PM Capital cheap for China exposure

It's off many investors' radars, but PAF remains a cheap option for Chinese exposure.

PM Capital Asian Opportunities Fund’s focus on companies operating in Asia (ex-Japan) has meant that many of its holdings have been affected over the past year by increasing concerns over whether Chinese authorities can successfully transition the country from an investment-led economy to one led by consumption. These concerns have not only impacted companies directly involved in the Chinese economy, but also those indirectly impacted by it due to their dependence on the Chinese consumer.

Given this, we were happy to see portfolio manager Kevin Bertoli take advantage of the market pessimism in the first quarter of calendar year 2016 – and in particular in January and February – to take PAF to a fully invested position.

Fees

At current prices investors can purchase PAF at a 12 per cent discount to pre-tax net tangible assets (NTA) or 10 per cent discount to post-tax NTA (both figures ignore any dilution from options being exercised).

Due to the management and potential performance fees charged by a listed investment company’s manager, your investment in a LIC is likely to lag the returns of its underlying portfolio. As such, all thing equal, it’s better to purchase a LIC at a discount that “capitalises” these fees (say at 10 per cent) to compensate for the drag these fees create on your returns.

For example, PM Capital – the manager of PAF – charges investors one per cent of net asset value per year and so capitalising these at 10 per cent suggests a 10 per cent discount to NTA is warranted before purchasing.

If you would like to be even more conservative, a discount to post-tax NTA is preferable to buying below pre-tax NTA, although the tax status of the investor is also relevant here.

Of course, these rules are somewhat arbitrary and the more undervalued you believe the LIC’s underlying holdings are, and/or the more confidence you have in its manager outperforming its benchmark, the more justified you are in paying a smaller discount or even a premium to NTA.

However, an investor always has the option, in theory at least, of removing the middleman and directly purchasing the LIC’s holdings so this limits how much of a premium to NTA you can be justified in paying.

Future dividends

With a market capitalisation around $50 million, PAF remains too small for most brokers to cover and so is off the radar for many investors, one reason it continues to sell at a discount to NTA.

The lack of a dividend is another. As such, it’s not surprising that PAF announced its initial tax payment recently, which gives it the capacity to pay up to 10 cents in fully franked dividends in coming years.

We’d expect an initial, albeit relatively minor, dividend to be declared shortly (most likely in September) and regular dividends should help narrow the discount to NTA over time. Nevertheless, capital growth remains the focus for PAF and it’s unlikely to ever be a stock that offers a high yield.

Unfortunately, the options issued to investors who subscribed to its 2014 IPO are due to expire on May 31, 2016, yet PAF’s share price remains below their $1.00 exercise price. The announcement of the tax payment and suggestion of dividends in the near future was also likely made with this in mind.

Whilst the exercise of the options would dilute NTA per share for current shareholders, not only would it result in PAF essentially doubling in size (if all options are exercised) but it would also provide Bertoli with the opportunity to deploy more capital at a time when many Asian companies’ share prices are still depressed.

Unless its share price rises to around $1.00 or above by the end of the month, then it’s likely that options not owned by PM Capital and its associates won’t be exercised. If so, this wouldn’t be ideal but certainly won’t be a disaster.

If PAF outperforms its benchmark like the unlisted Asian Companies Fund that PAF attempts to replicate has since its inception in July 2008, this will also help reduce the discount to NTA over time, particularly as it will probably result in the LIC coming onto the radar of more investors sooner or later.

Cheap exposure to Asia

Selling at a discount to NTA and with many of PAF’s underlying holdings themselves appearing undervalued, there is a reasonable margin of safety for investors at current prices. As such, PAF remains a Buy for those who share Bertoli’s long-term focus and who desire exposure to companies operating in Asia.

Disclosure: The author owns shares in PM Capital Asian Opportunities Fund