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Has uncertainty around franking credits taken the shine off LICs?

Australia’s heading to the polls and a key policy difference between the two parties is likely to influence portfolio construction in ways not in recent memory. This is Labor’s proposal to remove refundable franking credits. We take a look at how this has impacted the LIC market.

By ETF Watch - May 01, 2019

Australia’s heading to the polls in what some are calling the most boring election campaign for decades. However, for share market investors it certainly isn’t boring, with key policy differences between the two parties likely to influence portfolio construction in ways not in recent memory.

For those that have been living under a rock, one of the biggest policy differences is Labor’s proposal to remove refundable franking credits from shares, meaning investors on low tax rates, in particular SMSFs will no longer be entitled to the circa 30% boost in dividend earnings they currently receive. We covered the specifics in detail last year, not long after the Labor announcement.

What has happened since Labor’s initial announcement?

Since their first announcement in March 2018, Labor announced some amendments in order to stop Centrelink recipients being impacted by the changes.

We’ve also seen the Government run a parliamentary inquiry  into the proposed changes, in which they received almost 2,000 submissions, and unsurprisingly (given this is an opposition policy), the findings found that the Labor proposal is deeply flawed.

Geoff Wilson of Wilson Asset Management  has led the charge for the LIC brigade, speaking out against the changes which will impact a large number of investors in his funds. Wilson has also landed himself in some hot water due to his perceived influence over distant relative and chair of the parliamentary inquiry, Tim Wilson.

Meanwhile, Labor have stood by their guns on franking credits, taking it to the electorate as a core election promise aimed to provide a fairer tax system to all. With Labor short priced favourites to take out the federal election, it Is therefore highly likely that these changes to franking credits will see the light of day, or at worst, go through a complex negotiation.

How has the share market reacted?

Given franking credits have been a core part of Australia’s tax system for over 20 years now, and as a result we have a culture of high dividend payouts, it is somewhat surprising that as we edge closer to election day, the sharemarket as a whole is on a tear, adding over 15% return this year. The market as a whole does not seem too concerned.

Many companies have been preparing for the possible changes, with special dividends on the cards to rid themselves of excess franking credits before the changes. Popular LICs such as BKI and AFIC have begun paying special dividends in order to get ahead of the changes.

What about LICs?

It is the LIC market where things don’t look so rosy. Once the holy grail for the income focused investor, with regular, stable, fully franked dividends. Being been one of the key aspects that has seen the LIC market double over the last 5 years, both in number of LICs on offer and total Market Capitalisation. Things now aren’t looking so great, with effective dividend yield likely to reduce by 30% for many investors.

Many LIC managers have floated the concept of moving their structures to a Listed Investment Trust (LIT), which will partly resolve the franking credit issue, but will remove one of the key aspects of LICs that income focused investors love, being their ability to retain earnings and thus provide a consistent stream of dividends. LITs must pay out all earnings, as a result returns for many LITs would be more lumpy, like a traditional managed fund, who share the trust structure.

Taking a look at LIC Premiums and Discounts to Net Asset Value (NAV), the market is not happy. Below we chart the average Pre and Post tax Net Asset Value Premium or Discount of all the LICs we cover since 2012.

 

Since Labor’s announcement in March 2018, we’ve seen the average Post Tax premium reduce from almost 2% to a 7% discount, and the Pre tax fall from a 2.5% discount to a 9% discount. This is a circa 7% loss to investors before before the consideration of any market movements, not an inconsiderable amount in just a year! During this period, there were large market falls in December, however with markets since recovering, NAV discounts have not. It seems the market is pricing in a Labor victory and the reduced intrinsic value of LICs to many investors, without their lucrative franking credit refunds.

Time to Invest?

Some might look at the recent falls from grace of LICs and stay clear. However, with Labor at short priced odds to win the election, the bad news may already be priced in. 85% of LICs are now trading at a discount to their NAV. This may become the new norm, but for a contrarian investor, it may be the signal that it’s time to buy.

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