Despite the strong growth recorded across the Listed Investment Company (LIC) market, share prices trading away from their Net Tangible Assets (NTA) is a factor that continues to act as a barrier to entry for many investors. Owing to this dynamic, many investors have preferred to gain exposure to unlisted managed funds to avoid divergent return outcomes caused by market sentiment and trading patterns.
Amidst this dynamic, Zenith has analysed the market to examine what investor returns have been generated through investing in LICs (and Listed Investment Trusts) at a range of premiums or discounts to NTA. These results provide a framework for how investors can implement transactions over the short and long-term.
Logically, the propensity for LICs to trade away from their underlying NTA should provide opportunities for returns arbitrage and potentially higher yields. But this raises a number of questions:
At what level is a discount to NTA a good buying opportunity?
Is this a persistent phenomenon?
Does this effect decay over time?
Zenith believes that to a certain extent, these questions are broadly answerable. We have conducted a study of LICs using historical data on 51 vehicles (not limited to those rated by Zenith), with the following attributes as at 30 April 2018;
Minimum three-year trading history to ensure that lack of dividends for new LICs was not over represented as a factor
We measured the outcomes for each LIC by aggregating them into brackets based on their prevailing premiums or discounts to their pre-tax NTA. We then assumed purchasing each at their corresponding market price and measured the outcome in terms of the actual Total Stock Return (TSR - share price movement and dividends reinvested). TSR’s have then been averaged on a simple basis rather than using a market capitalisation weighted approach. We ran this analysis for 12-month periods over each year for five years with the following results.
These results show that purchasing at a discount is, on average, a valid strategy. Buying at an average discount of 15% to 20% to Pre-Tax NTA delivered an average 12-month TSR of 18.2% over each of the one-year periods tested between 2014 to 2018.
Purchases at progressively lower discounts, and then escalating premiums, resulted in poorer results. While this is a somewhat intuitive result, interestingly, the worst result was not buying at the highest premium bracket (15% to 20%), but rather the second highest (10% to 15%). This scenario generated an average TSR of -1.4% for the year, versus 0.4% at the highest premium. Zenith believes that this is a result of including those LICs which frequently trade at high premiums for prolonged periods. Examples here included Djerriwarrh Investments Limited, Mirrabooka Investments Limited, WAM Capital Limited, WAM Research Limited and Platinum Capital Limited.
As we measured performance over five consecutive years, this does suggest some level of persistence in this phenomenon over time. However, Zenith recognises that this is likely to decay in markets where strong market demand causes widespread narrowing on discounts and increases in premiums, as was observed in the sample group (and more broadly), between 2012 and 2014 (see following chart).
Thirdly, we asked the question, does the effect of arbitraging price to NTA decay over time? Based on our assessment, the answer is yes.
To do this, we examined what happens if the holding time exceeds 12-months. Using data ending 30 April 2018, the following results were derived.
Interestingly, holding for longer timeframes delivers a very different outcome. There is a strong propensity for the effect to be relatively short-lived, with six to 12 months appearing to be the optimal timeframe (measured at six months, similar outcomes were observed but at weaker levels than at 12 months). Over longer timeframes, Zenith believes that other factors such as portfolio performance and market sentiment begin to override the discount effect and as such it results in much stronger return profiles.
While not illustrated here, we also ran scenarios over different time horizons i.e. data measuring TSR over 1, 2 and 3 years ending in each year over five years between 2014 to 2018. The results consistently showed that the effect of buying at a discount decayed materially past a 12-month holding period.
Zenith believes that this bears out our view that while movements in share price relative to NTA may throw up advantageous opportunities to enter or exit positions in LICs, other drivers influence long-term outcomes. This is important, as it addresses a widespread view held by the market that LICs are unattractive versus managed funds because of their ability to trade away from their NTA.
That said, Zenith does maintain that there is material danger in buying LICs at strong premiums. Our results around the performance of longer-term holdings indicated that notwithstanding the potential to generate reasonable returns when buying LICs at a premium, these premiums are also at greater risk of dissipating where market sentiment moderates.
Ultimately, while relative pricing on the secondary market is an important aspect, it should not eclipse the longer-term performance that can be achieved. On choosing quality LICs, if an appropriate investment horizon is adhered to, shareholder outcomes should not differ materially from that of the portfolio over the longer term.
While this data is encouraging, it should also be obvious that when treated on a case by case basis, individual LICs may not be so accommodating as to provide such arbitrage opportunities. Portfolio performance aspects aside, those LICs exhibiting negative features such as suboptimal scale, egregious fee terms, poor shareholder engagement practices or lacking sufficient transparency, will frequently find the market applying negative feedback loops, making share price discounts difficult to overcome. Similarly, LICs with strong market support may trade at irrationally high premiums for prolonged periods of time.
To finalise, Zenith rated LICs achieved the following returns on a TSR and portfolio basis for the year ended 30 April 2018. This highlights the short-term impact market sentiment can have in terms of the dispersion between portfolio and shareholder outcomes. While there is a large dispersion of positive and negative outcomes, Zenith believes that longer term outcomes should be the focus when purchasing.