LICs playing with fire

There are signs of unwarranted and excessive enthusiasm in the listed investment companies market that could ultimately leave some participants with burnt fingers, writes Dominic McCormick. Nimble investors in LICs should enjoy the warmth for now – but perhaps have their eyes on the exit.

I often point diehard believers in market efficiency to the behaviour of listed investment companies (LICs).

There you periodically see inefficiencies of the most anomalous and obvious kind. As LICs increasingly trade at greater than the value of their underlying assets, now is one of those times.

These times provide opportunities for nimble investors – and for fund managers and LIC promoters – but ultimately these periods of excessive enthusiasm wane. Investors often end up disappointed and poorer as a result.  

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For investors particularly, now is a time to be careful and selective. Of course, that is exactly the opposite of how most investors in LICs are currently behaving. Indeed, if that weren’t the case the exuberance and resulting anomalies we are currently seeing would not be occurring.

Essentially, many LIC investors have recently become rather insensitive to value in their participation in the market.  This rarely works well with investing generally but is particularly prone to failure when it comes to LICs. 

So what are some of the signs of excessive enthusiasm we are talking about? 

Many funds trade at premiums to NTA

Historically, LICs or closed end funds (CEFs) as they are known in the US, have tended to trade at a discount to net tangible assets (NTA) on average.

However, at the end of October 2013 most of the liquid LICs were trading at premiums to post-tax NTA and even pre-tax NTAs. (The former is after providing for tax on both realised and unrealised gains.)

This is certainly not unprecedented but goes against the normal tendency to trade at discounts.

Academics have debated for decades the reasons for such discounts. The present value of management fees, tax issues and illiquidity of holdings have all been put forward as possible explanations for why such funds should trade at discounts.

The problem with all these explanations is that they are blown out of the water at times like now when most funds are not trading at discounts and many are trading at significant premiums.   

It is clear that behavioural finance provides a much more satisfying and real world explanation of fluctuating premiums and discounts. Trading in LICs is dominated by retail investors.

Their (and their brokers/advisers) appetite for LICs is cyclical and heavily sentiment- and momentum-driven. Typically, this appetite to buy and sell is inverse to the fundamental value on offer.  

Here is a simple representation of the LIC cycle from go to woe. New LICs conduct initial public offerings (IPOs) and list on the ASX in a wave of enthusiasm at a time when markets are performing well and effectively at a small premium to NTA because of issue costs and the perceived benefits of “free options” which are often attached.

While the initial premium supports investor confidence, early underlying asset performance often disappoints – partly because the fund has to first overcome these issue costs and partly because the good performance of markets that helped sell the floats often gives way to more subdued or even negative market returns.

The “free” options can also weigh on secondary market appetite for the ordinary shares as they dilute participation in upside performance from the exercise price (which is usually the IPO price).

Further, the “tax paid” nature of LICs further dilutes the perception of performance as NTAs are reported. 

Once the initial enthusiasm around the IPO fades, funds typically begin to drift to a discount to NTA.

Poorly performing LICs are used as a source of funds for other more exciting investment ideas, leading to a self-reinforcing cycle of larger discounts, poorer historic performance and negative sentiment.  

Eventually discounts become excessive, attracting value-oriented investors and activists, some of whom encourage boards and managers to undertake measures to reduce or eliminate discounts.

These may include on- or off-market buybacks or more aggressive marketing. Some funds are restructured or wound up. Some eventually see a re-rating, especially as underlying NTA performance improves.

Eventually discounts narrow to single-digit levels and the more favoured funds begin trading on premiums. This eventually encourages new fund issuance. The cycle repeats. This is where we are now.      

What is contributing to such strong enthusiasm?  

FOFA has helped level the playing field of LICs versus unlisted funds by banning trailing commissions on the latter for new clients.

Meanwhile, there is some urgency to chase strongly performing sharemarkets, particularly from heavily cashed-up SMSFs which are seeing lower returns from cash and term deposits and may have missed part of the recent run, particularly in global shares.

It is clear most SMSF investors have a preference for ASX-listed vehicles.

Why listed appeals

Why listed rather than unlisted managed funds? The payment of franked dividends from the company structure of most LIC’s is one factor.

They can also be easier to buy and sell and to administer on an ongoing basis. Investors and advisers can more easily and frequently monitor the price of their holdings.

More controversially, they may allow underlying fund costs to be hidden. However, such “advantages” don’t justify ignoring price versus value in buying and selling LICs.

Of course, passive ETFs that trade at around NTA are another listed investment structure gaining strong support, although when markets are running and some managers are outperforming, active fund managers with a brand have strong appeal.    

