Investors need to squeeze every ounce of return from their portfolio with the Australian share market near its record high and interest rates at record lows. One opportunity is out-of-favour Listed Investment Companies (LICs) that invest in small- and mid-cap stocks.
I cannot recall seeing as many LICs trading at such large discounts to their pre-tax Net Tangible Assets (NTA). Even LIC leaders such as Australian Investment Foundation Company (AFIC), Argo Investments and Milton Corporation are trading at decent discounts to NTA.
LICs have lagged the share market recovery this year. Theories for that underperformance include: investor “fatigue” from an increase in LIC floats in the past few years; the poor performance of several LIC floats; rapid growth in Exchange Traded Funds and index investing; the shift away from active fund managers; and waning sentiment towards the LIC sector.
In theory, this should be a good market for LICs. The Australian share market has rallied, dividend yield (which many larger LICs specialise in) is in higher demand as interest rates fall, and there was no change to franking credit after the Coalition’s election win.
Whatever the cause of underperformance, a larger-than-usual number of LICs are trading at discounts to NTA that are well beyond the LIC’s average five-year discount – a sign that value may be emerging.
To recap, LICs are akin to a listed managed fund. These closed-ended funds manage a fixed pool of capital and investors buy and sell shares in the LIC, not in its underlying portfolio.
In contrast, investors in an open-ended fund, such as a unit trust, buy units in the actual fund. LIC proponents say the fixed capital pool is a significant advantage; a LIC manager does not have to buy shares when fund inflows are strong or sell them in a bear market to meet investor redemptions.
Detractors say the closed-ended model provides “captured capital” for the managers: they earn their fees from a fixed pool of capital. Unlike unit trust managers, they don’t earn less fees when the size of the underlying portfolio contracts.
Another issue is discounts and premiums to NTA. Unlike open-ended funds, closed-ended funds often trade at persistent discounts to their NTA, frustrating the LIC managers and shareholders. An LIC with $1 of assets per share, for example, could have a share price of 90 cents.
A strategy to find LIC value
LIC discounts are not always what they seem. An LIC can trade at a large discount to NTA because the market has concerns about its performance, dividend record, liquidity or the asset class it invests in. Or because the LIC, some of which have small marketing budgets, does not promote itself well to investors.
My strategy with LIC selection has several parts. First, I look for LICs trading at a discount to pre-tax NTA. Some LICs trading at a premium have been excellent performers and increased their premium; but paying more for an asset than it is worth is rarely a good idea and relies upon the LIC continuing to have strong future performance.
Second, I compare the pre-tax NTA discount to the LIC’s five-year average discount and its discount-to-premium range. An LIC might be trading at a 10% discount when its five-year average discount has been 5%. The current discount might be at the bottom of its discount-premium range over five years.
Using the long-term discount average is far from foolproof, but LIC discounts and premiums often revert to their mean over time. Those trading at historically large discounts may be an opportunity and those at historically large premiums need extra caution.
The third part of my strategy is vital: the manager. As with any managed fund, assessing the LIC’s long-term performance, investment style and its team is key. We’re after quality LIC managers trading at historically large discounts to NTA.
The fourth part of my strategy is often overlooked: the LIC’s underlying asset class. ASX 200 companies, in my view, are collectively overvalued, so I’m wary of investing in LIC managers that specialise in blue-chip shares and will provide market-like returns over time.
AFIC and Argo are trading at larger-than-usual discounts to pre-tax NTA and tick the box for quality. But I don’t want to add more blue-chip Australian share exposure to my portfolio because those shares are pricey after the market rally this year.
Small-cap LICs out of favour
Small-cap Australian equities continue to lag large-caps. The S&P/ASX Small Ordinaries Index’s total return of 4.6% over one year (including dividends) compares to almost 12% for the ASX 100 index. Rising demand for blue-chip yield partly explains the gap.
