The complete guide to LICs with Daryl Wilson

'Buying a dollar for 80 cents' is an old investing cliche that's rarely taken literally these days. In a bygone era, 'net-nets' - stocks trading below the value of their net tangible assets - were a relatively common occurrence. Some investors built their whole portfolios (or careers) around them. But finding them today is easier said than done. 

When dealing with listed investment companies (LICs) and listed investment trusts (LITs) though, buying a dollar for 80 cents is commonplace. In fact, according to Daryl Wilson from Affluence Funds Management, buying at a discount should be central to the strategy.  

Not only is it possible to pick up assets at a discount, but "the quality of managers is tremendous," says Daryl. 

In this episode of The Rules of Investing podcast, we take a deep dive into the world of LICs. We cover the basics and some common jargon, how to pick a great LIC and some common pitfalls to avoid, and Daryl shares some of his favourite LICs in the market today. 

Scroll down for a full transcript of the interview. 

Topics discussed and time stamps

• 2:17 - From accountant to LIC expert
• 8:20 - What is an LIC and why should you care?
  
• 10:23 - Some common jargon explained
  
• 16:44 - Should you ever buy LICs trading at a premium?
  
• 22:17 - Daryl's approach to discounts and premiums
  
• 26:56 - Should you buy LICs at IPO? 
  
• 30:00 - Are LIC options valuable? 
  
• 33:18 - What to look for in a great LIC
  
• 36:27 - What should you do when the LIC invests in unlisted assets? 
  
• 38:33 - Red flags and pitfalls to avoid
  
• 40:13 - Constructing a portfolio of LICs
  
• 43:39 - Three LICs that he likes
  
• 47:35 - Daryl answers our three favourite questions.
  

Books discussed

• The Most Important Thing: Uncommon Sense for the Thoughtful Investor, by Howard Marks. Available on Booktopia and Amazon.
• Greenlights, by Matthew McConaughey. Available on Booktopia and Amazon.

Full transcript...

Patrick Poke: 

Daryl, welcome to the show. Good to be chatting with you.

Daryl Wilson:

Thanks very much, Patrick. Good to be here.

Patrick Poke:

A bit of a different topic today — LICs is not something we've really discussed at length on the podcast before. I did discuss it a little bit a couple of years ago when we interviewed Geoff Wilson. Obviously he's a big fan of LICs. But you're the first LIC expert that we've really had on the show. Really looking forward to having a bit of a chat today and to getting some insights into your area of the market.

Daryl Wilson:

Yeah, it should be interesting. Hopefully.

Patrick Poke:

I'm sure it will be. Let's start, I guess, just with a little bit of background about LICs and also how you got into the sector. I mean, as I kind of alluded to, it's not the biggest area of finance, particularly when you're talking about in funds management. It's fairly popular amongst retail investors, but not a lot of fund managers are active in this space. What kind of first piqued  your interest in the sector? And why did you decide to launch Affluence?

Daryl Wilson:

Yeah. I mean, you're right. We didn't start out at all targeting LICs. We kind of came across them by accident. So the history of Affluence is that the two of us doing investing at Affluence are myself and Greg Lander, who's the co-owner of the business. And we'd worked for over 10 years together at a listed property fund manager in Brisbane called Cromwell. Got to know each other pretty well.

He's a valuer by trade and I was originally an accountant, so we're pretty conservative. And it struck us that whilst we'd spent a long time in property, there was kind of an opportunity to do something a bit wider. And the Cromwell business was a fantastic place to work. It's still very focused on retail investors; on helping people with not a lot of money to invest and sort of guiding them through the process.

And so that was one of the things that really struck a chord with us at our time there and we've taken that through to Affluence. And the germ of how Affluence started was one of my jobs at Cromwell was I used to do some of the investor relations because I was sort of running a funds management business and I've been the CFO. I literally met hundreds of fund managers over the years.

At Cromwell, one of the amazing things I found was that almost the more obscure they were, the less money they were running. The ones you'd never heard of would walk in the door and impress you tremendously. And they just seemed incredibly smart. And when we looked into it, there were some features that a lot of these really good fund managers had in common. And so we started Affluence as a manager of managers, if you like.

So our core product is not our LIC fund. That's the one we're probably best known for. But our core product is the Affluence Investment Fund. And it's really designed to kind of bring that family office style of investing to everybody. The first thing we did back in 2014, 2015, when we started, was we spent almost a year looking at every manager, every unlisted fund in Australia, trying to work out what worked, what didn't, how the outperformers did well.

And we used that to set up the starting portfolio for the Affluence Investment Fund. And to this day, it's chock full of managers who a lot of people don't know of. They're almost exclusively boutique. They have skin in the game. They own a share in the fund manager. A lot of them are actually full. So around 40% of the managers we invest with through that fund are closed to new investors and another 20% you have to be a wholesale investor to access.

