Two simple ways to beat the market

Financial journalist
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Self-managed super fund (SMSF) proprietors looking to get an edge on the stock market can look within it at the two largest listed investment companies (LICs), Australian Foundation Investment Company (AFIC) and Argo Investments Limited.

To many investors, LICs are the tortoises of the sharemarket. But that is not necessarily an insult: in fact, the LICs do a very good job of their stated mission, which is compounding share price rises and dividend income to generate long-term capital growth.

AFIC, the largest LIC on the Australian Securities Exchange – it is capitalised at $5 billion – was founded in 1928 by the JBWere group, while the second-largest, Argo Investments ($3.9 billion) was founded in 1946 in Adelaide by a group of stockbrokers that included Sir Donald Bradman.

Both AFIC and Argo specialise in managing portfolios of large-cap stocks. They have been solid performers against the market – although, like the market, they have taken a hit over the last three to five years.

For example, over the 20 years to the end of September 2012, Argo’s gross net tangible assets (NTA) figure has appreciated by 10.9% a year, versus 9.8% a year for the S&P/ASX All Ordinaries Accumulation Index. For its part, AFIC compares itself to the S&P/ASX 200 Accumulation Index (because it holds a smaller number of stocks in its portfolio): over the 20 years to the end of September 2012, AFIC says its gross NTA has appreciated by 11.4% a year, compared with a 9.9% a year gain for the S&P/ASX 200 Accumulation Index.

The NTA figure, which is the market value of the fund’s share portfolio divided by the number of units on issue, is the best measure of the performance of the LICs. The NTA tells you the dollar amount of the portfolio’s value that ‘stands behind’ each unit. Each month, the LICs will quote two NTA figures, one gross, one net of capital gains tax that may arise should the entire portfolio be liquidated (they are required by current accounting standards to do this.) As most LICs are long-term investors that don’t intend to sell their portfolios, the gross NTA is the figure to use.

For self-managed super fund (SMSF) investors, LICs are an excellent way of holding a stock that delivers instant diversification and a decent shot at outperforming the market return.

LICs vs managed funds and ETFs

When investors are paying upwards of 1% a year for an actively managed fund, not beating the index is a problem.

This point was recently reiterated with the release of the mid-year 2012 S&P Dow Jones SPIVA Australia scorecard. This research measures the performance of active fund managers against S&P’s main market indices such as the S&P/ASX 200 accumulation index.

In the equity funds category, over the 12 months to the end of June, the index outperformed 72% of active share fund managers. Over three and five years, the proportions of funds beaten by the index were 72% and 81%, respectively.

That is why ETFs and index funds, which at least give the market return, and cost one-quarter of that, have grown in popularity.

Where LICs fit into this discussion is that they are actively managed vehicles – but they charge as if they were passive.

LICs are closed-end investment vehicles: this means that after the initial capital raising, the shares trade at a price set by the market. No new money comes into the fund unless new shares are issued or through a dividend reinvestment plan.

This makes LICs very different to unlisted equity trusts, which are open-ended investment vehicles: at any time a new investor can buy new units in the trust, which are priced at the prevailing NTA. The unlisted equity trust manager has to invest new money coming in; and conversely, sell shares to meet investor requests to take money out of the fund.

LICs do not. The fund manager gets to take a long-term view on their investment portfolio. All managers advertise that they do this – but the structure of the LIC means that they really can.

Performance

This ability can have a very material impact on investment performance. For instance, William Spraggett of Bell Potter – probably Australia’s leading analyst of LICs – reckons the larger LICs outperform unlisted equity trusts by about 1.6% a year. (Spraggett compared the domestic equity LICs he covers to about 700 unit trusts with performance figures in the Morningstar database.) Considering that the big LICs focus on the large-cap stocks – where arguably the market is materially more efficient, and outperformance harder to achieve – this is a very pertinent statistic.

And for that performance, Spraggett says Argo Investments charges investors an indirect cost ratio (ICR) of 0.18% a year; AFIC charges 0.19% a year.

On yield grounds, the big LICs are solid performers, but not spectacular. Looking at 2011-12 dividends, Argo paid a dividend of 26 cents last year, while AFIC paid 21 cents. At a share price of $5.75, Argo is priced on a historic nominal yield of 4.52%. At $4.73, AFIC shows a trailing yield of 4.44 per cent.

The dividends are fully franked, which means that an SMSF in accumulation mode is earning 5.5% on Argo shares and 5.4 per cent on AFIC. In pension mode, these yields are augmented to 6.4% for Argo, and 6.3% for AFIC.

These are not as lucrative as bank yields, for example, but for a less-volatile, diversified portfolio, they are very solid income contributors.

Pricing

There is one other feature of LICs that investors must grasp, and that is that the share price of a LIC can and will fluctuate around its NTA figure. What this means is that when the price is less than NTA, investors can buy an interest in a high-quality, well-diversified share portfolio for less than the cost of establishing that portfolio themselves. The reverse also applies, and an LIC’s share price can exceed the prevailing NTA.

The LICs’ NTA figures come out each month, but Spraggett models the figures on an intra-day basis: at present, he has AFIC trading at a 2.8% premium to its NTA, while Argo is valued by the sharemarket at a –2.1% discount to its NTA.

Traders on the market can make money on the fluctuations of the LICs’ share prices compared to their stated NTA figures, but that constantly shifting balance should not concern SMSF investors.

The bottom line

However, that slight discount – and a touch better yield – indicates that Argo is a better bargain at the moment. But both Argo and AFIC should be considered highly effective and cheap ways to capture the long-term total performance of the sharemarket, over an extended period of time.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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