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Are LICs worth the trouble?
Listed investment companies (LIC) are in the spotlight as many groups within the sector either enjoy a substantial premium or suffer a huge discount to their underlying worth. As financial planners look to boost their use of listed assets for clients, will the ability of LICs to deviate substantially from net tangible assets prove to be a competitive disadvantage for the sector? Vishal Teckchandani reports.

As markets recover from the recent economic crisis, it is no secret financial planners are searching for better ways to invest their clients' money.

New competitive investment structures have emerged, including exchange-traded funds (ETF) and managed accounts, which promise more transparency, simplicity and on most occasions lower fees than their managed fund counterparts.

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Yet as potential reforms loom over the horizon, including the abolition of trailing commissions, planners are also considering whether to use another structure that traces its origins to before the Great Depression: the listed investment company (LIC).

Put simply, LICs in some ways are similar to traditional managed funds but are listed on the stock exchange.

The overall LIC sector's market capitalisation peaked at $31 billion in July 2007, before plummeting to $14 billion by February 2009 and recovering to $19 billion by July 2010, according to Australian Securities Exchange (ASX) data.

There are a few crucial elements that make LICs very distinct from other investment vehicles.

The key aspect is that LICs are closed-ended vehicles and often end up trading at either a discount or premium to their net tangible assets (NTA) or actual underlying value.

A recent report by financial services firm Patersons Securities showed the share prices of many LICs varied significantly from their NTA.

The report covered 34 LICs, 17 being established companies and 17 newer listings.

"The weighted average premium to liquidation NTA of the established LICs was 10.1 per cent at the end of May," Patersons analyst Mark Barsdell says.

"The smaller and riskier LICs continue to languish at large discounts to NTA."

It is this phenomenon in particular that has made market observers and planners wonder whether LICs are a viable addition to a client's portfolio given other structures, such as managed funds, ETFs and managed accounts, do not deviate from their actual worth.

Australian Foundation Investment Company (AFIC) chief executive Ross Barker claims LICs have a number of advantages that make them more attractive than other structures.

"Well, LICs have always been for people who didn't want to do it themselves," Barker says.

"The cost of SMAs (separately managed accounts) is also an issue too.

"The thing with AFIC is you are getting exposure to 75 stocks straight up. To replicate that through an SMA you have got to go out and buy all those stocks and that's quite a process."

AFIC, established in 1928 as Were Investment Trust, is the country's largest LIC with a market capitalisation around $4.8 billion.

 

Why choose LICs over ETFs

Barker says that while ETFs are a legitimate investment vehicle and their popularity is on the rise, index-tracking ETFs have no selection and so investors are given whatever is in the benchmark, "good or bad".

"[ETFs] are a completely hands-off approach," he says.

"We like to think the intervention we have in terms of managing the portfolio and concentrating on stocks that have good businesses and pay good dividends tend to give you a better return over time."

AFIC has gained 9.3 per cent a year over the 10 years to 30 June 2010, compared with 7 per cent for the S&P/ASX 200 Accumulation Index.

"So over a 10, 20, 30-year history, AFIC has outperformed the index and with an MER (management expense ratio) of 0.16 per cent - that I would suggest is even lower than some of the ETFs out there," Barker says.

"The other comment I would make is that because we have got a company structure and the shares are bought and sold, if you get into a difficult time in the market where you are uncertain and other shareholders sell, it doesn't affect remaining shareholders.

"Because we are a company we don't get forced to sell things because of an outflow of money from the fund and that's actually very valuable in times of market uncertainty because we know we can stick with our portfolio and not have to sell the good stuff to fund the outflows."

However, he agrees it is a challenging situation when LICs trade at a deep discount to NTA.

"When it's a big discount there is no doubt that it is a challenge," he says.

"But for the largest and more liquid ones it isn't much of an issue because there are enough buyers and sellers out there that have the potential to rectify that situation."

Interestingly, despite the funds under management (FUM) decline for the LIC sector, he says AFIC's shareholder base has continued to expand.

"AFIC's shareholder base has been increasing progressively year by year. We are up now to around 92,000 shareholders, so that's quite a sizeable company," he says.

"Certainly over the last few years there has been a growth in shareholder numbers through SMSFs, particularly due to franking.

"The advantage is that SMSF investors get exposure to the market straightaway and a diversified portfolio and, in AFIC's case, an MER of 0.16 per cent.

"So that's very low and also they get exposure to fully-franked income, which means they can actually use that franked income to help them with their tax obligations within their SMSFs."

 

LICs popular because of cost

Argo Investments chief executive Jason Beddow says LICs are still popular with investors due to features including low costs and the fact they are a post-tax product.

"We are also very much a post-tax product - we pay tax on profits and we pass that through as fully-franked dividends through to shareholders," Beddow says.

"And historically the traditional LICs like AFIC and Argo have had a solid track record of beating the benchmark.

"So if you can remain low cost and continue to outperform in a tax-effective way, you have a pretty good story to tell."

He says that although ETFs would compete against LICs for market share, they would also pass on benefits.