So there's some great fund managers out there, if you know where to look. And so that was what we started the business with and that's what we do as our core activity. But in the course of looking at unlisted funds for almost a year, we sort of started looking at listed investment companies. And Greg went, "Hey, there's actually an opportunity here." And there's a couple of reasons we like LICs. The first one is that the manager set is actually incredibly talented compared to unlisted funds.

So it's quite concentrated. There's about 100 LICs listed on the stock exchange here in Australia. And the quality of managers is tremendous. And the second opportunity is to be able to take advantage of, and I'm sure we'll talk about this a little bit more, but to take advantage of the fact that these things can trade at discounts and premiums to their kind of underlying value.

So we came across the sector. We liked it. We started doing some work. In 2015, we started running a small portfolio of LICs within our Affluence Investment Fund. And in 2016, we spread that out into its own fund and we set up the Affluence LIC funds. So it's been going now for five, five and a half years.

Patrick Poke:

It sounds like you maybe started with a similar insight to what we did here at Livewire, which was just the incredible underappreciated talents amongst these smaller boutique fund managers. There are so many of them out there that the average retail investor in the market has probably never heard of. But I honestly believe that most of the best managers in Australia are operating boutiques.

Daryl Wilson:

I would absolutely agree with that. Because in a lot of cases, the larger fund managers, the way they risk manage the investment teams actually holds them back from making a lot of money. They struggled to outperform. There are exceptions. Perpetual is an example of a large fund manager that does a very, very good job of allowing their investment teams to do what they can to perform well. But it's quite rare. In general, what we find is the more money a manager has, the less chance they have to outperform. It's as simple as that.

Patrick Poke:

Let's assume you came across an investor who's never heard the phrase LIC before. So assume they have some knowledge of markets, but don't know anything about LICs. How would you explain to them what an LIC is and why they should consider investing in it?

Daryl Wilson:

An LIC is essentially at its core no different to any other managed fund or any other ETF (exchange-traded fund), for that matter. It's just a big investment bucket. A load of people put money into it — in the case of an LIC, through owning shares that are listed on the stock exchange. In the case of an unlisted fund, you'd buy units. But the concept is the same. There's a bucket of money, which is managed by a professional investment manager.

So the biggest difference between an LIC and other forms of pooled funds is that in the case of an LIC, or an LIT (listed investment trust) for that matter, the price is determined by the market. And so by that, I mean, if you put money into an ETF or a managed fund, what generally happens is that the price you get is determined by the value of the assets that that fund owns. So the manager adds up the total of everything, divides it by the number of shares or units, and that becomes the price.

And so the price you get when you go in or come out is based on that. With an LIC or an LIT, the price is determined by the market. So if the market loves it today, it might trade higher than the value of its assets. And if the market doesn't like it today, it might trade lower. And that essentially is one of the big reasons you might want to be investing in the sector, because that brings with it an additional risk and reward. You can actually make money if you can buy well and sell well over and above what you can actually get from the underlying.

Patrick Poke:

Well, let's go over some jargon terms that might not be familiar to those who are not already invested in this area. You actually mentioned just one of them just then. So we'll start there. LIT. What does it stand for and what is it?

Daryl Wilson:

Okay. So a listed investment company is exactly as it sounds. It's a company listed on the stock exchange that owns an investment portfolio. A listed investment trust is the same. It's a trust listed on the stock exchange that invests in a portfolio. Now, the difference between the two at its heart comes down to tax and the way they pay money to investors. So an LIC, like any company, pays tax generally at a rate at the moment of 26% or 30%, depending on the size of it.

And it pays dividends to the investors in that company. And so when it pays the dividends, depending on how much tax it has paid, they can be franked dividends as well. And so you get a franked dividend and a share of the tax credits for the tax the companies pay. An LIT uses the trust structure, which is the same structure that a listed fund, an unlisted fund and an ETF use.

And then there's what's called flow-through vehicles. So they don't pay any tax at all. And so what happens there is that they essentially just work out how much of the income they get is taxable. And they let you know that every year and you put that in your tax return. And they pay a distribution rather than a dividend. So to make that really simple, if a listed investment company made $100, it would pay $30 of tax, and it could distribute $70 out to investors.

A listed investment trust would make $100 and it would pay no tax and it could distribute the entire $100. So in some cases, actually, an LIT is a better structure because you're going to be able to get potentially a higher cash distribution, but less tax credits. But everyone has a preference. Some people love their franking credits, others prefer more cash. So it comes down a little bit to a personal level.

Patrick Poke:

The next term, NTA. What does it stand for and what does it actually mean or what's its importance?

Daryl Wilson:

So NTA stands for net tangible assets, or sometimes NAV is a term that's used, which stands for net asset value. It's a similar concept. So I spoke before about the fact that managed funds work out the value of their units or their shares. So an NTA for a listed investment company or listed investment trust is simply taking all of the value of the assets it owns, investments it owns, and dividing that by the number of units or shares that are on issue.