LIC demand has been particularly voracious recently in the small number of global funds listed on the ASX. Platinum Capital, Magellan Flagship and Templeton Global have all moved from substantial discounts in recent years to premiums.

Even the discount on the out-of-favour Hunter Hall Global Value Fund recently shrunk to single digits. Only very niche LICs or those with a history of very poor governance are still trading at substantial discounts.   

For example, 18 months ago Platinum Capital (ASX Code PMC) traded at a 10-15 per cent discount to NTA.

Recently it was trading as high as a 10 per cent premium to pre-tax NTA. In the year to October 31 PMC retuned 72.1 per cent while the unlisted Platinum International Fund returned 45.3 per cent.

The difference was even greater if you adjusted for franking credits from the 7 cents dividend paid over the year. 

This demonstrates the benefits the “double whammy” of narrowing discounts and good underlying performance can provide – but this can also work in the opposite direction. 

Do the current premiums make sense, particularly when these LICs often have a similar unlisted fund alternative?

It clearly shows the current appetite for vehicles with an ASX listing. ASX’s Managed Funds Service (Aqua 2) – which will provide unlisted funds with some, but certainly not all, of the advantages that listed funds have – cannot come fast enough for some fund managers.  

Indeed, just 12 to 18 months ago very few investors were interested in LICs, despite many trading at large discounts to NTA and equity markets providing attractive value.

Today, after big rises in markets and significant fund re-ratings, investors are now clamouring to buy these more expensive underlying assets at 10-15 per cent premiums to NTA.

Could premiums go higher? Perhaps, but in LICs more than other areas demand creates its own supply, as we will discuss below. LICs clearly provide an excellent microcosm of the behavioural pressures and mistakes that investors are vulnerable to in all markets.       

A wave of LIC capital raisings 

This exuberance has allowed LICs to raise considerable capital in recent months, often around or above NTA. Of course this is being mirrored by a much larger wave of capital raisings in the broader market.         

In the last six months Australian LICs have raised over $500 million in a range of IPOs, placements, option exercises, rights issues as well as share purchase and dividend re-investment plans.

Larger offerings have included $107 million in a placement/rights issue by Brickworks Investment Company and the recently announced $98 million placement/rights issue by Platinum Capital.

Watermark Market Neutral Fund raised around $70 million in an IPO in July 2013.  

There are more IPOs to come, with PM Capital looking to raise between $50 and $200 million and list in December and a number of other floats in the wings.      

Quality, well-structured LICs have done a good job of providing investors’ exposure to markets over time – particularly those that have very low costs or those with higher costs but demonstrated and consistent ability to add value/alpha.

However, a significant determinant of the return to individual investors has been the timing of entry and exit, and particularly whether investors paid a significant discount or a premium.  

Unfortunately, when investors are clamouring for LICs, new IPOs are often structured with a focus on the interests of the management and boards, rather than the initial or potential investors.

As such they often come with high fees/expenses, structural impediments (eg, “free” but heavily diluting options, rigid management contracts), sporadic marketing support and poor governance (particularly around managing discounts).

Many new funds will likely trade at substantial discounts in coming years.

Of course, it’s hard not to welcome any wave of new LIC issues because this will help expand an attractive discounted opportunity set in coming years.

The upside “double whammy” of good underlying market performance and narrowing discounts/expanding premiums has helped produce some impressive returns in LICs recently.

However, the downside “double whammy” of poorer underlying performance and widening discounts/shrinking premiums is coming closer. Only when that plays out will the really attractive medium-long term buying opportunities emerge for value investors.  

For now, nimble investors in LICs should enjoy the ride but perhaps have a finger very close to the exit – or at least lightening – button. As with previous LIC cycles the end game will likely be muted disappointment at best and painful losses at worst.    

The value of following LICs is not just the investment opportunities derived from exploiting these waves of excessive pessimism and optimism, but also the information that such changing sentiment can provide in developing one’s broader market views and strategy.

Today’s enthusiasm for LICs is indicative of a broader, excessive optimism and complacency in markets and a lack of attention to fundamental value and downside risk.

Money may well be made in the short term while the enthusiasm continues – but the chances of making money in the medium, or even long term, are fading and the risks of large losses increasing.

It’s a time to be cautious and selective, recognising that the current exuberance may end at any time. It makes sense to bear this in mind when making any current investment decisions about LICs or about share market exposure generally.           

(Funds run or advised by Select Asset management may own LICs mentioned in this article.) 

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