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Listed investment companies to suit your investing style

By Peter Rae, ASA member and supervisory analyst at Independent Investment Research (IIR)

Listed investment companies (LICs) provide investors with a relatively easy way to build a diversified equities portfolio or add diversification to an existing portfolio. But with around 90 LICs and listed investment trusts (LITs), how do investors select the right LICs to suit their investing style?

Each LIC has its own individual investing style. The ASX categorises LICs into four investing styles, Australian shares, international shares, private equity funds and specialist funds. But in order to assist investors, we break down the LIC universe down into a broader number of investing styles as shown in the table below.

Listed investment company investing styles
Investing strategy   No. of LTIs Market cap $m
Australian shares - large cap   19 19,042
Australian shares - mid/small cap   25   4,721
Australian/international shares blended    6   1,033
International shares - diversified     6   2,105
International shares - emerging markets    5      778
International shares specialist    5      414
Fixed income funds    6      265
Private equity funds    4      330
Absolute return funds    7      699
Other specialist      1      155
       

Source: IR Monthly LMI Update

     

By investing in one or more LICs from a number of the above categories it is possible to build a well-diversified portfolio comprising only LICs. An investor with an existing portfolio, comprising predominantly large cap Australian equities, might add one or two small cap LICs and an international shares LIC to achieve better diversification. Those with a higher risk profile could add an emerging markets LIC and potentially a private equity LIC.

In this article we look at how an investor might construct a well-diversified portfolio, or enhance an existing portfolio, using LICs. To demonstrate this we discuss a number of individual LICs. These are not recommendations and are for illustrative purposes only. Each investor’s needs and strategies are different and investors should undertake their own research before deciding which LICs are best suited to their own investing needs. (For a full list of LICs and LITs by investing style, refer to the IIR Monthly LMI Update at www.independentresearch.com.au).

The basic building blocks

For most Australian investors, holding a core portfolio of quality Australian companies paying regular, fully franked dividends is a key element of their investing strategy. There are 19 LICs that invest across the large cap sector of the market with the top three, Australian Foundation Investment Company (AFI), Argo Investments (ARG) and Milton Corporation (MLT) dominating the sector. These three have been listed for decades and have well-diversified portfolios of Australian equities. Management expenses are low due to the fact they are managed internally and they pay regular, fully franked dividends with yields in excess of 4%. Due to the fact their earnings are derived largely from dividends on their underlying investments, the dividends they pay to their own shareholders are likely to be more sustainable than LICs that rely on capital appreciation to generate their earnings. For someone starting their investing journey, these LICs offer a stable foundation to a portfolio.

Over the past year, Australian large cap shares have underperformed relative to small caps, so large cap focused LICs have underperformed the broader market over the past 12 months, but over the long-term they have performed in line with, or slightly better than the market. We would expect market performance over the medium to long-term.

Other LICs that invest in Australian large caps and could be considered as part of a core portfolio include Djerriwarrh Investments (DJW), Australian United Investments (AUI), Diversified United Investments (DUI) Whitefield (WHF) and AMCIL (AMH). DJW has a higher yield than its peers as it uses options to enhance returns, but it is currently trading at a large premium to NTA and its dividend will fall in 2017. AMH, which also has a weighting to mid and smaller cap stocks is also trading at a premium to NTA. AUI, DUI and WHF all look attractively priced at discounts to NTA. As with AFI, ARG and MLT they have underperformed the broader market in the short term, but long-term we would expect them to perform broadly in line with the market. For investors seeking to avoid exposure to the volatile resources sector, WHF invests primarily in large cap industrial shares.

Add some growth with small caps

Small caps provide diversification to a portfolio and can offer exposure to higher growth opportunities and industries not represented amongst the large cap sectors. However investing in small caps can be a riskier proposition given the sector is less researched and small companies are usually more leveraged to economic changes and competitive forces. Investing in small cap focused LICs is a good way for all investors to obtain exposure to this market sector. Most small cap focused LIC managers spend considerable time on research and undertake hundreds of face to face visits with key management personnel. So they are able to build an excellent understanding of a business and the industry it operates in before investing.

