Some investors perpetually hunt for the ‘next big thing’ even when value stares them in the face. They focus too much on returns and not enough on risk. Other investors move too quickly from one idea to the next. When a stock falls, they sell and look for the next idea. When a stock rises, they take profits and search for the next idea. Seldom do they return to old ideas.
The best investors I know seek lower-risk bets, often in assets they know well. They revisit old ideas when valuations become compelling during market volatility. For them, buying undervalued assets is the best form of portfolio risk management because there is less downside risk.
Consider the Listed Investment Company (LIC) market. Only 10 of 87 LICs on the ASX currently trade at a small premium to their Net Tangible Assets (NTA), ASX data shows. Remarkably, the other 77 LICs trade at a discount to their NTA.
Some discounts are well into the double digits, meaning the market values the LIC well below the value of its underlying share portfolio.
I wrote about this valuation discrepancy earlier this month in this column, highlighting undervalued LICs for yield-focused investors. This week, I identify undervalued LICs that can form part of the portfolio core.
To recap, I cannot recall when so many LICs traded at such large discounts to their NTA. It’s been tough for LICs that are trading at unusually large discounts to their portfolio, frustrating their shareholders and managers.
Discounts and premiums are a feature of closed-ended funds like LICs. Unlike open-end funds, such as Exchange Traded Funds that trade near NTA, an LIC can trade above or below NTA due to market demand for its shares. That’s no different to other listed companies that trade above or below their true value.
Still, a few things in this LIC market are unusual. The first is the extent of discounts with so many LICs trading at historically large valuation discounts to NTA. Second, even the market’s best LICs are trading at double-digit discounts to NTA, which is highly unusual by their standards.
Third, the LIC bloodbath is occurring in a bull market for equities when LIC demand, in theory, should rise.
I’ve heard a few reasons for the extent of current LIC discounts. The simplest is more marginal selling from first-time LIC investors who bought during the COVID-19 pandemic. Also, less LIC buying as new investors are seduced by ETF hype and the allure of passive investing and market return. They’d rather buy a passive fund at low cost than an active fund.
Whatever the case, some high-quality LICs are trading at a discount of 10% or more to their NTA. For prospective investors, that means buying $1 of assets for 90 cents – an opportunity that is more compelling with the Australian equity market trading 4% above fair value, using Morningstar forecasts.
Adding Australian equities exposure to portfolios at a significant discount makes obvious sense – provided investors are confident the gap between the LIC’s share price and NTA will narrow.
Moreover, there is potential for greater capital growth if the market realises the LIC’s valuation has fallen too far below its stated NTA.
Granted, some LICs seemingly always trade at a big discount to NTA because of poor performance, a patchy dividend record or management issues. The trick is finding high-quality LICs trading at an unusually large discount to NTA by historical standards, knowing some LIC valuations revert to their mean over time.
Here are two LICs to consider. Neither will shoot the lights out or appeal to investors searching for the next big thing or exciting ideas. But owning the market’s two largest LICs when they trade at an unusually large discount to NTA can build long-term wealth in the portfolio core, at lower risk.
1. Australian Foundation Investment Company (ASX: AFI)
Picture this: An investor who wants exposure to large-cap Australian equities buys an ETF over the S&P/ASX 200 Index, such as the SPDR S&P/ASX 200 Fund (ASX: STW). The ETF provides passive exposure to the largest 200 stocks and charges a low 0.05% in fees annually.
Alternatively, they could buy AFIC, an LIC that invests in large-cap Australian equities. Capitalised at about $9.1 billion, the well-run AFIC is by far this market’s largest LIC and among its oldest. AFIC’s running costs were 0.14% in FY23, which is low for an actively managed fund (and lower than some ETFs).
AFIC this week traded at a 10.5% discount to NTA, using Bell Potter data. Over the past five years, AFIC’s valuation has ranged from a 10.5% discount to a 19.6% premium. Over the past five years, AFIC has averaged a 4.6% premium to NTA.
Simply, the market’s top LIC is trading at the bottom of its valuation range in the past five years, and well below its historical average, in a bull market no less. That’s odd.
AFIC’s underlying portfolio has outperformed the ASX 200 over one and five years to end-June 2024. Its net assets per share (including franked dividends) rose 15.1% in FY24, ahead of the 13.5% rise in the S&P/ASX 200 Accumulation Index. So, AFIC’s double-digit discount cannot be explained by poor investment performance.
Nor can the discount be explained by dividends. AFIC’s latest interim dividend is up slightly on the same time in FY23. At $7.29 a share, AFIC has a gross yield of 5% on Bell Potter numbers, which is solid rather than spectacular. The LIC suits investors seeking a mix of capital growth and income – at a discount to ASX 200 valuations.
My main concern with AFIC is its largest stock holding is the Commonwealth Bank at 10.1% of the portfolio. That position has done well, but CBA and some other Australian bank stocks look overvalued.
Chart 1: Australian Foundation Investment Company
2. Argo Investments (ASX: ARG)
Capitalised at $6.7 billion, Argo is the market’s second-largest LIC and also one of its oldest. Argo, once chaired by Sir Donald Bradman, has been a high-quality LIC for a long time and a staple of many portfolios.
Like AFIC, Argo invests in large-cap Australian equities and is actively managed. Argo’s management expense ratio is 0.15%, which is low for an active fund.
Argo currently trades at a 10.7% discount to NTA, on Bell Potter numbers. Its valuation over five years ranges from a 10.7% discount to a 10.9% premium, meaning Argo is at the bottom of its historic valuation range. On average, Argo has traded at a 0.7% premium over five years.
Of the two LICs, AFIC appeals more. Argo’s investment portfolio underperformed the S&P/ASX 200 Accumulation Index over six months to end-December 2023.
Chart 2: Argo Investments
Source: Google Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 26 July 2024.
