Investment Road Test: Contango Microcap Limited

PORTFOLIO POINT: Contango is trading at a discount to its NTA but has strongly outperformed the broader market and consistently generated fully franked dividends.

Turns out Warren Buffett was overly optimistic when he made his famous post-GFC speech that “the markets will move up '¦ so if you wait for the Robins, Spring will be over”.

Since Buffett boosted capitalism that day in October 2008 the US stockmarket levels have indeed recovered – deliberately underpinned by cheap money from the US Fed – while the Australian market has consistently struggled since its short-lived buoyant recovery in 2009. Many retail investors are now exiting our sharemarket, probably never to return, and the sages are questioning whether “this time is different” such that even the concept of an enduring equity risk premium is no longer applicable.

The bottom line is that investors are looking to reduce their investment costs across the board, and also looking harder to find investments or managers that are capable of adding real returns. The good news is that most of our Listed Investment Companies continue to beat the broad market indices, offering a wide range of investment styles, including the potentially highly lucrative “micro-cap” sector. LICs like Contango (ASX Code: “CTN”) that specialise in the small to micro cap sector offer the potential for strong returns and good income from ongoing dividends of 6% pa plus franking.

I have the good fortune to train financial advisers using ASX-listed investments, most of whom use listed products as a way to respond to the increasing retail scepticism about traditional managed funds. I spend time looking at the damage to returns produced by the typical “benchmark aware” mandate employed by old-style managed funds: to track but beat the index, the typical mandate causes high turnover, high tax, and triggers selling when markets are falling. I validate the accuracy of this critique by comparing the above-index returns evidenced by most of our leading LICs, before/during and after the GFC.

At its heart, this analysis shows the difference between the “open-ended” format of the traditional managed fund versus the “closed-ended” format of the LIC. Rising yields from profitable investments and the chance to generate meaningful capital gains drive the returns from LICs, who can follow a longer-term, strategic investing style. Because traditional funds are open to the continuous creation and redemption of units, they focus on highly liquid stocks and high turnover trading strategies. In contrast, because LICs are closed to new investment after their IPO (or other periodic liquidity events like rights issues), and because a shareholder by definition can’t request that the company buy its shares back directly, the only source of liquidity for an LIC investor is via the ASX and not the manager/company itself. So LIC managers can adopt much more patient “buy and hold” strategies than those that are available to traditional fund managers.

Morgan Stanley Smith Barney LIC research in April 2012 confirmed that the LIC sector has consistently and strongly outperformed the broad Australian sharemarket since 1979. In doing so, the LIC sector has also beaten the returns of many traditional active fund managers. The problem for many LICs is that their greater or lesser use of concentrated and low-turnover portfolios can lead to liquidity concerns, and investor perception of this risk causes LICs typically to trade at large discounts to their net tangible asset value. While this may be bad news for early-stage investors, it can be great for new investors prepared to wait for better times and the removal of these discounts (most LICs begin to trade at a premium in bull markets).

The illiquidity problem for LICs is compounded in the small and micro cap sectors of the ASX. Contango will invest into companies with a market capitalisation above $10 million and below $400 million – the true engine room of the Australian economy. The rationale is obvious – profitable companies in this range are successful (wouldn’t you like to own a small business worth $10 million?) – but it’s a hard road to travel for any investor. Identifying and researching these companies is notoriously hard (low turnover in small companies means that most brokers can’t earn enough brokerage to justify researching most small and micro cap stock) and expensive, and it’s into this space that specialist managers like Contango play.

High management fees are one of the often expressed analyst’s concerns about Contango, which charges a base fee of 1.25% pa with an additional fee of 15% of any performance above the ASX All Ordinaries index. Even a cynic should agree that the strength and consistency of Contango’s returns over the eight years since its launch tells us that this manager has valuable stock-picking skills. Since inception CTN’s portfolio has returned 22.1% compared to 7.8% for the All Ordinaries index.

It’s unfortunately not so easy to simply track this through to the annual returns to the CTN shareholders due to the fairly frequent rights issues and options exercises, which have changed and diluted the share structure over time. Dividend yields during the last three years have been strong at 4.97%, 2.72% and 6.89% (all fully franked), with the stated aim going forward to pay dividends of 6% pa fully franked. Coupled with a share price that has beaten the All Ordinaries index for extended periods since the GFC, Contango should be of interest to investors looking for a well-diversified manager in the micro cap sector.

Contango’s share price was trading at a 17.48% pre-tax discount to its NTA as at the end of April this year. The management has increased its communication to investors to reduce fears about illiquidity and risk in the portfolio. It provides detailed information about key stocks within the portfolio as well as a detailed list of the top 30 holdings. It can be seen from recent shareholder reports that Contango currently invests more than 50% of its portfolio into cyclical companies, with the balance in diversified industrial companies, a small exposure to technology and zero exposure to defensive stocks.

Because of its relatively high turnover compared to larger cap LICs, Contango is treated as a trading LIC and not able to access concessional CGT treatment for its portfolio. The “benefit” for investors is in the resulting fully franked dividends which flow from Contango – the pre-tax equivalent bond yield of 8.6% is highly valuable in the “new normal” world of low returns. Against a market capitalisation of $150 million the liquidity in the stock is pleasing, with $50 million worth of Contango shares trading hands in the last 12 months.

Investor concerns about the ongoing discount to NTA at which the Contango share price has been trading since the GFC are well founded. The discount has improved from a whopping 25% to the more modest levels current. The detailed information available at the company’s website should be sufficient for most investors. The discount is larger than for some of the longer established, large cap LICs – and is probably reflective of general investor concerns about further prospects for market disruption prevailing at this time.

But given the strong and consistent track record evidenced over the eight years since Contango Microcap Limited was launched, and the strength of its current (fully franked) dividend yield, patient investors may be well rewarded from a small allocation to this company.

The score: Contango Microcap Limited – 3.5 stars
0.5 Ease of understanding
0.5 Suitability of underlying asset
1.0 Innovation
0.5 Fees
1.0 Regulatory risk

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides consulting and financial product services but does not receive any benefit in relation to the product reviewed.