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 90^th 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:

1. Funds investing in Australian listed companies
2. Funds investing in internationally listed companies
3. 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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[1] Australian Securities Exchange, ASX Investment Products Monthly Update – October 2017 http://www.asx.com.au/documents/products/ASX_Investment_Products_Oct_2017.pdf

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What are the features affecting Australian equities and listed investment companies?

Forward view for Australian equities and LICs

This is the second in a series by Ross Barker, Managing Director of Australian Foundation Investment Company (AFIC), looking at features affecting Australian equities and listed investment companies (LICs).

While part one followed the trajectory of performance in the Australian share market, part two looks at local and global factors affecting the Australian share market and the medium to long term outlook for LICs and Australian equities.

Australia’s business and investment community is currently operating in an environment of low wage growth, low interest rates and technological disruption. The other critical element is the current political landscape which is making it difficult to put in place long term policy frameworks. These factors will inevitably influence future financial, economic and investment landscape in Australia. Against this backdrop, several industry sectors in Australia are currently trading close to, or at the top of their long-term valuation ranges.

Given the above factors, the overall outlook for Australian equities and industry sectors in the medium term remains somewhat mixed.

Features affecting business and investment sentiment in Australia

Interest rates

The U.S. Federal Reserve has indicated it will gradually increase interest rates over the coming years in a slow-growing but durable economy. It has already increased the official interest rate to 1.25 per cent following three modest rate rises in six months to June 2017 and has indicated it will make one further increase in the second half of 2017. Longer term, U.S. interest rates are projected to trend higher.

In contrast, the Reserve Bank of Australia (RBA) is likely to keep interest rates on hold at 1.5 per cent for the medium term to help minimise any risks associated with strong residential property prices. Any major correction in prices would clearly reduce household wealth, with an attendant impact on consumption and the construction sector.

It will be a significant balancing act for the RBA to deal with high property market values and the heightened level of household debt. In the long term, it is likely to approach any rises in interest rates with extreme caution given these circumstances. 

Growth projections for Australia

Economic and population growth projections are supportive of long term interest rate rises. Economic growth is expected to increase gradually to almost 3 per cent per annum by 2018^[1] with the population expected to reach 25.6 million by 2020.

Impact of technology disruption

As new business models emerge from the use of the internet and development of smart software solutions, there is likely to be a continued rise in companies coming to the market as well as offshore companies listing on the ASX. There are a number of technology businesses in the embryotic stage that investors will be watching closely.

The future impact of technology disruption for the Australian market remains mixed for different industry sectors, with consumer-facing sectors likely to face higher risks in the shorter term.

Federal and state government policy setting

A recent survey indicated almost 40 per cent of company directors identify uncertainty around policy, political instability and lack of long-term vision as key issues affecting confidence^[2]. Heightened taxation risk from federal and state governments in an environment where budgets are under pressure has also become a feature of the Australian economy.

Although reform is challenging for the Federal government, a well-considered, comprehensive approach to taxation and budget reform will be vital to create a more robust foundation for the Australian economy.

Energy policy

Energy policy setting in Australia has been inconsistent for the last decade, ultimately resulting in challenges for suppliers and higher electricity prices for households and industry.

Future sustainability of the energy sector is dependent on a careful balance of setting policy and rising costs of energy, managing future demand for resources and the gradual move to a greater use of renewable sources.

Household debt

High levels of household debt against subdued wage growth is producing a weaker outlook for discretionary consumption. This will affect the retail sector in the medium to long-term, which also faces future competitive challenges from Amazon’s imminent entry to the market and with global supermarket chains already challenging Coles and Woolworths’ dominance.

Change in commodity prices

The recent strength in commodity prices has come on the back of increased infrastructure spending, greater real estate investment and reduced coal production in China, as well as reduced supply across a number of commodities over very recent times as investment was withdrawn. Demand from the steel industry in China for quality iron-ore also remains strong. As we have seen already this will benefit earnings growth for top quality producers including BHP and Rio.

However, there are indications that the Chinese Government plans to renew its long term economic shift from heavy industry to services which could affect demand in the future.

While commodity prices aren’t expected to stay around current levels, global growth remains supportive of commodity prices over the medium to long term.

Australian property prices

Any disruption to the highly-geared household sector may affect future earnings growth for the banks. Banks are already facing increased capital requirements and higher lending standards have been imposed.

