Why LICs may be close to bottoming

For those interested in the Active / Passive Debate a couple of observations.

The 'S&P Dow Jones Indices Australian Scorecard' is the principal source of the 'proof' that Active Managers consistently underperform benchmarks. But the facts is that it assumes that investors naively (or randomly) invest in managed funds with retail fees. Having spent over 50 years working in institutional investing I can assure you that this in not the case fro Institutional Investors.
In reality institutional investors:
a) Pay only a small fraction of retail fees; and
b) Not investing with the average manager - due to the manager search that they carry out.

The net result of this can be seen in the performance of Australian Super's and Hostplus's actively managed and indexed products, which have been running for over 10 years.

Australian Super: Periods to June 2023
Option Investment Fees 1 Year 2 Years p.a. 3 Years p.a. 5 Years p.a. 7 Years p.a. 10 Years p.a.
Balanced (Active) 0.50% 8.22% 2.60% 8.23% 6.72% 8.14% 8.60%
Indexed Diversified 0.10% 11.56% 2.57% 7.44% 6.44% 7.18% 7.22%

Active Outperformance -3.34% 0.03% 0.79% 0.28% 0.96% 1.38%

i.e. The Actively Managed product has consistently outperformed after fees (by 1.38% p.a. over 10 years) even though active investment management fees have been 0.40% higher each year.
The equivalent Hostplus products show similar levels of consistent outperformance.

Unlike the S&P Scorecard (and recall that S&P are in the business of selling index data to index managers) the Australian Super and Hostplus products are real funds that real investors have had investments in over the last decade.

It's complicated.

1. I see the "retained funds to guarantee dividend" argument as a negative. Some LIC's have many years worth of dividends sitting in an account, being charged fees. Why doesn't the manager reinvest it, to increase dividend? Why not pay it out, so the investor can reinvest? When will shareholders actually receive value from these parked profits?

2. Some of the big old LIC's, like AFI, used to pay above market dividends. Good time to buy & hold. But now they pay below market dividends. Why should anybody buy now?

3. likewise with NTA calculations. Why should a new investor buy a tax debt? I can buy the underlying shares without a tax liability.

4. I have flirted with LIC's. I like the concept, but reality is often different. I currently own GVF, D2O & VG1. All were purchased at significant discount to NTA, pay strong dividends in a timely manner. But mostly they do things I can't do directly, and this is the essential factor, for me. It helps tolerate the inherent deficiencies, knowing I don't have a better alternative.

5. Buybacks are rife, and don't work.
Wilson's & Plato seem to have shown that paying a strong dividend does more for the share price than a buyback

1) Sounds like a bit of a misunderstanding of what retained earnings is about. Can you name a LIC that holds this in cash purely as a reserve and not for some other reason?

I suggest reading the comments on this previous post which highlight retained earnings as purely an accounting measure that measures whether franking can be applied to a dividend: https://www.firstlinks.com.au/lic-dividend-coverage

Regarding buybacks, you're right that they don't often have the desired impact, though the recent buybacks from AUI and DUI seem to be having some effect already. And it's worth noting they don't just support the immediate share price but are also NTA accretive.

Thank You, JM.
I had no idea the concept of retained earnings was so arbitrary. I am naive enough to have thought it a real quantity of funds, in the LIC's possession.

You are spot on about retained earnings being an accounting measure that measures dividends that can be paid out. I am not sure retained earnings or dividend coverage in an LIC (perhaps these are different things?) necessarily indicates that there are sufficient franking credits to pay franked dividends.

I know Wilson Asset Management regularly publishes the amount of dividend coverage on the LIC’s they run but recently they have had to pay only partially franked dividends in some of these companies because they had insufficient franking credits.

I've never understood the regular bagging of LIC's, nor investor dislike of buying a share at a cheaper price than its true value, or management embarrassment about their higher yielding portfolio.
Let's assume an LIC is trading on a Market Cap. of $80,000,000, but at a (not uncommon) discount of 20% to the NTA of its underlying portfolio, $100,000,000.
If the underlying portfolio is generating a net return of 10% - that is, $10,000,000 .... then the LIC's yield is a very heathy 12.5%, being $10million on its (purchasable) trading value of $80,000,000.
Now, I'm no rocket scientist, but what that (and the performance of my portfolio) tells me, is that I'm getting something for which I'm not paying full price. I'm still able to assess the holdings in the portfolio as well as the calibre of the investment team, who are often similar personnel as for a comparable ETF - where you'll get NO discount and usually NO franking credits.
But as long there are those in the market willing to suppress the price of well managed and performing LIC's, on the basis of changing fads, I remain delighted to accept their money.

