Building a diversified portfolio using LICs

There are around 100 LICs listed on the ASX with a market capitalisation of approximately $50 billion. LICs have been available on the ASX for decades. In fact, the oldest LIC recently celebrated 100 years of being listed.

Historically, LICs focused mostly on Australian equities and to a lesser extent global equities. However, over the past 5-10 years there has been a significant expansion in the number of asset classes and strategies available. Today investors can construct a surprisingly diversified portfolio across asset class and strategy using only LICs.

A wealth of choice in LICs

Here are some examples of the wide variety available among the LIC universe.

Why LICs

There are many alternatives to using LICs, such as ETFs and Managed Funds. So why do we believe that investing in LICs can be a superior strategy? Here are three good reasons we think LICs can be attractive.

• Above average investment manager quality, compared with managed funds.
• A stable capital base can allow the manager to more effectively implement their investment strategy.
• The ability to purchase LICs at a discount, can provide potential for additional investment returns.

In our view, by far the biggest advantage in using LICs is the potential to profit from buying LICs well. An ETF or managed fund always trades close to its net asset value (NTA). With an LIC, the ‘market’ determines the price. This can lead to situations where the share price and net asset value of the underlying portfolio vary dramatically.

There are two potential advantages of purchasing an LIC trading at a discount to its NTA:

• Returns are higher. As an example, if an LIC has an NTA of $1.00, and is trading at a 20% discount to NTA, then you can purchase the LIC for $0.80. If this LIC were to produce a portfolio return of 8% after fees and costs, than this translates into an increase in value of $0.08. However, because you only paid $0.80 for the LIC, your return would be 10% ($0.08 divided by the purchase price of $0.80).
• Discount capture. This is where you purchase an LIC at a discount to NTA, and profit from the discount reducing. We rarely expect LIC discounts to NTA to disappear completely. What we spend our time looking for is an LIC trading at a discount higher than we believe is warranted. In the example above, if you bought the LIC at a 20% discount, and that discount narrowed to 10% over time, that would result in additional returns over and above those generated by the LIC investment portfolio.

While discount capture can be an advantage, we acknowledge that it can also work against you. Discounts can get bigger, LICs can underperform, and higher fees and costs can be a drag on returns. That’s why it’s important to do your research before investing in this space.

What to focus on

To successfully invest in LICs, you must be prepared to do more work than if you were to invest in a Fund or ETF, where trading is always close to NTA.

Similar to an unlisted fund or ETF, issues we consider for LICs include:

• What is the investment strategy.
• Who are the people making the investment decisions.
• Are the investment managers suitably aligned with investors.
• The long term investment performance versus an appropriate benchmark.
• Are the investment fees appropriate for the strategy.
• Are the underlying assets cheap, fair value or expensive.

The additional piece of the puzzle for an LIC is working out what is an appropriate discount to NTA. There are many factors which affect the discount an individual LIC trades at. We believe some of the more important issue to consider include:

• Historical performance. LICs which have performed very well tend to trade at a premium, or at a lower discount than comparable LICs.
• Consistent dividends. LICs that have historically paid reliable and growing dividends are often rewarded with lower discounts or even premiums.
• Size. Larger, more liquid LICs tend to trade at higher prices relative to NTA, whereas smaller LICs are more likely to trade at a discount.
• Treating investors with respect. For example, if an LIC manager raises new capital at a discount to NTA, this has a dilutionary impact and any shareholder that chooses not to participate. If management and the board of the LIC have disrespected shareholders once by raising capital at a discount to NTA, there is every chance they will do it again.

Obviously, we prefer to buy LICs at a discount to their NTA. But there is no one rule which determines the right discount. There are a whole range of factors to consider for each LIC. A good place to start is to look at the share price vs NTA history for each LIC you are considering, to get an idea of how the discount (or premium) has varied over time. This data is sometimes published by the LIC itself or may also be available through your broker research.

The biggest mistakes we often see

Unfortunately, many investors have had a bad experience with LICs. Usually, the poor experience is the result of one or more of these three factors.

• Buying an LIC at IPO. Purchasing a new LIC at listing time, means you’re buying at NTA, or even a small premium. Quite often, over the first 12 months after listing, an LIC slips to a discount to NTA. Once this starts to happen, buyers eventually get discouraged, and sell. Rather than buying brand new LIC’s, we quite often wait 12-18 months, and then take a closer look.
• Buying an LIC based on its dividend yield alone, without considering other factors. Like any listed company, those paying the highest dividends can sometimes be “value traps”. Make sure you look at all relevant factors before buying, including the level of discount or premium.
• Paying a premium for recent, short term outperformance. Time is a great leveller, and LICs are no different. Performance tends to be cyclical, and yesterday’s winners can quite often be tomorrow’s losers. We’re more likely to buy an LIC that has poor short term performance, particularly if the long term track record is good.

Want to know more?

We encourage you to do your research before investing in any LIC. If you would like to learn more, here are some additional resources for you:

Read more about The key differences between LICs, unlisted managed funds and ETFs

Read more about How to buy a LIC at the right price

Listen to or read about our take on LICs in this Rules of Investing podcast.

Take care, and all the best with your investing.