How advisers can do their due diligence on listed investment companies (LICs)
How can you best assess whether and which LICs are right for your clients?
A close up on listed investment companies (LICs): factors advisers should analyse for due diligence purposes.
In this article, Geoff Driver, General Manager – Business Development & Investor Relations at Australian Foundation Investment Company (AFIC) explains how financial advisers can best assess whether and which LICs are right for their clients, and how investment managers of LICs – like AFIC – evaluate industries and companies for the portfolio.
One of Australia’s oldest and largest listed investment companies (LIC), Australian Foundation Investment Company (AFIC), will celebrate its 90th anniversary next year. For many years since its inception in 1928 as Were’s Investment Trust Ltd, AFIC was one of only a limited number of LIC’s available to investors. More recently there has been an explosion in the number of LIC’s available on the market.
Today, the LIC sector is represented by more than a hundred listed investment companies (LICs) and listed investment trusts (LITs) on the Australian Securities Exchange (ASX) with a total market capitalisation of $37.19 billion. The sector has grown by 19.3 per cent in 2017 alone, representing a 24.7 per cent increase in market capitalisation[1].
The increase in popularity of LICs can largely be attributed to the surge in self-managed super funds (SMSFs) and to the increasing interest from financial advisers post future of financial advice (FOFA) reforms, which I explain further in the Video 1. The attraction in LICs is also driven by the search for returns in a low interest rate environment, increasingly by an engaged cohort of younger investors, and from parents and grandparents looking to invest on behalf of future generations. Finally, many fund managers have established LICs as a way of tapping into LIC sector, further accelerating growth.
Video 1
LIC attributes advisers should consider
LICs can be classified into three areas of investment focus:
- Funds investing in Australian listed companies
- Funds investing in internationally listed companies
- Specialist funds that invest in specific assets or industry sectors
In assessing the options financial advisers should start with their client’s profile, his/her financial objectives and appetite for risk when determining the right LIC vehicle to invest with. This will support in evaluating the appropriateness of the attributes of a LIC, including its portfolio structure, investment approach, fee structure, management and performance history, dividend policy and net tangible asset value per share.
Portfolio structure and investment approach
All LICs are actively managed and will have an investment team responsible for analysing the companies to include in the portfolio, and rebalancing the portfolio when required. As LIC’s are “closed end funds” with a set amount of capital to invest (otherwise through capital raisings) many are longer-term investments with a timeline of five to ten years, with growing dividends a key outcome.
A LIC’s portfolio structure and investment approach will depend on the fund’s objective. As an example, AFIC’s investment focus is on capital growth to enable us to pay fully franked dividends to shareholders over the medium to long term. Therefore, it has a bias towards investing in companies that pay dividends, and favour companies with a mandate to grow their dividend policy in the future.
Many LIC’s focus on after tax returns as significant portfolio turnover can detract from returns as tax is paid on these transactions. In addition, the opportunity cost of paying tax needs to be offset by the potential returns of replacement investments.
Fee structure
There is evidence that both retail investors and financial advisers are becoming more attuned to fees charged on investment products – largely because of the FOFA legislation and the increasing profile of low cost investment options.
Ultimately, a LIC’s performance must always justify its fee or fees charged. The fees associated with LICs are:
Management expense ratio (MER)
The MER is a fee charged by all LICs as a percentage or “base point charge” to cover the cost to the investment company to operate the fund. This includes management, administration, share registry costs and other expenses incurred.
Internally managed LICs, including AFIC (ASX: AFI), Argo Investments (ASX: ARG) and Milton Corporation (ASX: MLT) have competitively low MERs, charging between 0.12% and 0.16% in financial year 2017. On the other hand, LICs managed by asset management businesses tend to have substantially higher MERs.
Performance fees
Some LICs, particularly the newer or externally managed LICs run by fund managers, charge a performance fee as an addition to the MER. This fee incentivises the LICs’ managers for outperforming the fund’s stated benchmark.
AFIC, similarly to some of the other well-established LICs, does not charge performance fees to shareholders.
Management and performance history
For advisers to understand the management of a LIC, they should look to assess the professional background, expertise relating to funds management, governance and remuneration structure of the vehicle’s management team.
