The cyclical nature of the listed investment company (LIC) sector means the current rate of growth is unlikely to be sustained in the medium to long-term, says Zenith Investment Partners.
There has been a 98 per cent increase in LIC listings between June 2013 and March 2017, according to research house Zenith – but that growth is unlikely to be maintained.
In his review of the LIC sector, Zenith senior investment analyst Justin Tay said the growth and contraction in LIC listings is cyclical in nature and ultimately linked to stock market performance.
"Given this belief about the cyclicality of LIC listing growth, with investor and market sentiment key drivers, we expect that the current rate of growth in the sector is unlikely to be sustained over the medium to long-term," Mr Tay said.
There is also a relationship between market sentiment and whether LICs are trading at a discount or a premium to their net tangible assets (NTA), he said.
"When there is negative market sentiment, LICs generally trade at a discount. However, the research also revealed that regardless of the sentiment towards the sector, LICs had, on average, traded at a discount to NTA up until April 2013," Mr Tay said.
He put the phenomenon down to the rapid increase of SMSFs as well as amendments to the Corporations Act in 2010 that allowed dividends to be paid out based on a solvency test (rather than profitability).
"Although these factors are highly subjective, particularly with regards to fully franked sustainable dividends and high levels of shareholder engagement, we believe these factors are the key drivers to ensure that an LIC does not trade below its NTA," Mr Tay said.
Given the importance of dividends for LICs, cuts are "highly undesirable", he said.
"Zenith believes the dividend coverage ratio can be an indicator of a LIC’s dividend sustainability," Mr Tay said.
"Ideally, a LIC should have at least two years’ worth of profit reserves to maintain current dividend payments in the event there is a downturn in the LIC’s profitability."