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Franking sugar hit not enough to put the shine back on LICs

How did markets react to the Coalition election win, and their commitment not to mess with Franking Credits? Did LICs fall back into favour due to their lucrative tax treatment? We take a look at what happened, and you might be surprised about the result.

By ETF Watch - Jun 19, 2019

When we took a look at the impacts that Labor’s proposed changes to franking credits were having on LIC Net Asset Value discounts, Labor were at near unbackable favourites to win the election.

We thought it was only a matter of time before Labor were rolling out the changes in a fresh faced parliament. Of course, Labor will go down in history as losing the unlosable election of 2019, and the Coalition Government has promised no changes to Franking Credits in the foreseeable future.

Today we take a brief look at how markets reacted to the changes.

Did LIC Net Asset Values Recover post election?

When we took a look at LIC Net Asset Values pre election, they were at some of the largest discounts seen in over 5 years, with an average of an 8.9% pre tax and 6.2% post tax discount to underlying Net Asset Value. This increased to 10% pre tax and 7.7% post tax in the final month before the 18 May election. We put this down to the uncertainty around Franking Credits as a Labor Government looked almost certain, removing some of the appeal of one of the attractions of LICs, their often fully franked dividends.

Fast forward to 31 May, and whilst Clive Palmer billboards still line the streets, the dust has settled from the surprise election result. We expected to see the prices of LICs rebound on this news and begin clawing back that discount.

We were certainly surprised when this wasn’t the case, with a slight but not material rebound to 9% pre tax and an identical 7.7% post tax discount to Net Asset Values. The last 12 months Net Asset Value average discounts can be seen below (5 year history available in our previous post).

Is poor performance to blame for these discounts?

We decided it would be worthwhile digging a bit deeper into the discounts we are currently seeing and observed the following:

Of 83 LICs we follow with more than 12 months price history, at 31 May 2019:

  • 62 (75%) had a Pre Tax Net Asset Value less than 12 months ago, meaning their total assets are worth less today than they were a year ago.
  • 51 (61%) had a higher Net Asset Value Discount (or smaller premium) than 12 months ago.

All of this in an environment where the broad Australian share market has returned 5% in growth and 4.5% in dividends and global share markets have returned about 6% growth and 2.5% in dividends.

With 75% of LICs having returned a loss of the last year (excluding dividends), it seems that LICs have a bit of a performance problem.

Why is this?

It is easy to argue that LICs, with locked in capital are not incentivised to outperform, compared to Active ETFs or Managed Funds, where underlying capital is available to redeem by investors with just a click of a button (or completion of a form). However, we believe these types of LICs are in the minority and Activist Investors seeking to pounce on underperformance and attempt to wind up the fund for quick profit are always in the back of LIC managers’ minds.

Our stronger belief is it has simply been a difficult period to pick stocks for active managers. With valuations seemingly appearing stretched for a number of years, many fund managers have carried excess cash and have misread the market.

Looking through the list of poor performers, there are a number of previous high flyers near the top (or bottom…) of the list, including CDM – Cadence Capital (25% decrease in NAV), FOR – Forager Australian Shares (18% decrease in NAV), AEG – Absolute Equity Performance Fund (16% decrease in NAV), APL – Antipodes Global Investment Company (14% decrease in NAV) and PMC – Platinum Capital (14% discount in NAV). Many of these funds have been employing Value investing strategies which have been struggling of late, and carrying excess cash, waiting for opportunities that appear not to be coming up.

Even perennial LIC favourite, WAM Capital has had a poor 12 months, dropping almost 10% in its NAV, and reducing its pre tax NTA Premium from a near record of 26% last year to 14%.

Strong performers not rewarded

Whilst many of the well known LICs have outperformed over the last year, there’s a bunch of LICs that have had excellent performance, including mining startup focused LSX – Lion Selection Group (39% increase in NAV), technology startup focused TEK – Thorney Technologies (23% increase in NAV), and Global equities focused WQG – WCM Global Growth (15% increase in NAV).

Share prices for these funds are yet to catch up with their performance, with the above 3 LICs trading at 15%, 23% and 8% larger discounts respectively than they did a year ago. Given that LSX and TEK invest in speculative asset classes, and WQG has a large amount of options due to expire next week which if exercised will reduce it’s NAV by about $0.15, we can forgive the large discounts at least for these three.

However, there’s a whole range of LICs suffering from similar discounts despite their solid performance, including, VG1, URB, BST and MA1. The below chart shows all LICs who are trading at a discount of more than 5% than their discount to NAV last year, and their corresponding change in NAV during the period.

Grandfathers not Perturbed

The Grandfather LICs (those that have history of 45 years or more), which includes AFI, ARG, AUI, CIN, MLT, WHF are looking down at this noise from their more junior counterparts and wondering what all the fuss is about. All have had underlying NAV performance excluding dividends of -1.59% to 3.91% over the 12 month period analysed. Only CIN, with its more concentrated portfolio is trading at a significantly higher discount to NAV than a year ago, at just under 5% less, with the others all roughly in line with where they were a year ago.

There’s not much to get excited by with the grand daddy LICs, apart from their boring consistency, regardless of what is happening around them.

Have we hit peak LIC?

The NAV discounts opening up with many LICs, post a period of rapid growth of the sector must surely concern LIC managers. Labor’s franking credit proposals are certainly not totally to blame for the discounts, given they have yet to recover post the election.

Perhaps these are just growing pains and the current weakness is providing investors with an opportunity to buy at a discount? Only time will tell.

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