Income Report / Income Report: How could a change of Government impact Listed Investment Companies (LIC’s) (WLE, CDM)

By Market Matters 27 March 19

Income Report: How could a change of Government impact Listed Investment Companies (LIC’s) (WLE, CDM)

Market Matters Income Report 27th March 2019

Local stocks have failed to embrace the positive leads from overseas, with the market trading lower in the first 30 mins of the session – the ASX 200 down by -20 points / -0.34% at 6109. Alumina (AWC) which we hold in the Income Portfolio is off by ~3% trading at $2.48 after presenting at a conference in Miami overnight despite Macquarie upgrading their PT on the stock by 4% to $2.80. The shorter term issue facing AWC is the likely resumption of operations at the Alunorte refinery in Brazil, which produces around 5% of global Alumina. The refinery has been out of action since October last year and that’s supported the market, however it may be back online in the next month or so – we are looking to cut AWC from the portfolio before then, considering Estia Health (EHE) as a replacement.  

ASX 200 Chart

The past week saw the Income Portfolio down by  -0.76%, dragged lower by Perpetual (PPT) which fell by -5%. The ASX 200 Accumulation lost 0.85%. In the current financial year, the portfolio is up +3.64% vs the benchmark (RBA + 4%) which is tracking at +4.04%, while the accumulation index has managed just +2.46% in the period. Since inception (5/7/2017) the portfolio is up +11.04%, outperforming its benchmark (RBA Cash plus 4%) at +9.48%.

The new NAB Hybrid started trading during the week, currently trading at $101.10.

**The Bookbuild for the Perpetual Credit Income Fund is closing early today – at 1pm**

Another raising in the Income space with Perpetual launching the Perpetual Credit Income Trust that is to be listed on the ASX (subject to approval) under code PCI on the 14th May. While I  haven’t met with the managers (I will) , the deal is lower risk than the MOT outlined above and a more traditional credit offering. As a consequence, the return targets / fee structure is aligned with that risk / return profile. The deal looks attractive.  Our desk at Shaw can place bids for those with an account, or who wish to open one.

The trust will focus on investment grade assets in the high yield Australian corporate loan market  and the global high yield bond market – it’s sort of a cross between MXT and NBI that we own in the MM Income Portfolio. MXT invests in corporate loans in Australia targeting a return of 4.75% while NBI is a global bond manager targeting a 5.25% return. PCI combines both sub asset classes into the one $400m listed investment vehicle.

The trust targets a return of the RBA cash rate plus 3.25%, which is the same target held by MXT, equating to 4.75% net of fees. Distributions to be paid monthly  and the fund should be a good diversifier for those looking for income that is not heavily aligned to equity markets. They charge an annual management fee of 0.88% and no performance fee.

While we are not adding it to the MM Income Portfolio given our existing holdings, this looks a good offer.
To bid into the book today, please email [email protected] or call (02) 9238 1561

How could a change of Government impact Listed Investment Companies (LIC’s)

Listed Investment Companies (LIC) are a popular home for income conscious investors however as the Federal Election looms in a few months, its right to ask the question – will this sector be adversely impacted by the proposed change to franking credits?

To recap, under a Labor Government which is likely in May, they plan to remove cash refunds for excess imputation credits – or in other words, those in a no / very low tax environment who get a cash refund from the ATO will no longer get it unless you’re a government supported pensioner, a charity or can take advantage of a few other carve outs. In general terms (and we stress general) a SMSF investor with a balance of $200,000 to $1 million will lose income, and all things being equal some LICs may become less attractive for this cohort. In today’s note, we’ll look at the larger LICs listed on the ASX, with most (but not all) offering attractive yields.

The list above covers LICs that invest in large cap Australian shares  - a number of these have been around since Adam stumbled across Eve while some are more recent, the Plato Income Maximiser for instance listed in 2017 as the first LIC to pay monthly dividends. The majority of these trade at a discount to the value of their assets while some are at a slight premium. WAM Leaders (WLE) is the most expensive in terms of fees and trades at the biggest premium to the underlying value of its holdings while Australian United (AUI) is the cheapest in terms of fees.

WAM Leaders (WLE) Chart

Whitefield (WHF) is the LIC in the above list offering most value relative to its assets, trading at a 9% discount, however they have underperformed their benchmark over 1,3,5 & 10 years, albeit by a small margin. Whether or not a LIC trades at a premium or discount happens for a few reasons, performance over time is key however communication with investors and potential investors is also very important. I had lunch yesterday with a good client of mine and about 10 years ago he put 500k into WAM , and got a call from Geoff Wilson welcoming him as a shareholder. That’s the sort of investor engagement that will drive a premium.

