Taking LICs at face value
After a strong run, many LICs are trading close to NTA and we're changing how we cover them.
We've always struggled with how to cover listed investment companies at Intelligent Investor, because they can be viewed in a couple of ways: as stocks or as funds. From time to time they can offer clear value as the former, and we're delighted to recommend them as such. But most of the time they act as funds and can only really be justified if you think their manager can outperform other funds.
Of course we have strong feelings about the investment strategies that are likely to do well, but picking managers is beyond our remit. Yet many of our members are interested in funds as well as stocks, so in the past we've stretched our normal value investing criteria to include a few LICs on our coverage list.
Now, though, we have joined forces with InvestSMART and Eureka Report, and they cover this area far better than we could. InvestSMART offers a range of data and filtering tools so you can see in a flash which LICs match your criteria for such factors as size, fees, yield and – most importantly – discount to net tangible assets (NTA). Eureka Report, meanwhile, provides regular interviews with different fund managers, so you can assess their approaches and maybe pick up some clues about their psychology. Look out for an interview with AFIC chief executive Mark Freeman tomorrow.
Strong run for LICs
Most trading close to NTA
Shifting coverage to InvestSMART
This is the sort of coverage of LICs – as funds – that we haven't been able to offer before, and we're delighted to be able to do so now. If you're interested in the sector, we'd urge you to take a look. Rather than compete with that, Intelligent Investor will stick to valuing LICs as stocks and, as such, we'll only recommend them where we see clear value and a decent margin of safety.
The valuation process we use is relatively straightforward. Most fund managers perform in line with their benchmark over the long term – minus their costs – so we make that base assumption (it's no doubt a bit harsh in some cases, but remember that we're being cynical value investors here). That means an LIC will be worth the sum of its assets, less a discount to account for costs.
Imagine, for example, that you buy a portfolio of assets worth $100, and that you expect returns of 8% over the long term. The assets will deliver $8 a year, but costs of 1% would knock that down to $7. To get that back to your 8% return, you’d need to buy the assets for a discount of 12.5% (the 1% fee divided by the 8% expected return). If the costs were 2%, then you’d need a discount of 25% (2% divided by 8%).
Two types of NTA
As ever, though, there are a number of complications. First and foremost, LICs typically publish two different figures for their net tangible assets (NTA): pre-tax and post-tax. The former adds everything up at their current values, less any debt, while the latter also deducts any tax that would be payable if the portfolio was liquidated.
Using the latter figure is more conservative, but long-established LICs (think Australian Foundation Investment Company and Argo Investments) rightly point out that they’re not going to sell their larger holdings any time soon, so their returns are actually generated from the pre-tax figure. We tend to pick a figure in between the two, closer to the pre-tax for LICs that don’t trade much and closer to the post-tax for those that do.
It’s also worth noting that some management teams will add franking credits to the pre-tax NTA. Whilst they generally have some value, it’s hard to quantify, so the more conservative approach will be to exclude them. In any case, it’s worth checking to see which approach is being taken.
Margin of safety
Once you’ve come up with an adjusted NTA figure and applied an appropriate discount for costs, you have a fair value – but you then need to allow for your margin of safety.
As portfolios of stocks themselves, LICs are relatively safe (although less so for those with unlisted investments), so less margin of safety might be acceptable; but you’ll still want some, otherwise you’d be better off buying the stocks yourself.
In the past this is where we've stretched the point a bit, recommending some LICs at prices only slightly below the appropriate discount, to help members that are perhaps partly interested in them as funds. After all, if you’re committed to investing in a fund anyway, then you’ll have to pay some costs somewhere along the line, so skinnier discounts may be acceptable.
At Intelligent Investor, though, we feel uncomfortable combining the words 'skinny' and 'margin of safety' – so we're going to take the opportunity to tighten things up. As chance would have it (and as you'll see below) a strong run for the sector means that all the LICs we currently cover are trading above the prices at which we might buy them. Indeed most are trading above what we'd conservatively estimate to be their underlying value – after the relevant discount for costs and assuming average performance.
We're open to recommending them again, and we'll be keeping an eye on the sector – but they’ll need to wash their face as out and out value purchases rather than as funds that are reasonably priced. That might look a distant prospect at the moment, but there's nothing like a good market shake-out to put this sector on the nose.
In the meantime, Intelligent Investor is formally CEASING COVERAGE on the stocks listed below. As already noted, though, you'll still find plenty of data and coverage over on InvestSMART.