So if it has a million dollars worth of investments and a million shares on issue, the NTA is going to be $1. And LICs and LITs, under the ASX listing rules, they have to put that number out every month. They get 14 days after the end of the month to calculate it, which is quite generous. So by the 14th of each month, every LIC and LIT has to tell the market what their NTA was for the previous month.

And that usually comes out in two ways. They have a before-tax and an after-tax NTA. So you can understand potentially if they had a lot of tax to pay, if they sold all of their portfolio, you can understand it by looking at the difference.

Patrick Poke:

It seems a lot of the LICs these days are actually kind of exceeding their their regulatory requirements and declaring those NTAs more often than that too. Is that right?

Daryl Wilson:

Yeah. Look, there's a range of different treatments amongst individual LICs. And you're right. There's generally been a trend to disclose that value more often. So there's quite a lot now that will disclose weekly and there's a few that will do daily. So you get everything from knowing what it is essentially every day to those who will wait right to the last minute to tell you what the NTA is 14 days after the end of the month.

And that's part of what creates opportunity for us because we're quite active in the space, particularly for those that disclose less often. If the market's moving around and the value of their investments is moving around, we can estimate with reasonable certainty how that NTA is changing, but the market might not necessarily be totally aware. There aren't many cases these days where you can have an information advantage over the market, but that is one case where if you work hard, particularly in a market that's moving around a lot, you can glean some opportunities from that.

Patrick Poke:

One more term for you to define for us. It's technically two terms, but they are closely related to each other. And that's discount and premium.

Daryl Wilson:

Yeah. So that's a good one and it really goes to the heart of where the opportunity is in LICs and LITs. So the discount is when the share price is lower than the NTA and the premium is where the share price is higher than NTA. So if you're paying a premium, you're paying more than the value of the investments that the LIC holds. And if you are buying something at a discount, you're paying less.

And so for us, the perfect scenario is that we can buy at a discount. And hopefully over time those discounts and premiums can change and they can change quite a lot through a full market cycle. So the real advantage for us or one of the big advantages or the opportunities is to be able to buy it at a decent discount and sell it at a lower discount or even at a premium. And so then again, you're making money not only from the underlying performance of the manager, but you're also making money from that discount premium changing.

Patrick Poke:

Would you ever consider investing in or continuing to hold LICs that were trading at a premium?

Daryl Wilson:

We do from time to time. It's rare that we do. But what will happen from time to time — we actually saw it recently in WAM Leaders, for example (WLE is the code), where it was trading at a premium. They did a capital raising, it traded at a discount for a little while, and then it's been trending back towards a premium. So we held it through that process. We participated in the capital raising, we held it through until it traded at about 4% or 5% premium and we have sold a bit recently. So we would do, but it's rare. It would be rare that more than 10% of our portfolio would be trading at a premium because there's generally always opportunities to buy at a discount. So we tend to prefer to be owning things that are cheaper than they should be.

Patrick Poke:

Well, over the last, I guess probably three or four years that I'm aware of — it might be a longer running trend than that — but in the last few years, there's been a pretty noticeable trend of these larger LICs trading either close to NTA or at a premium to NTA in some situations. Why do you think it is that these larger LICs are more popular and draw more capital? And do you think it's sensible for people to be buying them at premiums?

Daryl Wilson:

Well, I don't think it's sensible. No. But it's just a feature of the market that I guess you just have to take into account when you're looking at the sector. So if you unpick that, there's a couple of trends happening. Firstly, the larger LICs, and certainly the ones that have been around the longest, if you look at one like AFIC, for example, which is the largest LIC out there. It's been around for 50 or more years, I think.

It tends to trade quite close to NTA; small discounts, small premium, most of the time. And it's just got a rusted on group of shareholders who tend to buy it, maybe add to it over time, but very, very rarely ever sell. And it's similar for a number of others. Milton is another one, although that's recently been taken over. WAM Capital, the largest of the WAM asset management vehicles is another one that has traded at a premium.

And so the reality is it's no different to the ASX 20. They might not be the best companies out there, particularly with the rise of passive investing, people just view that bigger is better. And so that's where the money flows. For us, very much our sweet spot is not that. Our sweet spot is the medium-sized LICs. So they tend to be the ones which are between, let's call it $100 million market cap and maybe about $800 million or $900 million.

And the reason for that is there's a lot of differentiated strategies in that space. There's a lot of exciting fund managers. And the discounts and premiums tend to move around a lot more. So that gives us more opportunity. So we don't tend to own the very large ones very often because there's just not enough variation in alpha in that space. But we tend to be in that middle ground.

Patrick Poke:

Why not the smaller end? Are there reasons that you tend not to go to the small? I mean, the LIC market goes a long way down. There are some really, really tiny ones, which I'm sure most people have probably never heard. So is there a reason you're avoiding those kind of, well, not avoiding, but less inclined to invest in those sub $100 million ones?