Small-cap companies tend to underperform when the economy weakens because they are more exposed to domestic conditions than large-caps that have offshore operations. So, it’s no surprise that small-cap industrials have lagged their larger peers over one year.
The LIC market reflects this. Only two of 18 small-cap LICs – WAM Research and Excelsior Capital – traded at a premium to NTA at the end of June, shows ASX data. Most traded at double-digit discounts to their underlying asset value.
Expect more corporate action in smaller LICs as those trading at persistently large discounts merge with larger LICs. Clime Capital and CBG Capital have announced their intention to merge and Sandon Capital has made a takeover offer for Mercantile Investment Company.
Using Independent Investment Research’s excellent LIC data, I compared the current indicative discounts in small-cap LICs to their five-year average (or three-years if there was not enough performance data). Almost every LIC in this category traded at a larger current discount than its three-year average; some discounts had widened considerably.
It is hard to see why well-regarded small-cap LICs are trading at a discount that is more than double their five-year average – particularly in a rising share market. That suggests an opportunity for experienced, patient contrarians who can tolerate risk and understand that buying quality LICs at a historically large discount to NTA can be rewarding.
3 undervalued small/mid-cap LICs
1. Thorney Opportunities (ASX Code: TOP)
The prominent investor in high-growth small-cap stocks, had an indicative pre-tax NTA of 89 cents at July 5, according to Independent Investment Research. The indicative NTA is the research firm’s estimate of the LIC’s NTA over the month, using the LIC’s disclosed holdings. The indicative NTA can vary from the LIC’s last stated pre-tax NTA and shares price of stocks held in the portfolio rise and fall.
At the current 69 cent share price, Thorney Opportunities is trading at a 22% discount to its indicative NTA. Its five-year average discount to NTA is 9.5%.
Thorney is exposed to several infrastructure service companies and participated in the recent $115 million acquisition of the Australian Community Media group from Nine Entertainment – a deal that could unlock significant value in more than 170 newspapers and publications.
Thorney’s NTA is rising but its share price went sideways for much of this year, before kicking higher in the past few weeks, no doubt a reflection that the discount for this well-run LIC had widened too far.
Chart 1: Thorney Opportunities
2. Spheria Emerging Companies (SEC)
Spheria co-founders Marcus Burns and Matthew Booker have a good record in small-caps. They generated strong outperformance in Schroders’ small- and mid-cap portfolio before leaving to set up Spheria, a boutique small-cap investor, in April 2016.
Spheria’s indicative pre-tax NTA of $2.07 compares to its current share price of $1.85 – an 11 per cent discount. Like Thorney, Spheria’s share price has kicked higher in July after drifting sideways for most of this year on low volume.
Spheria launched a $5 million on-market share buyback in July 2019 to arrest its double-digit discount, clearly believing its stock was undervalued.
The LIC’s portfolio performance has slightly lagged the Small Ords Accumulation Index since inception, but looks well placed to outperform in the medium term.
Chart 2: Spheria
3. Westoz Investment Company (WIC)
The Perth-based LIC invests in stocks that are mostly outside the ASX 100 and have a connection to Western Australia. Westoz’s largest portfolio holdings include several mining, energy and resource-services stocks that benefit from higher commodity prices.
Westoz’s indicated pre-tax NTA at the start of July was $1.33, estimated Independent Investment Research. The current share price of $1.06 gives a discount to NTA of 20%, meaning investors can buy $1 of Westoz’s assets for 80 cents.
Westoz’s five-year average discount to NTA is 10%. It’s hard to see why its discount is double its long-term average at time when resource-sector conditions – and the outlook for WA companies generally – is improving.
The LIC’s underlying portfolio has outperformed the All Ordinaries Index for more than a decade, yet the market ascribed a double-digit discount to the LIC. Some discount is warranted given Westoz’s focus on mostly smaller WA stocks, but the current gap between the share price and underlying asset base is too wide.
Chart 3: Westoz
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 17 July 2019.