That said, we struggle with the concept of paying $1.25 for $1.20 worth of value and I would think Geoff Wilson may also grapple with that concept. On the contrary, he often uses his overvalued stock to buy into other LICs that are trading at a discount to their assets, which makes total sense, particularly if he can buy enough of them and eventually take over the management.   

The table below shows WAM Capital (WAM) which is trading at a 21.6% premium to its assets meaning that a buyer is prepared to pay $2.25 for a company that holds assets worth $1.85. By doing that, you’re essentially backing management to extract more from that asset base over time which can be true for a company delivering a product or service, however in the case of an LIC it implies the stock market is extremely inefficient and WAM’s portfolio managers have an incredibly valuable edge.  

We covered WAM in a note back in November of 2018 titled, Why we’d sell WAMclick here to view

Calton Investments (CIN) above is at the other end of the spectrum, trading at such a large discount implies that the market has little faith in their stock picking abilities. While they had strong performance in earlier years, the last 3 have been tough, largely because their biggest holding – Event Hospitality (EVT) has traded down during the period. Interestingly, they have a massive 50% or $412m of the LIC in that stock which is the old Amalgamated Holdings for those with a good memory.

Along with another fund manager, Enbeear Pty Ltd, they own around 40% of EVT, while Enbeear also holds a large stake in CIN. All somewhat complex however it does go to show that understanding the underlying holdings of an LIC is very important, and looking beyond just discount / premium to assets and long term track record is critical. That’s really the key in determining whether or not an LIC will be impacted by the proposed change. If holdings are dominated by stocks that could be impacted (and we covered some of these last week – click here), those with high fully franked yields and no growth, then the LIC may lose some of its appeal.

Performance is obviously an important part of the equation, and we would argue that a track record over the past few years in more relevant than longer term stats, given most LICs start very small and nimble, often backed heavily by the founder and take risks to generate performance early, essentially setting up a good track record for the future. As LICs get bigger, performance tends to come back to the market and with that any premium should also come out. 

Of the high yielding LICs above, Perpetuals PIC has  36% of the fund in CBA (11.2%), WBC (8.3%), SUN (6.6%), WOW (5.5%) & TLS (4.5%) – a fairly vanilla sort of approach and it is trading at a 5% discount, so it’s probably okay.

Cadence (CDM) is slightly different with the ability to trade on the long and short side of the market – here and overseas, however like the recent debacle from L1 Capital (LSF), long/short funds have struggled, and the record from CDM has been particularly poor. Purely from a share price perspective, over the past 5 years Cadence has underperformed the ASX 300 by 45%, losing 1.99% versus the market which as gained 43%.

Cadence Capital (CDM) Chart 

Platinum Capital (PMC)  is actually more a growth manager with exposure in Australia and overseas however in reality, most exposure is in Asia with China (17%), Japan (16%) and Sth Korea (6.5%), along with US exposure at 17%. Their biggest holdings are Ping An Insurance, Samsung, Glencore and Alphabet, meaning that they are growth focussed, so how do they pay a 6.3% fully franked yield when investing in growth?

A LIC has the advantage of being able retain earnings, pay tax on those earnings and essentially build up a dividend reserve and a franking balance. This helps them to maintain a smooth and sustainable dividend over the long term (this is different to the newer sort of listed trust structures which are required to distribute all earnings to the underlying unit holders). They also hold shares that pay fully franked dividends which is another source of franking credits that can be passed onto shareholders.

Some LIC’s will eat into capital to maintain a dividend and they can also buy specific shares for income / franking reasons – companies paying big fully franked special dividends for instance can be appealing. This is all okay as long as performance stacks up, or, if performance is weak for a period, it’s only a short period. Where LICs (as is the case with all companies) get into some trouble is by maintaining a dividend when earnings or income aren’t covering it. This is more prevalent than you might think.

A number of high profile LIC managers have been very vocal against the change in franking credit policy – and rightly so, as Charlie Munger once said, “show me the incentive and I’ll show you the outcome”.  That’s a cynical comment and a LIC manager should act in the interests of their shareholders – ultimately they work for them, and a lot of shareholders will be negatively impacted by this change  which justifies the fierce opposition.

At Market Matters we think the LICs that are trading at a large premium to their asset values are most at risk from this proposed change if indeed it happens, while LICs that have some global exposure should be more immune.

Conclusion (s)

A change in franking policy will have an impact on fully franked shares, and LICs are simply a derivative of that.
Unlike hybrids and direct shares where institutions, at a point will see value and ultimately be the price setter, LICs typically don’t have that luxury until they trade at a steep discount to NAV
We are cautious LICs, and have no interest in those trading at high premiums or those that have maintained dividends through periods of abysmal performance.  
 Have a great day!

James & the Market Matters Team

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.

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