Daryl Wilson:

Look, we do invest in quite a lot of smaller ones. One of our larger holdings, in fact, is an LIC called NGE Capital. And it's got a market cap of probably $25 million. But it's quite illiquid. And so our constraint as a fund manager tends to be liquidity. So we're limited in how much of those types of investments we can hold. There's an LIC called AIQ, Alternative Investment Trust. It's, to us, a very attractive investment proposition, but it really trades by appointment and it's just too illiquid for us to hold it. So some of those smaller ones we'd probably like to own. We'd be very happy to own. If it was me personally investing, then I'd be very happy to own them. But as a fund manager, you do have to have some regard to liquidity. So that does limit what we look at.

And there are others, certainly. A lot of the smaller ones tend to be quite opaque as well. So quite often they just don't make the cut for us. There's just over a hundred LICs out there now and LITs. Our investment universe is probably 70 of those. We tend to chop off the very large ones most of the time and we tend to chop off the tail a little bit. But we've always got plenty to choose from.

Patrick Poke:

Forgive me if you feel like you've already covered this, but we've spoken a little bit about the discounts and the premiums. How do you actually think investors or how do you personally approach the issue of discounts and premiums? When you're looking at a discount, what are you trying to work out? What is a good discount and what's a bad discount?

Daryl Wilson:

Well, that's the bit of LIC investing I think that's more art than science. But I'll give you a sort of an idea as to how we approach it. I think, first of all, for the average investor out there, what we do is quite intensive because we're looking every day at the LICs. We're trying to work out where the current NTAs are and how they're moving around. But if you look at it as a whole of cycle opportunity and you say, okay, maybe once in every 5 to 10 years we're going to have a big market correction.

And when that happens, the market's going to fall, obviously, which means the investments most of the LICs hold will fall. So their NTAs are going to fall. Their share price will fall. And what also tends to happen during that time is the discounts across the board on average get bigger. And so the average at the moment is about not much. In March last year, the average was probably 20% to 25% discount. So once a cycle or twice a cycle, you're going to be out to buy LICs that have assets that are cheap because the value of them falls and they're going to have a bigger discount than average.

And then maybe once a cycle, people are going to get super excited about LICs and all those discounts are going to close up and turn into premiums. And the prices will rise and the NTAs are going well. And so they'll be much less attractive. And so as an investor, I would be saying, well, okay, look, the time to think about LICs or increasing your exposure is actually when markets fall and there's lots of opportunities.

And maybe then you scale that back a little bit when everyone's excited and you wait for the next opportunity. So at its simplest, that's the way I would think about it. For us, we use a simple theory when we're looking at discounts. We think of an LIC — in fact, any investment we make — we look at it over a three-year period and we say, well, what can happen over the next three years?

And for every LIC, the right discount is different. For some, the right discount is really not much, or maybe even NTA. For others, we wouldn't buy it at a 20% or even a 30% discount. And there's a few factors in that: size, what they're investing in, how well the manager markets the LIC, how long it's been around. There's a whole lot of factors. But the simplest way to think about whether it might be a good opportunity is to look at a particular LIC and say, okay, what is the discount or premium now and what has it been over the life of its existence?

And so just one quick, good example of that right now, there's an LIC called Djerriwarrh. DJW is its code. And it's been around for quite a long time. It's run by the same team that run AFIC. And it has a similar investment portfolio, except that as well as investing in Aussie shares, it also writes call options to generate a little bit of extra income, which potentially gives away a little bit of capital gain. But very, very similar to AFIC.

Djerriwarrh's history has traded at a premium a lot of the time. It's as high as 40%. But more recently, for a bunch of reasons, which are valid, it's actually fallen into a discount. And so it's one of our better holdings right now, because right now Djerriwarrh is trading at maybe an 8% or 9% discount. And AFIC, which is essentially from the same stable, run by the same team, is trading at about an 8% to 10% premium. And so we think that differential is not right.

And we also think that relative to where Djerriwarrh has traded over the long, long period of time, it looks cheap. So there's an example where we think it looks cheap. There are others we might sell when they got from a 25% to a 15% discount, because that's about as good as we think they can get. So it is different for every LIC.

Patrick Poke:

A few years ago, there was a spate of new LIC listings or IPOs (initial public offerings) that seems to have fallen out of fashion a little bit for now. You probably have a longer history of the industry than I do, but I'm guessing these things probably run in cycles, like everything else.

Daryl Wilson:

They sure do.

Patrick Poke:

But look, there are some advantages to investing in an IPO. You often get the options that come along with it and things like that. But there are some risks that come along with it as well. I mean, all things considered, do you think that it is good to buy LICs at IPO or not?

Daryl Wilson:

Almost never would be our answer. You're right. There was a lot of IPOs between about 2016 and 2018. We probably participated in about one in every five of those, and we probably wish we hadn't bothered with half of them. So generally speaking, and I guess that's the case with IPOs generally. The basic rule of thumb is, as an individual investor or even as a smaller fund manager, the ones you can't get access to because they're massively oversubscribed are the ones you probably should have and the rest, it's probably not worth it.

