down from around 45 per cent in late 2003. I would argue this is not sustainable and remind investors that even PMC traded at a discount as high as 25 per cent in its early years.

Opportunities

Do the current discounts make some of these funds attractive today?

Selectively, I believe this to be the case. While one also has to have a view about what to expect from the underlying markets in which they invest, at current discounts some of the funds with better investment management and corporate governance have become attractive ways to get exposure to certain markets, especially local equities.

While I doubt many, if any, of them will on average trade at premiums, the better performing vehicles should not trade at discounts of more than 10 to 15 per cent over the long term.

Investors should also remember that even if discounts stay the same, they may well do better in discounted LICs than an equivalent unlisted fund because of the compounding effect of the higher yield — for instance, a 4 per cent yield on an unlisted fund translates to a 5 per cent yield on a fund purchased at a 20 per cent discount to NTA.

The UK experience

However, discounts on some funds could also become larger if the underlying NTA performance continues to disappoint.

Interestingly, in the UK where listed investment trust boards are mostly independent and institutional investors in these vehicles are much more active, discounts have narrowed in recent years (although they still average around 9 per cent). Management contracts there are today rarely longer than a couple of years.

In Australia, many boards are controlled by the investment manager and management contracts for many of the new vehicles are as long as 25 years.

While these elements protect the manager, they do little to compel them to take action to ensure discounts stay low.

While a number of managers have been reasonably active in buying back their own shares, this has failed to prevent discounts widening, especially recently.

I suspect the discounts on some of the poorer performing vehicles with long management contracts could blow out to as much as 30 to 40 per cent in the coming years.

Tax issues

It is also true that there is some uncertainty over the ability of LICs to continue to utilise the long-term capital gains tax discount brought in during 2001, which effectively removed the tax disadvantage they faced compared to unlisted managed funds.

Some suggest this is a reason for the recent widening of discounts. I am sceptical of this explanation as discounts have widened across the board, including a number of more actively traded funds and pooled development funds that never relied on this concession in any case.

Still, the experience of recent years means that investors are well on the path to learning, once again, that buying into the floats of most LICs is likely to be a frustrating exercise, especially in the short-medium term.

I suspect that the flood of LICs will become a trickle in the next year or so, and that only well structured funds with unique mandates and exceptional management are likely to successfully raise money from a more sceptical public, in a market where discounts are once again the norm.

It is this type of environment that will provide some attractive opportunities, including the “double whammy” where investors can benefit from both a narrowing of discounts and good performance on the underlying investments.

However, I don’t expect the participants in the LIC floats of the past two years to be too active in seeking out such opportunities.

Dominic McCormick is chief investment officer of Select Asset Management.