"Both LICs and the ETFs are going to do really well because all of the advantages, including the fact that they are listed, transparent, have low fees and can be traded daily," he says.

"We think that from that perspective a lot of those benefits of ETFs, which will be promoted in the market, will flow through to LICs, not to managed funds. So that will benefit both of us.

"And then we think our competitive advantage against ETFs again is that we will always strive to have a higher dividend yield than particularly an index ETF and we will have a much higher level of franking."

Beddow disagrees that the fact ETFs disclose their holdings daily compared to monthly for LICs is a big disadvantage for the sector.

"Now if you are someone that really wants to know the holdings of a portfolio and movements on a daily basis, you are probably not going to be an Argo or an LIC shareholder anyway," he says.

"I think there will always be investors that would not want to invest in LICs but I don't think because the ETFs provide that disclosure you are going to drag too many people from the LICs because it is a very different type of investor I would think.

"If the LICs all of a sudden or over time didn't outperform, then there would be a cause for concern and say if I am not getting outperformance with this LIC, maybe I will consider an ETF because ETFs by definition won't outperform, they will perform in line with the index minus fees.

"So one of our strengths historically, but challenges going forward, is to continue to outperform."

Like Barker, Beddow says it is a challenging situation for LICs that end up at deep discounts to NTA.

"It depends on what sort of discount. Too big of a discount is definitely a disadvantage, particularly if you want to raise money," he says.

"But I think the longer, bigger LICs that are liquid and have a good history can justify a modest premium probably equating to the yield of the LIC, around 4 per cent to 5 per cent.

"Once you get much above that it's probably restrictive to attract new shareholders.

"It's the smaller illiquid LICs that tend to trade at a discount - quite a big discount. They really struggle with that liquidity but I guess ETFs probably won't have that problem."

He says on a 20-year time frame, Argo at times has traded at a discount to NTA of up to 12 per cent and a premium to worth of as much as 15 per cent.

"There is no real cycle to it," he says.

 

When income is an issue

Whitefield and Sylvastate chief executive Angus Gluskie says the fact LICs can control their dividend payouts is a unique advantage over other types of structures and benefits income investors in particular.

"[LICs have] consistency of income flow," Gluskie says.

"Because they are companies which have the unusual ability to retain profits in some years and distribute them in others - now most investment trusts don't have that luxury.

"Dividend income across the Australian share market fell by around 30 per cent during the recent crisis. Now that represents a significant income cut for investors who rely on that dividend income flow.

"Nevertheless, some of these LICs who have retained profits from earlier years were able to keep paying dividends to their shareholders out of those retained profits and keep paying them at peak cycle rates throughout that time."

He says he has noted four ways advisers and stockbrokers have incorporated LICs as part of their clients' diversified investment portfolio.

They include using just a diverse portfolio of LICs or having a core portfolio of LICs with satellite holdings of other LICs.

Planners are also using a core portfolio of LICs plus satellite holdings of other direct shares and, conversely, a core portfolio of direct shares with satellite holdings of LICs.

Gluskie says the fact LICs can trade at discounts and premiums to NTA can be a good or bad thing.

If the LIC's share price is below its pre-tax asset backing, the investor obtains benefits of returns on a portfolio of greater value than the share price, he says.

WAM Capital director Matthew Kidman agrees.

"People get very upset about premiums and discounts," Kidman says.

"But it also creates an incredible opportunity. If you can buy an asset below its backing, if you can buy $1 for 80 cents, it creates an opportunity.

"Or if you can sell $1 for a $1.20, then it's another opportunity to sell."

Dealer group Dixon Advisory managing director Alan Dixon says all the investment structures have their strengths and weaknesses.

"For example, we use the [SPDR S&P/ASX 200 ETF] quite a lot - it's a fantastic way to get index exposure and move in and out of the market really quickly," Dixon says.

"Whereas even the fantastic old-fashioned LICs like Argo and AFIC will still have liquidity issues from time to time."

He says SMAs would struggle to suit many standard retail investors because of loss aversion.

"I have dealt with a lot of retail customers over the year and when they look at their investments they don't want to talk to you about their overall portfolio return, they want to talk to you about the individual investments that have done badly," he says.

"As such, an SMA may lead them to spend an inordinate amount of time criticising the one or two bad investments rather than the overall return achieved by the manager."

 

Financial planners and LICs

Dixon Advisory has been one of the most active financial planning groups in the LIC sector.

The group in late 2009 led the ousting of the board of LIC Van Eyk Three Pillars (VTP), which consisted of van Eyk Research chief executive Mark Thomas, VTP management director Cameron McCullagh and independent directors David Iliffe and Andrew Grant, over concerns including poor disclosure and the company's deep discount to NTA.

The VTP board was replaced with Dixon Advisory executives Alan Dixon, Alex MacLachlan, Chris Brown and Chris Duffield.

"We felt we had to act as the previous board and management had lost their way and in our view posed a significant risk to shareholders," Dixon says.

"We really appreciate the support the shareholders have given us and they have been rewarded with a substantial capital return."