Jim, show me a well performing LIC that is yielding 12.5% ?

CC, the numbers used were to simplify the point being made. The principle remains.

Firstly, if you invest in an initial float of a new LIC, you will likely find that the price often dips into a discount-solution do not put your money into floats. Buy shares in a well run LIC trading at a discount. Avoid any LIC with an out- performance fee, since it introduces an incentive to take excessive risks-bad managers have destroyed LIC's, by gambling.
Secondly. Not all the published NTA's are quoted on the same basis. Is it proper to regard the pre-tax NTA as the standard, if liquidation would mean much of the capital gain may end up being paid to the ATO. Should franking credits be treated as an asset?
Thirdly. Market volatility. If you are patient, and buy at a meaningful discount, you can collect your dividends, and when price rises above NTA sell and buy a different LIC, that is trading at a discount. I recall that many of the LIC's that later became Australian Foundation, in the 1960's, were regularly trading at 20% discount. The cumulative rewards over time, for those who grasped the opportunity have been great.
For people, who read the prospectus for a new float, and then send their money in, you are likely paying an excessive price, and all the whining about discount to NTA, is because you paid too much. Learn. See the discounts as an opportunity, and not a negative.

My comments on the 2 most persistent negative issues re LICs:
1. FEES: So many investors object to performance and management fees associated with LICs. The LICs state these fees up front so they are obvious. We do not hear criticism of the management and performance returns received by various levels of management in our listed companies. That is because they do not receive fees as such. But the higher salaries, annual bonuses and performance bonuses paid in cash and share options can grossly exceed the rates available to LIC (and other fund) managers. Which investors reject investing in our largest companies because of exorbitant salaries and bonuses of various types?
2. NTA premiums and discounts: Many see this variation between shareprice and NTA as a reason to avoid investing in LICs. They are quickly and easily aware of this at any time because the LICs are required to publish their NTA values at least monthly. Are these wary investors aware of the NTA for major listed companies and would such awareness change their behaviour? This morning I found on Market Index, the NTA for WOW (latest 06/23) was $0.06 while todays shareprice is $33.2. Similarly, the CBA NTA is 0 while the sharprice is $120. The premiums being paid for these are massive. Who is complaining about all these? In case of a fire sale, these companies yield nothing to shareholders. At least one would expect better than nothing from a firesale of an LIC if such an event were to happen.
I'm just grateful I can see value in LICs after considering what others see as negatives and in the process I hope to profit from other investors fears,

Most of the LIC's are invested in those companies with tiny NTA.

Great article. Fundamentally, active managers have shown to consistently underperform the index. You can’t have over 80% failing to meet the benchmark and expect people to flock towards the investment. Despite the proclamations of active managers, they fail across bull and bear markets.

An Index doesn't pay tax. That "pre NTA" number is_after_tax has been paid on those realise gains remember.

Want a franked dividend? Well, your NTA needs to pay that tax then. Add tax paid to LIC returns and a much higher % of them will be outperforming that no dee and no tax index return

Regarding your point that "LICs can also be useful for income investors as they have the ability to smooth dividend payments via their profit reserves."

I'd also add for an income investor, if you're buying a LIC at a discount you're getting more income for your dollar, ie: you're getting the income from the full portfolio value without having to pay that full value.

Underperformance was it for me. Large LIC's continually not meeting the index is not good enough. End of.

A significant reason (not covered explicitly in the article) is the passive vs active investment debate. The fees favour passives / indexers when the market is hot, but when the market goes cold, will this still be the case as the passive investors "run for the hills"?

Neil, respectfully, there is now over 35 years of data showing this is never the case. All it has ever shown is persistent outperformance from passive over active. The tagline of, wait til the market turns, has been the ruse of active managers for years.

James, respectfully, the 'data' you quote is based on paying full retail fees and being a naive retail investor, which investors in institutional vehicles such as Super Funds and Large LIC's do not pay.
If you allow for institutional fees and the value added by institutional level research, then the 'data' that you refer to demonstrates that active significantly outperforms passive.

John,

Where's the data or evidence that active funds outperform post institutional fees?

SMA Managed Account Portfolios have rendered LICs pretty much redundant, unfortunately.
Not having to deal with NTAs is one less BID risk for advisers.