Banking on LICs?

The late Paul Samuelson, the first American to win a Nobel Prize in Economics, knew a thing or two about the sharemarket. He said ‘Investing should be more like watching paint dry or … grass grow. If you want excitement, take $800 and go to Las Vegas.’

Too few investors prefer ‘solid’ over ‘spectacular’. But long-term shareholders of the grand-daddies of the Australian listed investment company sector know that solid is just fine. Australian Foundation Investment Company (AFIC), to name but one, has produced a 10-year portfolio return of 9.9%. Excitement factor: zero. But who’s complaining?

AFIC, Argo Investments and Milton Corporation are like old men in blue ties: conservative, wise and with a sense of duty to shareholders, as Table 1 indicates.

These Australian-focused investment vehicles are very different beasts from the ‘iLICs’ covered in International LICs take the world from 1 Jul 13. For one thing, the domestics are internally managed, employing their own investment teams rather than outsourcing the role to an external manager.

So costs are far lower. Management expense ratios peak at around 0.2%, a far cry from the minimum 1.0% management fees the iLICs charge.

The domestic LICs have produced perfectly good performance over a long period. Their underlying share portfolios aren’t hugely different from the broader Australian market, so their returns usually mimic the market. While they tend to miss the shooting stars, they also avoid the portfolio disasters, and that counts for a lot.

But it doesn’t make them ‘set and forget’ investments. Their past performance owes much to the upward march of the banking sector, and the seniors are all ‘overweight’ banks. If that sector stumbles, so will the LICs (for more on the risks, see Time to sell the banks? from 30 May 13).

Low fees and decent performance mean the opportunity to buy domestic LICs at a discount to after-tax net tangible assets (NTA) has been rare. But we’re happier to pay a little above after-tax NTA than we are for the iLICs. But which one is best? Let’s consider AFIC, Argo and Milton in turn.

AFIC

With a market capitalisation of $5.8bn, AFIC is the largest of the three. While still wearing its conservative label proudly the company is, perhaps, becoming just a little less so. After issuing listed convertible notes in 2011, AFIC now has $319m of borrowings, including $100m of bank debt.

AFIC also has a small ‘trading portfolio’, and writes call options over shares it owns to generate additional income. All these strategies juice up returns, and help explain why its performance has been a little better than the other two (see Table 2).

The company’s portfolio is heavily overweight banks—the big four alone account for close to 30% of the portfolio. The bank weighting also helps to explain the superior (historical) returns.

Investors have rewarded AFIC for its premium performance and it now trades at a significant 30% premium to fee-adjusted NTA. While that’s probably not enough for long-term shareholders to dump their stock, the premium to NTA and high weighting to banks makes it our least preferred of the senior LICs. HOLD.

Argo Investments

Argo Investments, with a market capitalisation of $4.2bn, looks the slightly more conservative of the ‘big two’. While it also writes call options to earn income, it has no borrowings and a smaller weighting to the banking sector (22%, including Macquarie Group).

Its portfolio is a little more diversified, too; Argo holds 103 stocks compared to AFIC’s 75. A broader portfolio means a smattering of smaller companies, including some that are slightly odd for a conservative investor (although they’re insignificant in total).

While Argo’s price is a little more appealing than AFIC’s, at a 14% premium to fee-adjusted NTA it’s not quite attractive enough to consider buying. HOLD.

Milton Corporation

If you’re a bank bull, Milton Corporation is the LIC for you. The company, which has a market capitalisation of $2.3bn, has 36% of its portfolio in the banking sector and another 10% in ‘diversified financials’. It’s not exactly ‘low-risk’, whether banks have served the company well for decades or not.

Milton’s strategy is more acquisitive than the other two, having merged with sister company Choiseul Investments in 2010. It has also acquired various small, unlisted investment vehicles over the years, a strategy which makes sense if the prices they acquire them are at discounts to NTA.

But Milton itself trades at an 11% premium to fee-adjusted NTA. With a heavy weighting to banks, it’s too pricey for new shareholders. HOLD.

We’ve omitted recommendation guides for the seniors because buying them will depend on their discounts to NTA at the time of purchase. So if the seniors don’t offer much value, what about the juniors?

Junior league

You can see a selection of smaller domestic listed investment companies with low management expense ratios and conservative investment philosophies in Table 3. While the premiums to NTA are slightly lower, they suffer from the same affliction as their elders. Banking stocks are, if anything, an even greater percentage of their portfolios.

Only Carlton Investments trades at a discount to NTA, mainly because of its less-diversified portfolio. With a 37% weighting to Amalgamated Holdings, you might consider it if you wanted a more diversified exposure to that stock (and you don’t mind the banking exposure).

BKI Investment Company may end up merging with Milton Corporation, although there’s unlikely to be a takeover premium. Both are part of the Washington H. Soul Pattinson empire, and Robert Millner chairs both companies. At this stage we won’t be issuing formal recommendations on the juniors but, if they become attractive, we’ll let you know.

Local heroes

The domestic LICs have their place, particularly if you want a low-cost, hassle-free portfolio management approach. Indeed, many LICs have lower costs than the exchange-traded funds that have sprouted on the ASX in recent years.

Of course, buying a LIC is no different to any other stock. You have to pay the right price. Paying a premium to NTA means your return will be lower than the underlying portfolio’s performance. Until they’re closer to NTA we’ll stand on the sidelines.

The economist Paul Samuelson was right. Owning a listed investment company might be like watching paint dry, but that’s no bad thing. Who needs excitement when your LIC has performed as admirably as AFIC, Argo, or Milton? But as ever, the price you pay is the critical consideration and right now, the sector doesn’t offer much value.