Closing the gap: Can LICs narrow the valuation discount?

When it comes to investing, everyone loves a bargain. But while investors might prefer paying less for more, listed investment companies are facing increasing pressure over their valuations, with many trading well above or below their net tangible asset backing.

Some of the biggest names in fund management have suffered the embarrassment of sustained discounts, sparking pressure from activist investors and shareholders. Already in the spotlight due to a government review of stamping fees, LICs were hit hard by March’s market mayhem, which caused a further widening of the gap.

“The unit price should always be within about 5 per cent of the NTA,” said Morningstar’s Ross MacMillan, senior analyst, manager research.

“If it drifts too far either side of that it’s largely trading irrationally.”

A review of Morningstar’s latest LIC report shows some significant variations among the $48 billion worth of LICs trading on the ASX. Discounts in unit price to pre-tax NTA were as large as 64 per cent, while premiums reached as high as 46 per cent, according to the 31 October report.

Even some of the larger LICs were showing a large variance from their NTA. This included the $937 million L1 Long Short Fund (ASX:LSF), which had a 14 per cent discount to its pre-tax NTA and the $920 million Magellan High Conviction Trust (ASX:MHH), with a 7.4 per cent discount.

Conversely, the $7.9 billion Australian Foundation Investment Company (ASX:AFI) was trading at a near 8 per cent premium to its pre-tax NTA, while the $1.6 billion WAM Capital (ASX:WAM) was at an almost 31 per cent premium.

Among the reasons given for such variance is investment performance, dividend history and the level of marketing and communication with investors, together with the track record of management.

“This can make a huge difference for an investor—if they buy at a premium and sell at a discount, it will have a massive impact on their return,” MacMillan said.

LICs which suffer an extended period of trading at a discount can attract activist investors. One example was the campaign against the board of Australian Leaders Fund (ASX:ALF) which led to the appointment of an independent board committee to “consider appropriate capital management initiatives”.

Merger and acquisition activity in the sector is also intensifying, including WAM Capital’s bid for Contango Income Generator (ASX:CIE), led by WAM founder and well-known fund manager Geoff Wilson. This is part of a broader trend of consolidation not seen since 2003-04, according to the Australian Financial Review.

LICs fight back to close the gap

“A lot of people say the board should try and close the gap between the share price and NTA backing, but quite often this can be quite difficult to do,” MacMillan said.

“You can try all sorts of things—a share buyback, presentations to investors on why the discount is irrational. But it really comes down to the fact that there has been a lot of LICs on the market and some have been relatively too small with low liquidity, hence the gap has widened.”

MacMillan says greater attention has been put on the valuation gap for LICs following the rise of Australia’s exchange-traded fund (ETF) sector, “which tend to trade pretty close to the NTA.”

LICs are fighting back, however, with new approaches to closing the gap. After its market buyback failed to narrow the discount, the Antipodes Global Investment Company (ASX:APL) launched a conditional tender offer (CTO), which it described as common in the United Kingdom but “a first in the Australian market.”

Under the CTO, the company offered to acquire up to 25 per cent of its shares via an off-market buyback at a narrow discount to NTA. With the board planning to undertake similar CTOs “every three years”, other LICs undoubtedly will be watching the results closely.

MacMillan sees the ETFs as being more innovative, such as Magellan’s launch of “Quoted” funds. The previously unlisted Airlie Australian Share Fund (ASX:AASF) has been made concurrently available for investors to trade on the stock exchange, in addition to the traditional application and redemption process.

“The ETF market has thrown out a challenge to the LICs and I think it will be difficult for the LICs to regain their former prominence,” MacMillan said.

“The ones that will continue will be the older style, traditional LICs such as Argo Investments, Milton Corporation and BKI Investment, which have been around for decades and pay a regular stream of dividends.”

For investors seeking to tap into the LIC sector, Morningstar’s favourites include the silver-star rated Magellan Global Fund (ASX:MGF), which analyst Michael Malseed described on 3 December as a “compelling choice” for investors seeking a listed global equity with predictable income.

AFI also earned a “bronze” rating on 17 November from Morningstar analyst Christopher Franz, who described the fund as “our preferred LIC option for large-cap Australian equity exposure due to its low fees and strong investment team.”