Amazon’s arrival may create headwinds for the REIT sector if shopping centres become challenged to secure tenants and maintain rental growth. This will be an even more difficult task for less prominent retail centres.

There are also concerns around the compounding impact from a slowdown in construction, which may lead to higher unemployment levels in both construction and the broader real estate sector.

National Broadband Network (NBN)

The implications of the NBN will likely create headwinds for Telstra and the telecommunications sector more broadly as consumers seek out competitive deals and as the mobile market becomes open to new providers.

Geopolitical concerns

Tensions in the Middle East, the economic implications of Brexit for UK and Europe, uncertainty around the Trump Administration’s long-term legislative agenda and growing concerns surrounding North Korea will impact investor confidence at different stages. This could lift market volatility at least in the short to medium term.

New economic powers

China and Russia continue to look for opportunities to disrupt the United States’ preeminent geo-political position which will also contribute to global volatility.

Further, regional gross domestic product (GDP) projections to 2026 show large developed economies are becoming less significant while emerging economies continue to gain economic influence^[3]. Although pressures remain in all emerging markets, overall GDP growth is expected to average 3.7 per cent between 2017-2021 and settle on a trend growth rate of 3.5 per cent between 2022-2026.

Despite its economy slowing, China growth is projected to hit 6.7 per cent GDP in 2017, 6.3 per cent per annum by 2020 and 5.8 per cent per annum by 2022. ^[4]Projections are even stronger in India, with GDP of 7.2 per cent per annum between 2017 and 2018 and a medium-term outlook of GDP growth above 8 per cent, following the adoption of the Goods and Services Tax (GST) ^[5]

This compares with a 2.1 per cent projected GDP growth per annum for the United States in 2017 and 2018, with longer-term projections of 1.8 per cent GDP growth per annum.^[6].

Many Australian companies have been growing their businesses offshore for some time. This has helped diversify away from lower growth jurisdictions such as Australia to higher growth markets, including China. Some examples – which AFIC is invested in – include CSL, Amcor, James Hardie industries and Cochlear.

Continued support for LICs

The growing SMSF sector, alongside the future of financial advice (FOFA) reforms and low returns on cash and term deposits is one of the reasons for the 98 per cent increase in LIC listings between June 2013 and March 2017.

The sector has experienced a ‘renaissance’ in the last five years. While LIC sector growth can be cyclical in nature, the recent trend in AFIC shareholders growth at eight per cent per annum supports the view that the listed investment vehicle will remain popular among income-focused retail investors in the medium to long-term (five to ten years) as a way to access different asset classes in the current low interest rate environment.

Outlook for Australian equities

History has shown that good quality companies will deliver sound investment returns over the long term. These companies typically have good positions in attractive industries, sound balance sheets and have quality management. Importantly, one of the key decisions that will influence returns is the price an investor pays for the shares in companies. This is something we are very mindful of.

The long-term returns of the Australian share market are approximately 6.5 per cent capital and 3.5 per cent yield. Although these figures may not be as high in the future, given low growth and interest rates, it’s our view that over the next five to 10 years, Australian equities will continue to provide retail investors with sound returns, including good income returns.

As a long-term investor, it’s our role to analyse how Australian companies are managing the challenges that arise and look for opportunities to invest at the right time to create a low cost, diversified portfolio for the benefit of our shareholders, and which will grow dividends in real terms over time.

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[1] Organisation for Economic Co-operation and Development: http://www.oecd.org/australia/australia-economic-forecast-summary.htm
[2] Australian Institute of Company Directors, Director Sentiment Index (December 2016): http://aicd.companydirectors.com.au/advocacy/research/director-sentiment-index-second-half-2016
[3] The Conference Board: https://www.conference-board.org/press/pressdetail.cfm?pressid=6899
[4] International Monetary Fund: http://www.imf.org/en/News/Articles/2017/08/09/NA081517-China-Economic-Outlook-in-Six-Charts
[5] International Monetary Fund: http://www.imf.org/en/Publications/CR/Issues/2017/02/22/India-2017-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-the-Executive-44670
[6] International Monetary Fund: https://www.imf.org/en/Publications/WEO/Issues/2017/07/07/world-economic-outlook-update-july-2017

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What are the past, present and future trends in Australian equities and the LIC sector.

In the first of a two-part series on LICs, Ross Barker, Managing Director of Australian Foundation Investment Company (AFIC), will look at trends – past, present and future – in Australian equities and the LIC sector.

