CBG Capital Ltd (ASX: CBC), 8IP Emerging Companies Ltd (ASX: 8EC) and Monash Absolute Investment Company Limited (ASX: MA1) will soon cease to be LICs traded on the ASX. This is due to either a takeover or wind-up proposal, or a plan to convert to an exchange-traded managed fund (ETMF).
Buying into a LIC trading at a discount which then winds up and returns the money to shareholders, or one that gets taken over, can be a source of strong short term returns… when you get it right.
Video: What Is A LIC?
Why Are We Seeing Fewer ASX LICs?
Last financial year was generally a disappointing one for the LIC sector. I wrote in July that there were reasons to suggest LICs could bounce back. Unfortunately for the management teams of the above LICs, these potential positive catalysts didn’t come quick enough to save them.
Widening discounts to NTA are a source of frustration for LIC investors, especially those that may have participated in the IPO. I find that when the share price of a LIC trades at a 20% discount to its assets (NAV), the frustration can escalate to the point that triggers change. The LICs I mentioned above are some recent examples of this.
It’s the discounts getting to this magnitude which may see more LICs being removed from the ASX in the future.
Can We Profit From This Trend?
To the extent that corporate activity like takeovers and LICs being wound up is predictable investors can profit from it.
Buying into a LIC when the discount to NAV is 20% or more and narrows to almost zero investors can benefit from it. This is on top of whatever the underlying portfolio may deliver. Below I’ll discuss some other factors to look for when searching for such opportunities.
It can be tough to know which LICs might be subject to corporate activity, like closing up and returning money to investors. Even if you do select the correct LICs then the timeframe which it may occur can be critical.
What Are The Key Risks From This Strategy?
This issue of timeframe highlights a couple of key risks to this strategy. This can come to a head if you are investing in a LIC with a low-quality fund manager. If they end up underperforming then this can negate the benefits from closing the discount to NTA.
A related risk is with LICs that have a high-cost structure. For shareholders, time is the enemy of high fees. Meaning, the fees and costs of LICs can eat into the investment performance each year whilst you wait for a return. LICs under $100 million are often the ones that activists target to close the discount. Yet these are the ones that generally have higher cost ratios, which can often run in the range of 2% to 4% per annum.
One obvious risk, of course, is that your prediction of a takeover or wind up fails to occur at all. Mitigating this risk could be that it is an improved investing performance from the LIC which is the reason why it survives. If that was the case then the discount could narrow anyway, even if it is not eliminated completely.
Key Factors For Profiting From LIC Wind Ups
How can we deal with the risk of time and high fees dragging down your returns whilst you wait for a LIC to be taken over or wound up?
I would keep a bias for LICs with leaner cost structures. Modest base fees, low ‘other costs’ as a percentage of assets, and a buyback in place can help in this regard. A performance fee arrangement may also exist, so check the fine print as to how it is structured. In some cases, they may be so far behind the high watermark feature that it is unlikely to be charged for a long time.
Watch for activist shareholders getting a significant shareholding in the company. They can campaign to close the LICs discount. I would also examine the top 20 shareholders and be cautious where management has a large associated stake in the LIC. They may have reasons for keeping the LIC going which are not aligned with the smaller shareholder interests.
Check the Investment Management Agreement (IMA) of any LIC. These agreements can lock-in the fund manager and keep the LIC going even when it probably shouldn’t. Or sometimes it can include expensive break fees. This could prevent a wind-up even if shareholders would ideally like it to see the LIC cease operating.
Pay attention to “hidden” value such as franking credits on the balance sheet, or tax losses. This could mean extra value lurks beyond the reported pre-tax NTA figure. And as a rule of thumb, discounts of 20% to NTA can often be a trigger point that frustrates shareholders into wanting some sort of change.
There are other factors of course but these are the key ones that quickly come to my mind.
Conclusion
The key to trying to exploit this LIC investing strategy is to view capturing the discount to NTA contracting as ‘the icing on the cake’. That is, try to stay focused on LICs where you ultimately believe their investments can deliver returns above the benchmark after fees.
This should offer protection in the event that the corporate activity in the LIC you expected does not eventuate. Remember if no takeover or wind-up occurs you still might have $1 worth of assets inside the LIC effectively working for you, which you acquired for 80 cents. Over the long run that increases the potential to deliver a higher earnings yield, compared to buying a LIC at IPO.
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Disclosure: At the time of publishing, Steve Green owns shares in 8IP Emerging Companies Ltd.
