Part 1: A guide to Listed Investment Companies.

 

Some investors don’t have the time or energy to put into picking their own stocks.

But that doesn’t mean we shouldn’t invest. Not investing will put us further behind in life and hurt our future retirement.

There are some investment vehicles which are perfect for the passive investor, like, Listed Investment Companies.

To me, they’re another asset which investors can buy on the stock exchange and keep adding to over time. Helping you to grow your portfolio, net worth and passive income through dividends and capital appreciation..

Of course, they aren’t for everyone and you need to decide if it’s the right fit for you.

If this is your first time reading about LIC’s there’re some technical definitions to get your head around. But for anyone who’s serious about managing their own money it shouldn’t matter in the slightest.

In this 2 part series, I’ll be going over how LIC’s are structured and what you can expect from investing in some of these LIC’s.

How a listed Investment company is different to an ETF

If you’ve read my post on ETFs, you’ll know that they operate as an open- ended fund through a trust structure. Open-end funds essentially mean, new units will be issued when investors want to buy, and, cancelled off the open market when investors want to sell their units.

Money is flowing in and out freely, open-ended.

The trust structure also means that ETF’s must distribute all their income back to the unit holders. Dividends paid to the ETF and any capital gains the ETF accumulates will be passed back to the unit holder.

In terms of their structures what makes them different is LIC’s are a closed-end fund and operate as a company structure.

For some people this is only a subtle difference but to me it’s the fundamental difference and leads to why some people prefer LIC’s over ETFs.

The Closed-end Fund

A closed-end fund works like all other funds, in that, it’s a diversified portfolio (a diversified portfolio is jargon for holding lots of different stocks, bonds or any other asset) of stock, bonds, infrastructure or property.

Closed-end funds first begin their life by raising money through an Initial Public Offering (IPO). Every company that’s listed on the stock exchange is first bought to the market through an IPO.

Investors buys shares in the Listed Investment Company IPO, once all the shares are sold to investors the LIC has the money to spend on investments and the investors have the shares.

The fund (LIC) will then be listed on the stock exchange.

Once the IPO is completed no new shares will be issued. The amount of shares that can be traded in the stock market are fixed. Unlike the open-end fund where units are being created and cancelled all day.

The only way new shares are issued are if, the fund managers raises money by issuing more shares (known as a capital raising), a dividend reinvestment plan, or a share purchase plan.

The easiest way I like to think of a closed-end fund compared to an open-end fund is with a closed-end fund money flows in at the IPO and stops there (closed).

If you weren’t able to get in on the IPO you can simply buy the shares of the LIC on the stock market like any public company.

Redemptions

This closed-end structure also allows the LIC to not have redemptions at the worst possible time.

What do I mean by redemption’s you ask?

Using the ETF as an example, if investors begin selling their shares in fear of, or, during a market sell off the ETF will need to sell assets in the fund to raise money and give back to investors that want to cash out.

Hurting the other unit holders and driving the price down of the fund. Investors are redeeming their money

LIC’s don’t have to worry about redemptions and selling assets to raise cash and give back to shareholders when they want out.

This is because the amount of shares are fixed. Where as, an ETF must create and cancel shares based on the orders that’re placed in the market.

It all sounds confusing. Just remember this, LIC’s don’t have to sell off any assets to give back to shareholders if investors want their money back. They’ll need to sell their shares in the stock market to get their money back.

This process is major benefit of the closed-end fund, and being a company structure. Fund managers can take advantage of lower asset prices and focus on their job rather than having to worry about selling off assets to fund redemptions.

Company Structure

Since LIC’s operate as a company structure this means they can function just as a company does. Such as, retaining profits for future investment or paying out retained profits as dividends.

Essentially, it’s like you making money from your job, you can either choose to invest it, spend it or save it. Companies can do the exact same thing.

LIC’s will usually retain some profits to reinvest back into other assets, add to their profit reserves for future use or pay out as a dividend.

Some of the advantages LIC’s can have for retaining profits are:

  • Build up profits reserves to maintain dividend payouts if there’s a downturn.
  • Use the built-up profit reserves to invest in undervalued assets if there is a market sell off.

I’ll quickly touch on each one so you can have a better understanding.

Profit reserves

Assuming the LIC makes a profit for the year they can do whatever they want with it. Most LIC’s will payout a portion of their earnings and keep the other portion. When they keep the other portion, it gets added to their profit reserves.

The profit reserves are then used to either pay dividends or add more to the investment portfolio.

However, the older LIC’s who focus more on dividends will try to keep these profits reserves topped up so they can maintain dividend payouts or keep increasing the dividend payout. (rising dividends can be a holy grail of investing)

The maintaining of dividends, or for the people who like to call it dividend smoothing. Means dividends can be consistent through good and bad times.

You might get a reduction when times are tough but the idea is to have a much lesser reduction. And for the people who rely on the dividends, I’m sure you don’t want a big reduction in dividend income!

Buying Undervalued assets

Whenever the market has a downturn all fund mangers wish they had enough cash on hand to take advantage of the lower share prices.

Since LIC’s have their profit reserves and cash on hand they don’t have to sell off assets in the fund to raise money for investor redemptions.