With 25 small cap LICs there are considerable options for investors in the sector. All small cap focused LICs, with the exception of Mirrabooka Investments (MIR), are externally managed and therefore pay fees, and in some cases performance bonuses, to an external management company. So investors should make sure they are comfortable with a LIC’s fee structure before investing.

WAM Capital (managed by Wilson Asset Management) is the largest LIC in the mid/small cap sector and has a well-diversified portfolio of small and medium-sized industrial companies. The small cap focus has seen the LIC benefit from the strong returns from this sector over the past 12 months, but it has also built a consistently strong performance track record over a longer time frame. However, the shares are expensive trading at a large premium to NTA. Wilson Asset Management also manages two other mid/small cap LICs, WAM Research (WAX) and WAM Active (WAA). These LICs also have a strong track record but, like WAM Capital, are expensive, trading at premiums to NTA.

With a portfolio return of 31.6%, Contango MicroCap (CTN) was one of the best performing LICs over the past 12 months. Despite the strong performance, CTN was still trading at a discount of 14% to NTA at 30 September. CTN has a well-diversified portfolio of small and micro-cap stocks with a total of 77 securities, so performance is unlikely to be driven by any one stock.

Outside the larger small cap focused LICs there are a number of smaller LICs trading at discounts to NTA including NAOS Emerging Opportunities Company (NCC), 8IP Emerging Companies (8EC), Glennon Small Companies Fund (GC1) and Barrack Street Investments (BST). Before investing in any of these LICs, investors need to look at the performance of the managers and assess whether the discount is likely to narrow over time.

Gaining International Exposure

With the Australian equites market representing just 2% of global equity markets, Australian investors are starting to become aware of the need to build offshore exposure. There are 22 LICs with a focus on international investing, making it relatively easy for Australian investors to gain offshore exposure without the complications of direct international investing.

Platinum Capital (PMC), Magellan Flagship Fund (MFF) and Future Generation Global Investment Company (FGG) provide investors with exposure to diversified portfolios of international equites. Investors prepared to accept the higher risk associated with emerging economies, might also consider adding some emerging market LICs to their portfolio. Emerging market shares as a class can be more volatile than developed markets, but also offer the potential for higher returns due to faster economic growth than in developed countries. Platinum Asia Investments (PAI), Asian Masters Fund (AUF) and Emerging Markets Masters Fund (EMF) all provide exposure to emerging markets. Although not strictly a pure play international LIC (with only 48% of its portfolio invested in international equities) Hunter Hall Global Value (HHV) was one of the better performing international focused LICs over the past 12 months.

For Warren Buffett fans, Global Masters Fund (GFL) offers a unique way for Australian investors to gain exposure to Warren Buffett’s Berkshire Hathaway with 72% of its investment portfolio in Berkshire stock.

Alternatives and private equity

Alternative asset classes provide investors with another way of achieving diversification and enhancing returns as part of an overall portfolio strategy. It is usually difficult for retail investors to gain exposure to alternatives, so LICs offer a unique way for investors to gain exposure to these asset classes. Not all investors may be comfortable seeking exposure outside the traditional equities class and need to understand the risks before investing in alternatives. Such investments are more suited to patient, long-term investors that understand the risks associated with these asset classes. Returns can be lumpy and highly dependent on successful exits from investments.

US Select Private Opportunities Fund (USF) and US Select Private Opportunities Fund II (USG), are LITs that invest in portfolios of private equity funds in the US, with a focus on the small to mid-size market. Other options include Bailador Technology Investments (BTI), which offers investors exposure to a portfolio of unlisted internet related businesses founded in Australia and New Zealand and Blue Sky Alternatives Access Fund (BAF) which invests in a diversified portfolio of actively managed alternative assets. BAF’s portfolio includes water rights, private equity investments, student accommodation projects and residential projects.

Note: NTA refers to pre-tax net tangible assets

Disclosure: Peter Rae owns shares in WAM Capital, Contango MicroCap and Future Generation Global Investment Company.

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