So what's amazing about IPOs is they go through this fairly discernible pattern, particularly LICs, where they might list. They might trade at a small premium for a little while, maybe a few months, maybe a few weeks. And then they struggle for maybe a year or two after that and they go to a discount. And the discount keeps getting bigger. And the main thing that determines how sort of messy that gets is the performance over that first year or two.

But quite often what we've found is a great time to buy an LIC can actually be six months, 12 months or two years after it lists, because that's when it's sort of least favourite from a market point of view. And so you can potentially pick them up at a pretty decent discount. And we've done that quite successfully for quite a number of LICs I can think of.

Having said that, what we're seeing at the moment is not a lot of new LICs coming to market, but we are seeing quite a lot of LICs do capital raisings in various forms. Share purchase plans, rights issues and placements. And so we are selectively participating in some of those. And we think that's a good thing for the sector. The golden rule there to managers is just don't raise at a big discount to unit asset value because that really is just destroying value. So as long as they're not breaking that rule, there can be some opportunities there.

Patrick Poke:

Around the kind of back end of that period we were just referring to, there were a lot of IPOs. So there was a little bit of a controversy about those LIC options, which are often given at an IPO. And there was someone on one side kind of saying, "Well, they don't actually have any real value. You're just borrowing from yourself essentially." And others were saying, "No, no, these are a real thing. They do have genuine economic value." I don't suppose you would have an opinion on that topic that you'd be willing to weigh in on, would you?

Daryl Wilson:

Oh, look, yeah, we have an opinion on everything! Look, options can actually be a good tool. Because if you think about it, if an LIC issues options today, again, provided they're not exercisable or issued when it's trading at a big, big discount and therefore they're not diluting existing shareholders too much, that could actually be a good tool to grow capital because what happens is options get issued today by the LIC at somewhere close to the trading price and the NTA maybe.

And they might have one or two years or three years to run. And so if the manager does a good job, the options become valuable. They become exercised. The LIC gets bigger. But all of that only happens because the shareholders have had a pretty good journey — the LIC has actually made money. So for that reason, they can be good. And if the market does poorly or the LIC falls, then they tend to not get exercised. And again, no one gets hurt. The LIC doesn't grow and they effectively expire worthless. So they can be useful, as long as they're used for good, not evil.

At the moment, there are a few LICs that are issuing bonus options. So if you're a shareholder, you get them for free. And they do have a small value — they tend to. And then, again, you can decide as a shareholder whether you'd like to hold on to them, sell the options themselves on market, or wait until closer to the expiry and make a decision on exercise. So look, the only negative is that they do tend to obviously complicate the capital structure a little bit.

So you have to be aware of whether an LIC has got options on issue, because they dilute the upside, if you like. Because obviously if the share price goes up a lot, more are going to get exercised. And so that's going to have some sort of effect. But at the moment, we own, for example, options in two or three LICs. One we've bought relatively recently is PIC. Perpetual has an option which expires in about a year.

It's pretty close to where the current trading price is and we're buying it sort of one and a half cents per option. So it becomes like a very cheap option. Essentially, if they do very well over the next 12 months, then we can make good money out of that. If the market does poorly or the LIC does poorly, we haven't lost much. So there are times when that make sense.

Patrick Poke:

Well, let's get into the actual kind of analysis of an LIC. What are some of the, I guess, highly desirable attributes that you're looking for when you're sitting down and assessing an LIC?

Daryl Wilson:

Look, I think at the heart of it, we've talked about being able to buy at an attractive discount. So that's a given. The other important thing for an LIC is that the manager shows respect for shareholders. And by that I mean really that they're doing the things they need to do to try to make sure that the LIC trades consistently well. So regular marketing, explaining the investment performance, what's going well, what's going poorly, where the opportunities are and aren't.

So we need to be able to understand what's happening with an LIC and how the manager's thinking — not doing anything silly with the capital structure that destroys value. And then a lot of the other features we look for in an LIC are very, very similar to the features that we would look for in an unlisted fund. So we want to see that the investment team has skin in the game and preferably in two ways: preferably by having an investment in the LIC itself, but also by owning a share of the manager so that they're doing well.

We like performance fee structures. We like LICs that have perhaps a lower base fee and a performance component. And that's the same way we work with all of our funds. We don't charge any base fee at all. We are 100% performance remunerated. So that means if an LIC does well, if we do well, our investors do well — everybody's happy. And then I think we also look at what the investment strategy is.

And the reason we like to know that is if you're going to put a portfolio of LICs together, you really need to understand how each LIC is going to perform in different markets and how it might be differentiated from another LIC. And that is even the case if they're both investing in a similar market. They might go about it in very different ways. For example, one may be growth focused and one might be value focused.

And certainly over the last 8 or 10 years, you've had very different results. The growth managers have tended to go exceptionally well, the value managers not so much. So there's differences there you need to take into account. And then, of course, we'd like to see that the portfolio of investments that the LIC owns, the underlying shares or whatever they happen to be, we like to see that that's attractively priced as well.

