February 4, 2008

	LICs' slower, rougher ride By Scott Francis

• Ironbark Capital was excluded because it invested in a combination of Australian shares and fixed interest investments, and it was not fair to compare it against the return from just Australian shares. (As you would expect, its return was less than the sharemarket return as it also invests in bonds. Including it would unfairly decrease the apparent returns from LICs.)

• New Privateer was excluded because it issued a product disclosure statement early this year that suggested its activities are very different from a large-company LIC. Its one-year return was an unhealthy negative 31.69%, and the inclusion of its results would have negatively skewed the returns.

• Mirrabooka Investments, an offshoot of Goldman Sachs JB Were, was excluded because it invested in small and medium-sized companies, and its return should be examined against a small/medium company index, not a large-company index.

The key question in putting together the performance data is: Should we use the returns that investors receive (the change in share price plus dividends), or the change in the value of the underlying investment portfolio? For example, during calendar 2007, investors in AFIC received a total return (increase in share price plus dividends) of 23.65%. In its most recent report the portfolio performance of AFIC over the same period (calendar 2007) is reported to be 16.5%. (These figures can be reversed as well - with the portfolio performance being greater than the change in share price plus dividends).

I have used the return that investors receive: the change in share price plus dividends. My thinking on this is that this is the return that investor can spend. If, as an extreme example, the underlying portfolio returned 50% while investors received a return through share price growth and dividends of 25%, it is the 25% return that investors actually benefit from.

The results

The following table summarises the results (and although these results disappoint in relative terms, I do not deny that most investors in most instances would appreciate return of more than 10%!). The orange shading marks those listed investment companies that have failed to beat the average market return over each period. If some LICs cannot even match the All Ordinaries Accumulation index then the investor has to wonder why they would bother with them when they could buy an index fund that is guaranteed to mirror the Accumulation index.

On average, LICs that invest in large-company Australian shares underperformed the All Ordinaries Accumulation index by 6.59% during calendar 2007, and by 2.36% a year over the five years to the end of 2007.

When adjusted to weight returns by size, the underperformance was 3.65% over the 12 month period and 2.67% a year for the five-year period.

Premiums and discounts

In the 12 months to June 30, 2007, Carlton and Choiseul investments had returned just over 20% and 16% respectively. They were about 3% and 7% below the average market return for this period.

Six months later the return investors received over the past 12 months has reduced to just under 4% and 5% respectively - more that 13% below the average market return for the period.

The question is: What has happened to these relatively large, relatively well-established LICs? The answer lies in the ability of LICs to trade at a premium or discount to their "net tangible assets", of the underlying value of their portfolios.

LICs report the value of their portfolios each month. These portfolios make up their "net tangible asset" backing and are reported as the value per share of the underlying portfolio. For example, at December 31, 2007 Australian Foundation Investments (AFI) had a net tangible asset per share of $5.96. After adjusting for tax if the portfolio was sold, the net tangible assets per share were $4.85. At the time AFI was last traded at $6.14. Therefore AFI is trading at a premium to the value of its underlying portfolio. Carlton Investments (CIN) was trading at $20.30, while the after tax net tangible assets per share were $21.22, meaning CIN was trading at a discount to the value of its underlying portfolio.

Getting back to the poor performance of Carlton and Choiseul. At the start of 2007 Carlton was trading at a 4.96% premium to the after-tax value of its assets. By the end of the year it was trading at a 4.43% discount. Choiseul started the year at a 25.25% premium but by the end of the year the premium had eased to 17.84%.

The poor returns received by investors in Carlton and Choiseul were far more a function of the fact that they started the year at a premium to the value of their portfolios and that this premium fell during the year. This cost investors more than 9% over the year in the case of Carlton, and more than 7.5% in the case of Choiseul. The poor returns that investors received were not a function of poor performance of the underlying investment portfolio.

Of course, the opposite can happen as well. If the premium increases over a period then an investor will receive a return better than the return of the underlying investment portfolio.

My question is this: If we assume that over time LICs will change the extent to which they trade at a discount or premium to the value of their assets, are investors rewarded for this potential extra volatility in their investments?

Compare LICs to a simple managed fund. Every day a price is set for the managed fund. The price exactly reflects the assets of the fund so the fund never trades at a discount or premium to the value of its assets.

I don't have an answer to the question, but there certainly seems to be potential risk in a LIC trading at a reducing value to its assets, as demonstrated by Carlton and Choiseul.

Conclusion

LICs have a reputation as the "thinking person's listed investment" in the Australian landscape. Their returns over both one and five years to December 31, 2007, have trailed the market average by some margin. Looking at the poor performance of Carlton and Choiseul over the past 12 months another question has to be asked: Are investors in LICs rewarded for the extra risk that they take on as LICs move between trading at a discount or premium to the value of their assets?