The first in the series will review developments in Australian equities and the expansion of LICs, and second part will provide an outlook for future trends and performance of the market.

Although Listed Investment Companies (LICs) have been trading on the Australian Stock Exchange (ASX) for nearly a century, the sector is one of the great success stories of the ASX as investors continue to chase income in the new post-Global Financial Crisis environment characterised by very low interest rates and slower growth in many global economies.

As at 30 June 2017^[1], the market capitalisation for the sector has nearly surpassed $33 billion and in the last three years over $3.2 billion has been raised from LIC IPOs alone. The sector is continuing its growth trajectory and is expected to expand further as additional fund management groups seek to tap into demand, particularly from self-managed superfunds via the ASX. A look back at trends shaping Australian equities in the last decade will provide a perspective on why the LIC sector remains a popular option for investors.

Australian equities market: the past decade

The Global Financial Crisis

The severity of the Global Financial Crisis (GFC) caused by the United States (U.S.) real estate bubble in 2007 led to sharp declines in stock market indices in the U.S. and across global financial markets.

Over the crisis period (July 2008-May 2009), the U.S. equity market lost about 40 per cent of its market capitalisation compared to the total market capitalisation of ASX-listed companies which fell by 19 per cent to $1.2 trillion in the same period^[2].

While the U.S. economy continued to struggle despite the introduction of quantitative easing by the U.S. Federal Reserve, the Australian economy was buoyed by the resources demand from China which improved Australia’s terms of trade significantly. Australia also followed the U.S. lead in reducing official interest rates which contributed to the fall in the Australian dollar and improved the competitiveness of Australia’s manufacturers and services exports and imports^[3].

By 2010, the Australian economy had marked nearly two decades without a recession and by 2013, the Australian equity market had started its recovery, delivering close to 20 per cent total return for investors. This trend of low cash rates and term-deposit rates has further contributed to the recovery of the equity market, making it increasingly appealing to investors seeking income returns.

Today: Market performance across sectors

In the decade since the GFC, markets and economies have had to adjust to a new norm of low economic growth, low interest rates and the challenge provided to many businesses from technology disruption.

With the market capitalisation of Australian equities at around $1.5 trillion^[4], companies are responding to external pressures and focusing on cost-cutting measures to grow profits as revenue growth becomes more difficult to achieve. Low wages growth and reduced consumer confidence also makes for more subdued revenue for many consumer-focused businesses.

A look at specific sectors

Resources: Lower commodity prices have created headwinds for resource companies although those with lower costs and world-class assets such as BHP and Rio Tinto are better placed. More recently slightly higher prices have improved their position.

Energy: Lower oil prices and previous large capital expenditure on LNG projects has impacted the balance sheet and performance of Origin Energy and Santos. Woodside Petroleum and Oil Search are probably better placed given existing projects, their relative low cost position and access to capital. In the future, the energy sector may face significant challenges with emerging technologies, the shift to greater use of renewable energy, as well as accommodating disruptors such as the development of electric cars.

Banking: The big four banks, Commonwealth Bank of Australia, National Australia Bank, Westpac Banking Group and Australia and New Zealand Banking Group, have performed relatively well following the GFC as the banking sector market share consolidated in favour of the major banks given their better access to funding. Going forward increased competition, increased capital requirements and low growth in the Australian economy may provide headwinds for this sector.

Large retailers: Increased disruption and competition, particularly with the arrival of Amazon, may impact the retail sector. Already, the performance of larger grocery retailers including Coles and Woolworths is being disrupted by retailers including Aldi and Costco. Additionally, Amazon’s e-commerce model may signal a shift in consumer purchasing behavior which may put pressure on the ability of retail property trust sector to attract tenants at appropriate rents.

Telecommunications: The roll-out of the National Broadband Network (NBN) and increasing competition from smaller telco players offering competitive plans is impacting on incumbent, less agile organisations such as Telstra as the ‘grab’ for customers continues.

Property: The strong performance of the REITs over the last few years has been driven by low interest rates, attracting investors to this sector for yield-based security and high returning interest rate proxies. The sector’s performance was slightly weaker this year and will be influenced by the outlook for interest rates.

Health: Australia’s ageing population has buoyed the healthcare sector and while further growth is expected, returns will be dependent on several factors including the ability of the Government to provide funding support.