PM Capital Asian Opportunities Fund (ASX:PAF)
PM Capital Asian Opportunities Fund has delivered outstanding underlying performance since inception in 2008 of over 15% per annum. That might make it interesting to some as a fund investment (notwithstanding its management fee of 1% a year, plus 15% of any outperformance). However, with a discount of just 4% to pre-tax NTA and small premium to post-tax NTA, it doesn’t stack up as a value investment.
That’s a big turnaround since we recommended the stock almost two years ago, when those discounts were 16% and 13% respectively, and it delivered a return of 30% before we downgraded to Sell in November last year. At current prices, though, another opportunity looks a long way away.
Templeton Global Growth Fund (ASX:TGG)
This LIC has delivered a return slightly ahead of its benchmark since 1987. With a management fee of 1%, we’d need a discount of at least 12% to our blended NTA figure to get us to fair value, let alone allow a margin of safety. We’re a long way from that at the moment.
Australian Foundation Investment Company (ASX:AFI)
We generally prefer LICs to be internally managed rather than employing an external manager, because there’s a better alignment of interests between management and shareholders and (no surprise) the fees are typically lower.
The advantages get more significant as the LIC gets bigger and there’s none bigger than Australian Foundation Investment Company (AFIC), which has a management expense ratio of just 0.18% of pre-tax NTA. The low fees mean we’d only need a small discount to get to fair value; unfortunately the stock currently trades at a small premium. For those happy with an average market return, AFIC continues to be an option, but it’s unlikely to offer out and out value any time soon.
Argo Investments Limited (ASX:ARG)
Another internally managed LIC, Argo boasts total operating costs of just 0.15% of total assets. Currently trading at a slight premium to pre-tax NTA, Argo is another option for those looking for a fund investment to deliver close to the market return over the long term – but it’s highly unlikely to do better.
Bailador Technology Investments Limited (ASX:BTI)
Alongside Thorney Opportunities (see below), Bailador is one of the few LICs on our list that currently trades at a significant discount. With the stock priced at 20% below its post-tax NTA of $1.06, on the surface it appears as though there may be some compelling value.
There are, however, a few reasons why Bailador may deserve the discount.
First, its investments are unlisted and its NTA is therefore based on the valuations ascribed to them by management. That brings in a degree of subjectivity – and therefore increases the margin of safety we’d want to see. It’s also worth noting that Bailador earns a 17.5% performance fee, so there’s an incentive to provide higher valuations.
Second, the management fee is a whopping 1.75% and – with a market capitalisation of just $99m – operating expenses make up a large proportion of total assets.
Taking account of these factors, we’d consider fair value to be at least 20% below NTA – and that’s before the stock starts to offer any value.
Thorney Opportunities Limited (ASX:TOP)
The other LIC on our list trading at a significant discount to post-tax NTA is Thorney Opportunities. The big detractor here is the whopping 20% performance fee. Even worse for investors, that 20% figure isn’t calculated on any outperformance over a benchmark, it’s on any increase in NTA.
We don’t doubt the ability of Alex Waislitz, but with some of the highest fees in the industry, the LIC is deserving of its discount to NTA.
BKI Investment Company Limited (ASX:BKI)
BKI has a number of things going for it: its directors own sizable personal stakes, it’s achieved an annual return of 10.3% over 14 years, and it’s subject to a very modest management expense ratio of just 0.17%. It’s also good to see that Washington H Soul Pattinson has an 8.6% stake.
At a premium of just 1.3% to post-tax NTA and a discount of 4% to pre-tax NTA, it’s also reasonably priced given its very low fees. Of all the LICs we cover, BKI is probably the most attractive – but you couldn’t say that it offers out and out value.
Pengana International Limited previously known as Hunter Hall Global Value (ASX:PIA)
The LIC has slightly outperformed the benchmark since inception in 2004, but with a management fee of 1.2% and a discount to pre-tax NTA of just 5%, it’s trading well above what we’d regard as its fair value.
Perpetual Equity Investment Company Limited (ASX:PIC)
We upgraded this LIC to buy in September of 2015. At the time it offered a discount of 10% to pre-tax NTA, but this has since moved to a premium of 4%. Combined in a 20% rise in pre-tax NTA, that’s seen the share price gain 28% and, with dividends of a little over 10 cents, the total return amounts to about 38%.
That puts it almost on a par with the S&P/ASX 300 Accumulation Index, a performance that improves if you allow for the fact that it’s had around a quarter of its portfolio invested in cash. But given the management fee of 1% (0.85% once it reaches $1 billion in funds under management) and the premium to NTA we're downgrading to SELL and CEASING COVERAGE.
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