The international equity listed investment company (LIC) proposition is under siege, with almost all trading for extended periods at material discounts to their net tangible asset (NTA) values. The March 2020 market crash, subsequent evaporation of liquidity and widening of the discount has driven a further nail in the coffin, giving ammunition to critics who claim the LIC structure (and listed investment trusts, or LITs) is a negative in the value equation.
So where to from here? Undoubtedly, many fund managers will put their heads in the sand and ignore the problem. Others, running small sub-scale funds will use this as an opportunity to throw in the towel and liquidate or transition to complicated and untested structures.
Dividends in global and local stock markets
But there is another solution for the crème of the crop of international LICs that has the potential to transform the sector and enable it to flourish. This solution can be found in the structural advantages of the LIC as well as the insatiable demand from Australian investors for fully franked dividends.
Historically, most of these LICs have offered meagre and volatile yields, reflecting the generally low level of dividends paid by offshore companies and the erratic nature of realising net capital gains.
Conversely, Australian investors have prized stable, higher-yielding, fully franked dividends stocks above all else, focusing on Australian ‘blue chips’. However, with so many of these stocks now slashing dividends, investors recognise the need for alternative and more secure ways of generating fully franked dividends.
Bizarre as it may seem, it is possible to transform the way in which the ‘better’ international equity LICs operate, so that these vehicles become some of the most reliable fully franked dividend-yielding stocks. It may enable them to be used as a replacement for the blue chips that have disappointed.
Why are LICs well placed to pay stable dividends?
The only requirement for a LIC to pay dividends is to have sufficient liquidity, which is extremely unlikely to be a constraint for LICs that invest in liquid stocks and have no debt. This is unlike many other companies that are limited in their ability to pay dividends due to capital constraints, illiquidity or debt covenants such as banks, infrastructure and property vehicles.
However, many LIC managers are reluctant to commit to paying out consistent ongoing dividends as this reduces size, thereby negatively impacting their fees. This is compounded by a fear of being required to pay out dividends in periods where the LIC has suffered large negative return.
However, fund managers who not only provide strong returns to investors but also focus on capital preservation during market falls should be able to meet this commitment.
In order to pay fully franked dividends, a LIC must satisfy two tests.
Firstly, it must generate profits in a specific tax-paying period or alternatively to have profit reserves, to cover the dividend.
Secondly, it must pay sufficient tax from realising net capital gains.
It is impossible to guarantee having profits in a particular tax-paying period. However, some LICs have accumulated large profit reserves, enabling them to satisfy the first test over many years to come.
Obviously LICs cannot be guaranteed to satisfy the second test, but for fund managers who generally hold their positions over multiple years and invest in liquid stocks (that make it easy to recognise capital gains by trading in-and-out of) this should be relatively straightforward to achieve.
Global equities offer more opportunities
Finally, generating stable fully franked dividends is not sufficient, as managers must also deliver good long-term performance. This should not pose a huge problem in an international equity universe which is awash with a diverse range of opportunities.
There is a risk that proceeding down the path of stable, fully franked dividends could negatively impact fund manager fees and business models. However, we believe this is a risk worth taking, especially considering the long-term benefits of strong investor demand and retaining some of the benefits of the LIC structure.
Pengana International Equities Limited (PIA) recently 'relaunched' by changing its mandate to become the first international equities LIC to aim for stable fully franked dividends as well as good long-term returns. PIA has already built up profit reserves and is managing the portfolio to take additional profits when stocks hit our price targets.
Local investors usually turn to Australian shares to generate franking credits, but an international fund can be run with the same aspiration. In an environment where investors are desperate for fully franked dividends, it remains to be seen which other global managers have the opportunity and inclination to follow.
Russel Pillemer is co-founder and Chief Executive Officer of Pengana Capital Group. This article is general information and does not consider the circumstances of any investor.