Technology: Established technology disruptors such as realestate.com, carsales.com and Seek have challenged the position of incumbent companies and have been successful in taking significant market share. As new business models emerge from the use of the internet and development of smart software solutions, there is likely to be a continued rise in companies coming to the market. However, this sector can be complex to navigate from an investor perspective including the rise in offshore technology companies listing on the ASX.

Investor trends

The ongoing demand for yield has meant the demand for equities has remained elevated as investors shift from ‘more traditional’ investments in government bonds and other low interest bearing assets, such as term deposits, which are offering only 1 to 2 per cent returns per annum.

The Australian market has risen strongly over the past twelve months as investors embraced a more positive outlook for global growth. Notably with rising commodity prices, the resources index was up 23 per cent over the financial year after two years of underperformance and the banking sector also enjoyed a strong rebound over the year to produce a return of 18 per cent. This was somewhat surprising given the headwinds facing the sector came from regulatory and economic conditions as well as new taxes/levies. However, the dividend yield on offer in this sector remains attractive for income-focused investors.

In contrast over the year, investors displayed more caution towards other smaller companies which had previously been trading at very high share prices. Some experienced significant reductions in value as they lowered their growth expectations.

With investors seeking greater access to diversity and competitive yields, the popularity and demand for LICs continues to rise, particularly from SMSF investors. This has also meant there has been a significant expansion in the number and asset classes covered by the LIC sector, as well as the increased use of ETFs.

Financial advisers will be expected to understand the differences between LICs and ETFs, as well as understanding the features and benefits of LICs.

The rise of different investment vehicles: LICs vs. ETFs

Prior to the Future of Financial Advice (FoFA) reforms implemented in 2012, LICs were not popular investment options for many financial advisers because commissions were not available.

When the legislation became mandatory in 2013^[5] and trailing commissions were banned, many financial advisers changed their business models to accommodate a different approach to charging customers. This levelled the playing field for investment vehicles such as LICs and ETFs as advisers sought lower cost alternatives for their clients in the context of evaluating which investments would be best for them.

LICS:

LICs are close-ended actively managed funds with a fixed number of shares and capital on issue. The shares trade daily on the ASX allowing investors to buy and sell with relative ease. LICs are valued at the proportion of underlying net tangible assets (the portfolio) per share (NTA), while the share price depends on equity market demand. Sometimes the share price can trade at a premium or discount to the NTA. This can create further opportunities for investors.

Investors are also attracted to LICs because of their transparent and simple structure. Continuous market disclosure is a feature because LICs are listed on the stock exchange. This means shareholders have the opportunity to gain a greater understanding of what’s in the portfolio and receive briefings from the LICs’ management team. Similarly, the structure of LICs is such that dividend payments are often more reliable and tax implications are usually more straightforward e.g. fully franked dividends and LIC gains.

ETFs:

Comparatively, Index ETFs tend to track share market indices or use a rule-based approach to investing, rather than the active management approach of LICs. They are structured as open-ended trusts, meaning these vehicles are exposed to capital inflows and outflows as market sentiment changes. The ETF structure allows investors to receive the market value of the underlying portfolio (less a small margin), should they wish to buy or sell their position. There are certain tax obligations associated with distributions from an ETF depending on its investment focus.

The key differences – LICs vs. ETFs

The close-ended structure of a LIC allows it to concentrate on selecting investments without having to factor in money coming into or leaving the fund. This stability assists in taking a long-term approach to investing. It also allows the portfolio manager to take advantage of weak market conditions when value may be on offer as the LIC does not need to manage redemptions in a difficult market. In contrast, when the market is running strongly, a LIC does not have to buy holdings when value may be more difficult to identify.

ETFs, on the other hand, are exposed to redemptions and issuance depending on market sentiment with no control over the investment timing or process.

As a company structure, LICs can choose to retain earnings and reinvest them or pay out earnings as dividends. LICs pay company tax on their earnings and can pass through franking credits along with their dividends. This flexibility in the distribution of dividends allows them to potentially smooth out dividend payments over time. This is very important to many LIC investors focused on more certainty of income.

ETFs are unable to retain earnings so these vehicles must pass on any earnings – dividends or realised gains – within any given financial year meaning distribution may be more variable.

Both LICs and ETFs can appeal to retail investors, so it is the responsibility of the financial adviser to review the underlying performance of the fund, the cost and the track record of the people managing the money to ensure that the vehicle aligns with their clients’ best interests.

