|Summary: Buying any investment that is trading below its actual asset value is a great way of magnifying yield. Listed investment companies that commonly trade below their net tangible asset value are therefore an interesting potential portfolio addition.|
|Key take-out: From an investor perspective, there is a direct multiplier of yield from LICs trading below their NTA – the dividend is calculated based on the NTA of the portfolio rather than the lower price paid for the investment.|
|Key beneficiaries: General investors. Category: Investment portfolio construction.|
For the roughly $40,000 I spent on postgraduate business studies, the most profound sentence I learned was, “the value of any investment is the present value of all future cash flows, adjusted for risk”.
What that means is that it is the future cash flows from investments that give them their value. In the case of shares, that means future dividends. Add to this the definition of an asset price bubble as “the expectation that an investment will increase in price faster that its earnings/income/dividend” and you have both a warning about disregarding the income from an investment (you are buying in a bubble), and a reinforcement of the importance of income to the price of an investment.
This puts income at the centre of any investment strategy: it should not be an investment trend, rather an investment focus.
One attractive source of income for an investment portfolio lies with listed investment companies (LICs). These are managed investments listed on the ASX that are often cheaper than managed funds available to investors. LICs including Milton, Argo and Australian Foundation Investment Company have management fees of less than 0.2%, making them around one-tenth of the price of retail managed funds and amongst the cheapest managed investments available in Australia. They provide a low fee, diversified exposure to the growing income stream of Australian shares, and franking credits.
LICs have another characteristic that makes them an interesting proposition. They have the ability to trade at a premium or discount to the value of their shares. From time to time this presents an interesting opportunity – the ability to pay $1 (the price the LIC is trading for on the ASX) for a $1.10 portfolio (the net tangible assets value of the LIC) has a nice magnifier effect on your sharemarket exposure.
The multiplier of yield
Let’s have a look at how this works on a current investment – the microcap-focused LIC Contango Microcap (it invests in companies with a market cap of $10 million to $350 million, avoiding biotech and mining explorers). At the end of March Contango had a portfolio valued at $1.24 per share. The share price at the time was $1.03. The offer is interesting – a $1.24 portfolio costing only $1.03.
We do, however, have to consider tax – something that is well reported on by LICs (and which should be adopted throughout the financial service industry, especially with managed funds). At the end of March we are told that if Contango was to liquidate its portfolio (which it does not intend to), the NTA (value of the portfolio) after capital gains tax would be $1.15.
Now to the interesting point from a yield perspective. The investor receives income from a portfolio worth $1.24, or a portfolio that is 20% bigger than the price paid for the investment. As a rough benchmark to illustrate the situation, the yield on the Small Ordinaries Index is currently 3.4% (remembering that Contango invests in Microcap companies). A 20% “multiplier” effect on this increases the 3.4% into a 4.08% income stream – which is certainly an attractive boost. Add to this the impact of franking credits, which can add an extra 1.75% return on the fully franked dividends in the portfolio, and you have an attractive income stream from a portfolio of small companies that are already valued at more than you bought them for.
In thinking about this proposition, it is important to keep in mind that the yield from small companies (and especially micro-cap companies) is generally lower than the market average for various reasons, including that many small companies are in a phase where the focus is on growing their business rather than paying dividends.
In my look at Contango, the final question is – has its dividends paid matched the promise of an attractive yield? The answer is, yes – with a little additional clarification. Dividends over the past year have been 8 cents a share. Average franking has been 37.5%, taking the total gross dividend to more than 9.5%. However, a look at the company’s accounts shows that the dividends paid were more than income earned from the investment portfolio – something an investor should be aware of. That said, the very good investment returns to date from the portfolio (10-year returns of 17.4% per annum compared to 9.2% from the All Ordinaries Accumulation Index to March 25, 2014) allow dividends to be paid from the returns of the investment portfolio – if not all from pure income.
Contango’s stated dividend policy is the payment of a dividend equal to 6% of the portfolio NTA at the start of each financial year. This means that, from an investor perspective, there is a direct multiplier of yield – the dividend is calculated based on the NTA of the portfolio, which is more than the price paid for the investment.
The ability for investors to get exposure to a diversified microcap investment with a good returns history is an interesting potential addition to any portfolio. The ability to get $1.24 worth of portfolio for $1.03, with an attractive income stream, makes it a little more intriguing.
While I have looked at the Microcap LIC Contango, other LICs trade at discounts and this provides the same interesting yield opportunity. Just over two years ago I wrote about Argo trading at a discount to NTA, which provided investors at the time with the opportunity to buy an investment portfolio of large company shares for less than its value (around a 10% discount at the time).
The ASX website releases data on premiums/discounts to NTA from LICs – which provides interesting reading and the occasional investment opportunity with a little extra portfolio and yield, at no extra cost.
Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.