And that's a bit harder in the current environment with equity markets having had such a good run. It's certainly getting harder to find pure value in the LiC portfolios. So that's a rundown of the key things. There are a lot of other things we look at, but those tend to be the big, big things we focus on.

Patrick Poke:

Do you take any additional precautions? Some LICs invest in assets that are not easily priced — they're not traded on a public exchange or the like. Do you take additional precautions when you're dealing with that to make sure that the underlying assets are actually being valued and priced correctly?

Daryl Wilson:

Look, we certainly do. And most LICs will publish, even if you have to dig through the annual report to find it, you will find some information about how they value those assets. And I would say most of them these days that are invested in illiquid assets — it could be, for example, private equity or debt or any number of things, farm land in some cases — they're generally pretty good at pricing them. It's just that they tend to price them with a bit of a lag.

So we tend to factor that into our assessment. And what that means in some cases is we might demand a bigger discount for the fact that we don't know for sure how that valuation might have changed. In other cases, it could be a good thing. So for example, at the moment, three of the LICs we hold are codes CD1, CD2, and CD3, and they're invested primarily in US private equity.

Now, they do revalue those reasonably regularly, but there's always a lag. And so because US markets have had such a strong run, they tend to be announcing reevaluations upwards at a regular basis because the markets have gone pretty well. But there's probably still a bit more to come because maybe they were valuing them three or six months ago and the markets have moved since then. Having said that, we're a little bit wary about the US market right now. So our opinion has probably changed in the last two or three months. But up until then, they were some of our certainly better holdings for the last year.

Patrick Poke:

Beyond the possibility of an LIC trading at a premium, are there any other kinds of red flags that might cause you to just go, "No, this isn't right for our portfolio"? Whether it be a temporary or permanent thing, just something that's going to instantly exclude it from consideration.

Daryl Wilson:

Yeah, definitely. I probably mentioned a couple already. Certainly rising capital at a big discount is a no-no. So we tend to look at what the manager is doing. And some managers, their business model requires them to grow their funds under management. And so you can be sure, any opportunity they get, they'll rise capital. And so we tend to avoid those. There are some that are just too small and too illiquid for us to invest in well.

And so we, in some cases, reluctantly, give those a miss. We want to see clarity on the investment strategy. So if we see an LIC that has a kind of opaque strategy or it's not clear, a lot of investment staff turnover, we don't like that at all. So we very much believe that performance comes from the key people making the investment decisions. And if they change, it's less likely to perform the way it has in the past.

So that's something we would perhaps take time to understand. So they're probably the big things. But generally speaking, as I said, the quality in the LIC sector is pretty high. So we're pretty excited generally about the opportunities. There's always something that gets us interested.

Patrick Poke:

Of course there's kind of two levels to managing a portfolio. If we were talking public equities, we'd say stock selection and portfolio construction. It's largely the same for you, except it's LIC selection, I guess. But I want to talk about the actual portfolio construction. How do you approach that? How do you think about it? How do you go about diversifying your portfolio? So I'm sure it'd be nice just to buy the things with the biggest discounts, but there's always a little bit more to it than that. So what's your approach there?

Daryl Wilson:

Yeah, there sure is. So first of all, I mentioned earlier, we have three-year investment periods. So when we look at an LIC today, we think about how it might perform over the next three years. How will the investment portfolio go? How might the discount or premium change? So that kind of gets it into our bucket of interested or not interested.

At any given time, we would have between 20 to 35 LICs in the portfolio. And where that comes out is largely a factor of how many opportunities there are. So again, if I go back to 12, 18 months ago, post the COVID dip, we had 35. We were at the maximum because there were just so many opportunities. Two or three months ago, we were probably near the bottom end of that range. We only had about 20 and now we've got about 25.

So that's one idea of how many opportunities we see. And individually position-sizing within our portfolio, a large holding for us is 5% to 7.5%. It's quite rarely that an individual LIC would be more than 7.5%, but it could go to 10%. At the smaller end, 2.5% is probably a reasonable position for us. And we wouldn't really hold anything less than 1%. So that's how we think of individual LICs. And then we take a top-down view. So that's the kind of the opportunity set. And then we adjust that for how we feel about markets.

So right now we're feeling a little bit less comfortable. So we would be carrying more cash than normal, and we'll have some put options in place to protect us against down markets. So at the moment, our market exposure in our LIC portfolio is probably between 50% and 60%.

Patrick Poke:

I take it when you say put options, you mean on the market, not on individual LICs?

Daryl Wilson:

That's correct. Yeah. As far as we know, we can't get put options over individual LICs. Usually we would just use the ASX 200. So it's not a perfect hedge, but it does allow us to... there are times when we still find plenty of LICs that we'd like to own, but we're not so comfortable with the total market exposure. And so we will use put options or in some cases we'll take forward hedges directly to kind of hedge out some of that market. So the US private equity LICs, as I mentioned earlier, we still own them, but because we're uncomfortable about the US markets, we've hedged out a fair chunk of the underlying market risk that they might have.