Similarly, to evaluate whether a LIC is a sound investment option, advisers should also review the LIC’s long-term performance history.
Advisers should also note that in a post-FOFA environment, there is an increase in the number of externally managed LICs. The investment managers of these vehicles tend to have multiple asset management businesses so it would be worthwhile to also review the track record and performance of the other funds under their management.
Dividend policy
LICs have varying dividend policies dependent on their investment focus. Some dividend policies will fluctuate, while others will remain consistent with an aim to grow dividends over time.
LICs with consistent dividend policies generally have higher reserve positions. These reserves become particularly important during market recessions, enabling the LIC to maintain its dividend to shareholders – as AFIC did during the global financial crisis (GFC). From this perspective, a LIC with a consistent and growing dividend policy may suit retail investors with a specific need for regular income.
Net Tangible Assets (NTA)
The Net tangible asset is the value of the portfolio divided by the number of shares on issue for any given LIC. A LIC can trade at a premium or discount to pre-tax NTA due to a number of factors including the general market sentiment for equities, timing of dividend payments and dividend yield, particularly in the current low interest rate environment.
Advisers should analyse a LIC’s individual premium or discount to pre-tax NTA (in the case of AFIC) over a long period, then evaluate in context of the LIC sector’s historical premium and discount pre-tax NTA trading range. I explain the NTA equation in Video 2.
Video 2
How LICs analyse industries and companies to invest
The overall objective of the LIC will guide the approach its investment manager will take to analyse companies or sectors. For example, long-short LICs will have a different approach to LICs with a long-term focus. As such, the following areas of focus are specific to LICs like AFIC that aim to achieve growth and deliver dividends and capital to shareholders over the medium to long term.
Financial metrics
Financial metrics are an important element, but not the complete picture, guiding LIC managers’ investment decisions.
Debt to equity ratio, valuation, capital allocation, and a company’s ability to service debt is critical. LICs with consistent dividend policies will generally avoid highly geared companies, as gearing can impact a company’s ability to pay dividends in difficult trading positions.
Review of industries and companies on a macro level
While analysing growth expectations for industry sectors on a macro level is very important this is overlaid by a bottom up approach to investing. The aim is to select companies that are likely to deliver growth and dividends in attractive industries, over the longer term. The LIC will aim to have strong positions in those industries and buy positions at attractive prices.
LIC managers will seek out external expertise from specific industries in Australia and in similar or key markets internationally to help them to identify potential risks, the possibility for disruption, opportunities for industry growth, and how individual companies may be positioned over the medium to long term.
Recently, sentiment in the Australian market has been negative on a large cohort of the ASX 20 companies due to lower growth expectations. However, LICs with a long-term outlook must look beyond this, as ‘low growth’ businesses do not immediately make them poor investments – as illustrated in the banking sector, where high dividend yields plus franking credits have meant they’ve been sound investments for an income-biased portfolio.
Hence, LIC managers like AFIC look rationally at a company’s market position, its ability to grow over the long term, sustain strong dividends and maintain its brand position in the market.
Mark Freeman, Chief Investment Officer at AFIC, who will succeed Ross Barker as Managing Director from January 2018, in Video 3 outlines AFIC’s view on some of the challenges and opportunities currently facing large companies in Australia.
Video 3
Analysis of management and governance of a company
The governance and remuneration structures of companies are closely analysed by LIC management. Analysing company proxy statements, the individuals represented on executive teams and Boards of companies, and ensuring remuneration outcomes are in line with company performance are all part of the due diligence for LIC managers.
LIC managers will also meet with the management teams of current and prospective investee companies to understand the company’s long term strategy, its business objectives, performance and its future direction or growth aspirations and the challenges to these.
What does this mean for advisers?
The increased profile of LICs and with market conditions continuing to look supportive for the sector, we may see more LICs listing on the ASX.
Financial advisers must do their due diligence when considering which LIC would complement their client’s profile and financial objectives, by comparing LICs’ key attributes, performance and understanding how the LICs themselves evaluate industries and companies they invest in.
This analysis should also extend to the history of share price premium/discount to NTA, as buying at a high share price premium may detract from future returns irrespective how good the LIC’s underlying portfolio performance is.
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