Understanding the LIC Discount Dilemma
The format of Listed Investment Companies (LICs) has not changed meaningfully since they first appeared on the ASX. The LIC, Whitefield, was formed in 1923 and the Australian Foundation Investment Company (AFIC) in 1927. Argo was established in 1946. Many LICs have a long and proud history of providing capital growth and dividends. In recent years there has been a proliferation of LICs; the number and market capitalization of listed investment companies doubled in the five years to June 2018.
In very brief terms, LICs are closed-ended investment vehicles, meaning that investors cannot apply for new shares (that is growing the size of the fund) or redeem them (that is, shrink the size of the fund) on a daily basis. For the investor, using traditional LICs:
- Gives access to the underlying investment manager and the associated investment performance.
- Gives simplicity of being able to trade the LIC’s securities daily on the ASX.
- Gives access to franked dividends where franked dividends are available.
For the investment manager, using an LIC structure means they can invest for the long term without the distraction of daily applications and redemptions. Further, arguably, LIC investment managers have less motivation to hug an index relative to when managing a fund in which investors can redeem daily, as the manager does not need to be concerned about redemptions if they are underperforming the index in the short term.
However, the traditional LIC structure poses a number of issues for investors, including:
- Even strongly-performing LICs can and do trade away from their underlying net tangible asset (NTA) value, cycling between discounts and premiums. This creates uncertainty for investors as to whether they can obtain the underlying value of their securities.
- Capital markets activity targeted at growing LICs, such as rights offers, placements, share purchase plans, option issuance, can and most often do lead to a dilution of NTA per share for existing holders. This means shareholder NTA plus dividend returns are often very different to that which the investment manager delivers.
- Many LICs are raised by investment managers seeking to permanently lock up capital which, in the worst-case scenario, can lead to reduced manager accountability to shareholders and dissipation in shareholder engagement, leaving shareholders with the only course of action being to sell – often at a large discount.
Discount/premiums cycle dilemma
Discounts and premiums are not an isolated case among LICs. It affects the LICs we manage, including the PM Capital Global Opportunities Fund (ASX: PGF), and a wide range of well-known managers investing in different market segments. They can have significant effects on what returns the investor receives in the hand, notwithstanding the performance of the underlying manager.
History has clearly demonstrated that LIC share prices cycle between premiums and discounts to NTA, with both situations being problematic. For incoming shareholders, it is illogical to pay a premium to the underlying assets, and for selling shareholders, discounts represent the inability to obtain the look-through value of their investment. The charts below show what looks similar to a “discount to premium to discount” sine wave pattern of a sample of well-known Australian large-cap, small/mid-cap and international LICs since December 1999.
The discount/premium cycle dilemma – an industry-wide experience
"Many LICs have a long and proud history of providing capital growth and dividends"
Buying at a 20% premium and selling at a 20% discount can have a very real effect on investor returns. However, in our opinion, LICs’ benefits to investors mean that the issues of share price variances around NTAs and the effect on investment returns should not be a total deal-breaker. We, therefore, have attempted to combine the LIC principle with a new option that we think investors should demand becomes a mandatory part of the LIC investment landscape going forward. PTrackERS, or ‘Portfolio Tracking Exchangeable Redeemable Securities (Converting Security)’ are economically redeemable LIC equity exposure, but give investors more options to realize their investments than is currently the case. Apart from selling on the ASX, they can be redeemed in the future based on NTA, meaning even if PTrackERS are trading at a discount to NTA, investors can still obtain NTA. They can also convert into fully paid ordinary shares of the PM Capital Global Opportunities Fund (PGF) without triggering a CGT event.
When it comes to disposal of LIC interests, only the first choice – selling on market - is available to LIC investors currently, where they are subject to the vagaries of sentiment affecting the broader market as well as the performance of the individual LIC. The idea of PTrackERS is to insulate investors from these sentiment shifts – a redemption ‘safety net’.
Perhaps just as importantly, this new feature brings a significant change to LIC board and investment manager accountability. Firstly, the board and the manager want investors to remain invested beyond the date at which investors can choose to redeem. However, if the board/manager does not deliver to expectations, with PTrackERS, investors now have the power of redemption. Previously, LICs left investors to sell on the market at typically a discount where governance or performance problems persist.
Secondly, changes in a traditional LIC’s capital adds complexity for investors wishing to track and obtain the underlying performance of the manager. For PTrackERS, the performance delivered by the manager is relatively simple to determine: changes in NTA plus dividends equals investment manager performance after LIC operating costs.
Investors need to be aware of the effects of discount/premium movements in their LIC investments as they can overwhelm the investment manager’s underlying investment performance. We hope that with initiatives such as PTrackERS the LIC market grows, provides greater liquidity and provide investors a consistent path to invest with confidence.
Paul Moore, Chief Investment Officer, PM Capital