They’re able to utilize their cash on hand to take advantage of lower asset prices if there is a downturn.

This is beneficial to the fund because as they buy undervalued assets, they’re expecting the prices of the assets to return to normal levels. Giving the fund a nice gain and increasing the Net Tangible Assets (NTA). As the NTA increases eventually the market will realize and the share price will begin to gain in price.

The Net Tangible Assets (NTA)

You’ll see the acronym NTA thrown around a lot with LIC’s.

Investors will want to know if it’s trading at a discount or premium to NTA. But first you need know what NTA is.

When you’re looking at a LIC and you see the NTA per share, that number is the actual value of the portfolio on a per share basis.

This was Milton Corporations (ASX: MLT) NTA report as of 30th April 2020.  We will look at the before tax NTA price.

The number is how much the entire portfolio of shares is actually worth on a per share basis. This means each share you bought on that date is really worth $3.99 not the $3.85 you would have paid.

You’ll see there’s the before tax NTA and after tax NTA, it’s best to use the before tax NTA. The after tax NTA is saying if they were to sell off their entire portfolio there will be capital gains tax that needs to be paid. So, it’s assuming what the value on a per share basis would be if that tax was paid.

Premiums and Discounts to NTA

If you noticed from the example above, you would have saw the share price was $3.85 a share but the real value of the shares was actually $3.99. This is called trading at a discount to NTA.

You can see below the share price is more than the NTA. This is called trading a premium to NTA.

This LIC is trading at a large premium because it’s outperformed the market by nearly 4% a year.

People are happy to pay more if they think they’ll receive out performance and compound their money faster.

If your goal is to try earn higher rates of return through investing in LIC’s. You’ll either need to look for a LIC that outperforms the market consistently or buy when the LIC’s are at a discount.

The older LIC’s (ones that have been around for 40 years plus) never really trade at big premiums or discounts. They’re the slow compounders.

You might have value at heart though, and always want to buy things on sale. In that case look to buy at a discount to NTA.

Fees

Those nice fees that portfolio mangers just love to charge, they have to make a living as well… right?

We just need to be mindful of how much we’re actually paying, high fees can really impact your overall long-term returns.

Milton Corporation (ASX: MLT) only charges a fee of 0.13% a year. To put that in perspective it’ll cost you $1.30 for every $1000 invested.

Contrast that with a LIC that has a management fee of 1% or 2% and a performance fee of 20%. That $1.30 for every $1000 can quickly turn into $10 or $20. It’s easy to see how much more you’re paying which can have a huge impact on overall long term returns.

If you want to know what you’re really paying just find the Product Disclosure statement (PDS) and search for fees, most funds will break it down for you.

The Caveat to high fees

The LIC’s that have these higher fees are usually charging them because of their active management. These managers work to try and outperform the market and give you returns that’re much higher than the overall market average.

Sounds enticing, I know. Those nice big returns getting us to financial freedom faster. But alas, it doesn’t always work out. There’s a high chance the LIC won’t outperform the overall market. Putting a drag on your portfolio because of the fees. Then you’ll most likely trade in and out chasing above average returns.

Investment styles

The older LIC’s all have very similar styles; they invest in dividend paying companies and pass those dividends onto shareholders. They hold the biggest stocks that comprise the ASX so they’re similar to an index tracking ETF. I’d call these more passive in that they buy the best dividend paying stocks and leverage those dividends to give back to us shareholders.

To be honest, there’s not much difference in styles with the older LIC’s. The style deviates a little here and there but you can expect similar outcomes from each of them.

Then there’s the active LIC’s, these guys will try and outperform the market by buy and selling stocks and passing the capital gains onto shareholders as dividends.

It’s active because there’s a team of analysts researching under every rock to try find different companies worth buying. Then monitoring the portfolio to see if any positions need selling.

In a bull market this strategy will work nicely but I have my doubts that they’ll be able to perform this during a bear market and keep my dividend safe.

Diversification

If you were to start your own dividend portfolio or pick all your own stocks, then general theme is don’t put all your eggs in one basket. Or, another way of saying it is to be diversified.

Continuing with stock picking, there’s no set amount of companies to buy. But the theory is to get up into the range of owning 15-20 stocks. It’s easy to see how tiring picking and monitoring all those stocks that can be if you’re not up to it.

The Listed Investment Company (just like an ETF) gives you instant diversification by buying 1 asset.

The above is a list of Whitefield’s (ASX:WHF) portfolio on May 31st 2020 of their top 20 holdings. If you’re wondering, the percentage on the right is giving the value in percentage terms of how much that holding takes up the portfolio. So CSL is equal to 8.94% of the entire portfolio value and CBA is 8.02%.

Anyways, there it is, you buy Whitefield (or any of the LIC’s) and you’re instantly diversified. No stock picking ability needed.

Part 1 Wrap up

I’ll leave it here for now. There’s a lot to take in and probably get your head around if you haven’t done any research on LIC’s before.

These are the key points on how LIC’s are structured, read over it a few times if you have to. In the next part I’ll go over dividends and long term returns and a few other points.

Tell me what you think below if I’ve missed any other key points or you want to chat about LIC’s!

 

This post is for your education and enjoyment only, please do your research or talk to an investment professional before investing any money.

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