Patrick Poke:

I know we've discussed a range of different LICs and you've touched on a few of them, but could you pick out maybe one or two that you think offer particularly attractive prospects today? Just give us a bit of a rundown of what it is that you like about those particular LICs.

Daryl Wilson:

Yeah. Well, I think I've already mentioned one. Djerriwarrh, that's certainly one of our top three positions at the moment. So I won't go over that one again. But we think that's a good combination of a reasonable discount, a good team, a good yield. Another couple we like at the moment, we like Sandon Capital, which is SNC. They're coming off a capital raising, so their share price has been just a little bit soft recently.

But certainly they've got a really good track record. They run an activist strategy. So it's quite different, even though they're investing in mid to small cap Aussie equities mostly. Because they've got that activist focus, it tends to get quite a different opportunity set to your standard equity fund. It's got a very good yield. The discount is, okay, at about 11% or 12%. And we think if you look at it over a three to five year term, Sandon can do very well.

The other one we quite like is WAM Alternatives, WMA. Now it's the old Blue Sky Alternatives, but taken over by Geoff Wilson's WAM Capital last year. (Ed's Note: Wilson Asset Management, not WAM Capital, took over the management agreement of WAM Alternative Assets.) Their portfolio is quite good and they're carrying that 25% cash at the moment. So they are adding new investments to the portfolio. So that's certainly different. It's a combination of agricultural water rights, some private equity and some real estate. So it very much is that alternative asset bucket.

And the other feature we quite like is it's trading at a discount, maybe 10% or 12%, but the manager agreement was adjusted last year to specifically incentivise the manager to get it trading at net asset value. And if that doesn't happen at specified periods within a five-year term, then the manager has to put a resolution to shareholders to wind up the vehicles.

So that's similar to what we see in other markets like the UK, for example, where periodically the investors get to vote on whether an LIC should be wound up. And that kind of makes managers very focused on making sure they don't trade at a really big discount for a long time. It's certainly something we would like to see more of. So that'd be useful. Those are three quite different ones there, I think.

Patrick Poke:

When it was still the Blue Sky Alternatives Investment Trust, if I recall correctly, they had quite a large holding in student accommodation, which is not something I've really thought about for several years. But in light of COVID and closed borders, I'm just kind of curious, do they still hold those assets? And if they do, how have they performed over the last few years?

Daryl Wilson:

No, they don't own them. By good luck or good management, they sold out of most of them, I think, about two years ago — in fact, some of them even at a premium to the carrying value at the time. So I think it's fair to say they would have been tough assets to own for the last eight months or so for obvious reasons. But no, they did manage to get out of those. So the biggest holdings now I think are probably the water rights, which is about a quarter, and agricultural assets is maybe another 20%. And then private equity and the real estate components are quite small. I think there'll be more infrastructure that will go in there. And even though it's alternatives, it's actually quite diversified.

Patrick Poke:

Well, that's the end of the main part of the interview. But I have three favourite questions that I like to ask every one of my investors. I know we're nearing the end of the time we had scheduled, but if you've got maybe another five or 10 minutes to hang around, we can jump into those now.

Daryl Wilson:

Love to. Sounds good.

Patrick Poke:

Excellent. Could you tell me about a book that's been particularly influential on your investment philosophy? What did you like about it?

Daryl Wilson:

I want to say, I don't read many books any more. I read a lot of books when I was younger. These days my reading more often tends to be blogs and various small pieces that I can digest quickly.

Patrick Poke:

Like on Livewire?

Daryl Wilson:

Exactly. I think it works well to our shorter attention spans. But I will say there's two I'd mention. One is completely unrelated to investing and one is very related. So the one I would say first is Howard Marks. And you've probably heard this one before, I would expect. He's written a couple of books. But the first book that really struck a chord with me is called The Most Important Thing. And that is born out of the fact that Howard Marks started out investing essentially in distressed debt and built a massive business in the US out of that.

But he used to go and see his clients and he'd say "The most important thing is this ...". And then a week later, he'd say "The most important thing is that ...". And it'd be something different. And so eventually he kind of collected all these thoughts together and came up with about, I think there's about 12 or 13 most important things. And there's two reasons I like it. First thing is that all of the most important things he names are in fact to us very important.

The way he thinks about markets is very similar to our own philosophy in terms of having a value focus and thinking about market cycles and buying things when they're demonstrably cheap and being prepared to wait. But finally he has this knack of explaining complicated concepts very, very simply and getting right to the heart of the matter. So I would suggest for anyone who has at least an ounce of a value focus somewhere in their DNA, that would be a great book.