Dixon Advisory also manages LICs including the Global Resource Masters Fund, Asian Masters Fund, and Australian Masters Corporate Governance Fund.

The firm also manages five fixed interest funds from the Australian Masters Corporate Bond Fund series - three of which are listed.

Dixon says LICs suit Dixon Advisory clients because of their simplicity.

"They are very simple from a reporting perspective," he says.

"They are listed on the ASX so that gives you full transparency. Most pay fully-franked dividends twice a year.

"They are very open with their reporting and what stocks they own, so in their annual report they will give you their full list of what they own."

 But he says it is very important for LICs to trade at NTA over the medium term.

"Short-term gyrations around NTA are fine, but as soon as an imbalance appears, it's important that management and the board immediately do something about it," he says.

"We think that most LICs trading at discounts could solve their problems by implementing strong, aggressive buybacks.

"Unfortunately, most LICs either don't use buybacks or buy back with such impotence and low volume that it doesn't solve the problem.

"It is completely fair to say that every LIC with a discount of circa 20 per cent plus is solely due to the market not trusting or respecting the board and management of the LIC to do the right thing by shareholders."

He says LICs that claim buybacks do not work are just plain wrong.

"You get these guys claiming 'buybacks don't work, we've tried it'. It's just not true, they've never bought back strongly and aggressively, they need to admit they may have to buyback 20, 30 even 50 per cent of the company to get the equilibrium right post GFC," he says.

"The whole buyback process is value enhancing, so those who don't do it are hurting shareholders for the benefit of their management fees; a very sad situation."

 

Why LICs can trade at discount to NTA

There are many reasons LICs can trade at significant discounts to their NTA, he says.

"Sometimes it will be because of investor fear, investment performance, management fees, but the overriding theme I think has probably been that the manager has been acting in the manager's best interest and not the shareholders' best interests and that scares shareholders," he says.

"But there is no fundamental or structural reason about why it exists because in my view it's driven less so by investment performance rather than this fear about not being treated properly by the manager and board.

 "And so far in almost every case unfortunately that's been proven right."

He says there is no structural reason why newer LICs are worse than the old LICs.

"Our LICs all trade at or above NTA, because we always put the shareholders first," he says.

"We can assure all our investors if we see a discount, we will be buying back shares. If the other LIC boards acted that way, the sector wouldn't have the problems it has."

Atlas Capital managing director John Pereira says there is an inherent problem with most of the smaller LICs currently because their discounts to NTA range from 20 per cent to 40 per cent.

"It begs the question about the future of small LICs. My view is that for the LIC to prevent a discount to NTA it needs to have $300-400 million in funds under management," Pereira says.

"I think there are complexities when you do not have sufficient size and you also have illiquidity.

"But then to build that liquidity and build size you often have to raise more money, which in turn dilutes shareholders. So it's sort of a dog biting its tail situation."

He says the LIC sector will find it hard to resolve its discount to NTA situation.

"I don't think LICs are doomed, but going forward there will need to be some imagination injected into their structure," he says.

He says there will likely be a two-tiered LIC market.

"You have the large players and then you have the second tier LICs that are not large enough, do not have the liquidity and will either look to change the way they are managed or their value proposition to the investor, or they may be wound up for capital return like I have done for India Equities," he says.

Despite the sector's issues, Barsdell says many LICs still present value for conservative investors.

"For conservative investors wishing to match or possibly beat the long-term returns of the All Ordinaries Index, especially those with a limited amount of capital, a number of LICs can provide the necessary spread of investments," he says.

"Although many investors focus on whether a LIC is trading at a discount or premium to net tangible asset backing in reality, the better performing LICs trade at a premium and the poor performers often trade at deep discounts.

"The most important criterion in the evaluation of a LIC is its track record. Those with the best long-term performances, measured by total return, dividend and NTA growth are the ones likely to give the best future returns."

However, given the lack of track record for the newer LICs, a closer focus on investment philosophy, NTA backing and the investment manager's skill are most important in making a valuation call, he says.

"LICs that rely on a theme are unlikely to outperform the market over the long term, but can provide strong returns over a short to medium-term time frame," he says.

"Gearing is potentially a positive when markets are moving higher but can be a negative when bear markets prevail."

 

Reforms boost appeal of LICs

Kidman also points out recent reforms will boost the appeal of LICs.

"As you know there has been the Ripoll review where trailing commissions have effectively been banned from 2012," he says.

"So all of a sudden products like the LIC which didn't get that trail before is on a level playing field, which is very important for financial planners, and the financial planners have got that fiduciary duty to all their clients to put them into what they think the best products are."

He also says changes to the law that allow companies to pay dividends based on solvency will also be a major boost to LICs' appeal. "Now you can pay based not on your earnings or your retained earnings, it's based on your solvency, which is a totally different scenario," he says.

"So now a company that does not have retained earnings, did not make a profit that year, but the directors believe that it's solvent, it can pay a dividend.

"The flexibility is a lot greater for most companies and especially LICs."

 

Are LICs worth the trouble?
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