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[1] http://www.morningstar.com.au/s/documents/201706_ASX-LIC-NTA-Report.pdf
[2] http://www.asx.com.au/resources/newsletters/listed_at_asx/20090820_market_performance.htm
[3] http://www.treasury.gov.au/PublicationsAndMedia/Publications/2011/Economic-Roundup-Issue-2/Report/Part-1-Reasons-for-resilience
[4] http://www.asx.com.au/about/corporate-overview.htm
[5] http://futureofadvice.treasury.gov.au/content/Content.aspx?doc=home.htm

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The Australian market has risen strongly over the past twelve months as investors embraced a more positive outlook for global growth. In particular this led to rising commodity prices, with the resources index up 22.9% over the period after two years of underperformance. The banking sector also enjoyed a strong rebound over the year to produce a return of 18.4%. This was somewhat surprising given the headwinds the sector appears to be facing from regulatory and economic conditions as well as new taxes/levies. However the dividend yield on offer in this sector remains attractive for income-focused investors

AFIC’s portfolio was up 11.7% for the 12 months to 30 June 2017 compared with the S&P/ASX 200 Accumulation Index, which increased 14.1%. AFIC traditionally invests in the large resource companies such as BHP and Rio Tinto and so the portfolio was not exposed to the significant rise in the more cyclical, mid-sized resource companies which increased by approximately 76% over the period. In addition, whilst the portfolio maintains a very strong representation of the four major banks, AFIC’s exposure of 24.5% is below the 28% Index exposure to this sector.

The longer term performance of the portfolio, which is more in line with the Company’s investment timeframes, was 6.1% per annum for the 10 years to 30 June 2017, versus the Index return of 5.2% per annum (these returns include the full benefit of franking). AFIC’s performance figures are after expenses and tax paid.

Portfolio Adjustments

Major purchases included Link Administration Holdings which is new to the portfolio. AFIC also added to this holding through participation in its share placement to purchase Capita Asset Services in the UK. Carsales.com and Isentia were also added to the portfolio. Other major additions were to existing holdings in CSL, Brambles (following the recent fall in its share price) and CYBG (Clydesdale Bank).

Major sales included a slight reduction in the AGL and APA Group holdings and the complete disposal of the residual position in Santos early in the year. Cover-More Group and Asciano were sold as a result of takeovers. The position in Vocus Group, which was added to during the year, was subsequently sold following a marked downturn in its outlook.

Going Forward

Many sectors in the Australian market are trading at or close to the top of their long-term valuation ranges. Whilst this may be understandable against the backdrop of very low interest rates, the
outlook for the Australian economy remains somewhat mixed. The outcome of the upcoming reporting season will be important in providing support for the high share prices of many companies.

On a positive note, global growth may continue to deliver a better than expected outcome for commodity prices. There has also recently been a pickup in non-mining investment. However, as a counter to these trends, high levels of household debt relative to real wages growth is producing a weak outlook for consumption.

Heightened taxation risk from federal and state governments in an environment where budgets are under pressure has unfortunately also become a recent feature of the Australian economy. The latest move to tax the five larger banks is in our view symptomatic of an opportunistic approach to policy. It is not a substitute for a more well-considered comprehensive approach to taxation and budget reform.

Reforms are a difficult task for any government, but we believe they are necessary to create a more robust foundation for the Australian economy going forward.

Key Themes:

• AFIC invests in a diversified portfolio of Australian equities, seeking to provide shareholders attractive income and capital growth over the medium to long term at a low cost.
• Equity markets globally have been generally buoyant with the US market reaching an all-time high in anticipation of improved economic growth there.
• The Australian market has also risen strongly, led by a rebound in sentiment toward resources and banks.
• Share prices across a number of sectors in Australia, in our view, are fully priced.
• In this context, the upcoming reporting season will be important to support market valuations.
• AFIC has cash resources available to invest in quality companies when value presents itself.

Result Summary:

• Full Year Profit of $245.3 million, down from $265.8 million in the corresponding period last year:
  • Investment income declined $15.2 million, primarily as a result of a cut in dividends across a broad range of large companies, including resource and energy holdings.
  • Trading income was down to $3.1 million (from $12.3 million), as large gains generated in the prior corresponding period were not repeated this year.
• Final Dividend maintained at 14 cents per share fully franked. Total dividends of 24 cents per share fully franked, the same as last year
• Management expense ratio of 0.14%
• Twelve month portfolio return was 11.7%; including franking it was 13.7%.

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