The second book I loved recently was actually Greenlights, which is Matthew McConaughey, the actor's, kind of life story, if you like. And it was an interesting experience. I read a lot of things not related to investing these days and I think it helps with your investing mindset. It's just a combination of he's done quite a few pivots in his life. He'll have periods of dedication and focus, followed by him going off on a tangent for two years, doing something completely different. I found it a real eye opener to read particularly biographies these days from people not necessarily in the funds management space. I think it just gives you a completely different perspective.

Patrick Poke:

As always, I'll put links up in the wire for this podcast to both of those books for Amazon and Booktopia. So our listeners, if you didn't catch the name, or if you would just prefer to click on a link, just go to livewiremarkets.com, navigate to the wire for this podcast and you'll find the links in there. Could you tell us about your biggest gain or loss as an investor? What were the most valuable lessons that you took from the experience?

Daryl Wilson:

Look, I think I came to investing quite late, actually. Because I was an accountant for a long time. But personally, I think the best investment I ever had, I mentioned my time at Cromwell. And so personally, certainly the best investment we've ever had is Cromwell. The interesting thing about that business, is the power of a growing funds management business is enormous.

And so one of the areas we look to invest a small amount of money in our funds is actually into the listed funds management space. And Cromwell is a company that went from a cent a share to over a dollar. So it basically went up 100 times over a period of about 11 or 12 years. And that was all down to the fact that by being fairly capital light and being able to grow that business quite quickly for a number of years, it was able to do very, very well. So that was certainly one.

And certainly, I would think in the LIC space, in the last 12 months, we've had a number of investments that have gone up by 50% to 100%. Regal is one LIC that's done well. And L1 LSF is the other one that's done exceptionally. So again, it comes down to being prepared to put some money to work when there's real value on offer and to sort of close your eyes. And again, take that 2, 3, 4 year view and just put some money to work. That's something we would encourage anyone to look at.

Worse investments. We tend to be quite conservative and we don't tend to buy and sell quickly, but regularly we do buy options. They're a very small part of our portfolio in all cases, for all of our funds. We buy call options. I mentioned PIC earlier. We buy put options over the market. And we quite often lose 100 per cent of that money. But the reason it's there is that if we win, we will make multiple multiples of our money.

And so we're using those either to hedge or to perhaps take some advantage of some potential for upside if we think that's out there. So investing is a combination of two things. It's a combination of how much you might win or lose, and what's the chances of each of those things happening. And so sometimes we'll certainly put some money into something where we might actually lose a small amount in order that we might win multiple times that. And we think this may be a 50% chance or better of us winning. So it can be an interesting space to play, but it's not for everybody. You've got to be very careful.

Patrick Poke:

I have one more question for you. But before I ask it, I always like to insert a little bit of a disclaimer. Don't try this at home. I'm not actually suggesting to anybody that they go out there, put all of their money in a single stock, and forget about it for five years. This is supposed to be a bit of an exercise in long-term thinking and hopefully a little bit of fun. So with that being said, if the markets were going to close for the next five years, starting from tomorrow, and you could only own shares in one company, what would it be?

Daryl Wilson:

I like your disclaimer, because I would never put 100 per cent of my money to one company. If I'm thinking about this, here's what I'm thinking. Firstly, I've mentioned we've got a bit of a value bias. In fact, it's a fairly big value bias as investors. That makes us a little bit contrary. And so if I look around and I say, okay, where is the value right now? It's actually quite hard to find it. But if I look at small-cap Aussie shares with a value bias, there are some extraordinary opportunities on offer. And so then if I say, how do I take advantage of that? Then I come up with an LIC that focuses on that area. And the LIC is TOP: Thorney Opportunities. In fact, I think you might have actually had Alex Waislitz on the podcast before.

Patrick Poke:

I did indeed. He's been on twice, but the most recent one was only just a few episodes ago.

Daryl Wilson:

Well, he'll love me then. So the reason I like it is because of the opportunity set. There is a massive opportunity in small value. That particular LIC, Alex runs two. There's a tech-focused one, which has done exceptionally well and is trading pretty close to net asset value. And TOP, on the other hand, has done exceptionally poorly and is trading at a 25 odd percent discount to its net asset value.

If I look backwards, I go, why would you own that? But if I look forward, I say, well, actually there's an incredible opportunity over the next three to five years in small cap Aussie value, and that's where I want to be. So I would be buying that. It is one of the larger holdings in our LIC fund, I would say that as well. It's concentrated. There's a little bit of activism involved in that investment strategy.

Sometimes you have to push and prod management of some of those investments to get things happening. There's also one or two unlisted investments and some other things we like. So there's a lot to like about TOP. The only thing I would say against it is the fee structure is quite horrendous. So if you're fee sensitive, you're not going to like it. But if you can look through that, and we think your fees aren't great, but the upside on offer is quite tremendous. So that would be my pick, if you forced me to pick one, which you did.

Patrick Poke:

I did. I did. Well, Daryl, thanks for playing along there. And thanks for sharing your thoughts and your insights on the LIC sector with us today.

Daryl Wilson:

No problem. Very, very happy to do it. I enjoyed it.

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