January 19, 2019
Unless you’re brand new here, you’ll know I invest in listed investment companies (LICs).
If you are new, welcome! But do check out this post on LICs before continuing with today’s article. Otherwise you may not know what the hell I’m talking about!
For regular readers, some of you have decided that including diversified LICs in your portfolio makes sense. Especially for those looking to live off the dividend income from these investments one day.
But a quirk of LICs is, they can trade at a different price to the value of their assets. So this raises questions. How do you know when to buy? Is it okay to pay a premium?
Today, I’ll share the approaches you can take, and also what I do personally. Then you’ll be well equipped to decide what to do in your own investing. OK, let’s get stuck in!
As with most things in the finance world, this all sounds more complicated than it is. And after understanding the basics of it, you can quickly devise a simple plan for dealing with this factor and move on.
Firstly, you buy shares in a LIC just like you would any other company, like Woolies or Commonwealth Bank for example.
And the price of these shares fluctuate depending on many things, including demand and supply from buyers and sellers.
Obviously this is very different from an index fund. An index ETF moves up as the market goes up, and down as the market goes down.
LICs exist to invest in a portfolio of shares for the benefit of shareholders. And the main ones we discuss here on this blog, invest in a broad basket of Aussie shares from a range of sectors.
So the value of their underlying portfolio – known as Net Tangible Assets or NTA – tends to move in a similar fashion to the market, but the share price of those LICs does not. At least not on a daily basis.
Take AFIC for example. Because LIC share prices are dictated by buyers and sellers like every other company, AFIC shares may go up today, even if the market goes down – or vice versa.
Now, let’s say shares in AFIC are trading at $6. Whereas, its underlying portfolio (NTA) may be worth $5.80 per share. This means AFIC is trading at a premium of around 3%.
So does that mean it’s expensive and you shouldn’t buy? Well, it depends. More on that later.
For now, just get comfortable that the price of the LIC moves around separately from the value of its underlying portfolio (NTA).
Every month, the Aussie Stock Exchange (ASX) requires each LIC to report the value of its portfolio to the market, by the 14th of the following month.
Here’s an example of the January statement from AFIC, disclosing its portfolio value or NTA, as of 31 December.
Handily, this statement shows us the current top holdings, portfolio breakdown by sector, and even the premium/discount that AFIC shares have traded previously.
Note – not all LICs share the same detail. Others, like Milton show the dividend history but not the premium/discount information.
Of course, the market has moved in the 3 weeks since that statement, as it does. This means the underlying value of AFIC’s portfolio has moved too.
So we need to take it a step further if we really want to get a clearer picture of what our dollars are buying. But first…
On that portfolio statement, there are two numbers you’ll see. One is pre-tax NTA. The other is post-tax NTA.
Pre-tax NTA is simply the current net value of each share after the company has paid income tax and any capital gains tax owing from investments it has sold.
Post-tax NTA is the value of each share if the company liquidated its entirely portfolio today and paid all capital gains tax owing and then gave the money back to shareholders. Effectively, what’s leftover if the LIC sold everything and closed down forever.
For our purposes, pre-tax NTA is what we want to look at. The current ongoing value of the portfolio. Why would I care what Argo is worth if it closed down today?
A large and conservatively managed 70+ year old investment company with tens of thousands of shareholders and no debt isn’t going to sell everything and shut up shop. Ain’t gonna happen.
OK, back to estimating NTA during the month…
For simplicity, let’s say AFIC is trading at $6 per share. And the last monthly statement showed AFIC’s portfolio, or NTA, was $6 per share.
But given the delay in reporting, it’s now 3 weeks later. So we need to look at where the market went in that time, to see if AFIC is trading at a premium or a discount.
We’ll say the market went up by 2% over that time. Given AFIC’s portfolio is very similar to the ASX 200 index, we can roughly assume that its portfolio also increased by 2%. This would mean NTA increased from $6, to $6.12.
With shares trading at $6, AFIC is then trading at a 2% discount. See how that works?
Simply put – take the end of month NTA, and adjust for where the market has gone since then, to get a decent estimate of current NTA.
Also, once shares hit the ‘ex-dividend’ date (when you’re no longer entitled to the upcoming dividend), shares will fall by roughly the amount of the dividend.
Well, one easy way is to check where the market was on the last day of the month and where it is now.
Your broker likely has data on this. Or you can simply check this page, which shows the ASX200 price history.
Take the current ASX200 price and divide by the end of month price. For example, as I sit here on Thursday January 19, I’d do this…
5847 / 5654 = 1.034
This means the market has gone up by 3.4% since December 31. Now we take the latest pre-tax NTA from the company website or portfolio statement, and add 3.4%.
That’s it, the current NTA estimate! Here’s a real life example…
Milton’s website shows end of month NTA was $4.42 on 31 December. With the market up 3.4% since then (as at January 17), this means Milton’s NTA is somewhere around $4.57.
So with shares trading at $4.43, Milton is trading on a discount of around 3%.
Again it all sounds far more complicated than it really is. Not to mention it’s all entirely optional. More on that soon.
But thanks to some nifty work from fellow blogger Pat the Shuffler, there’s an effortless way (my favourite) to do this.
Enter, the NTA Premium/Discount Estimator.
Pat has created a Google Doc which is updated monthly with official figures, but also sucks in the daily price movements as they’re happening (delayed 20 mins).
So with a quick peek, anyone can quickly see whether their chosen LIC is trading at a premium or a discount. The Estimator includes AFIC, Argo, Milton and BKI.
Of course, these numbers are only a best guess. But it’s a much easier way of guessing!
And another good thing is, the numbers are adjusted on the ex-dividend date (when you’re not entitled to the upcoming dividend).
As alluded to earlier, these small discrepancies exist for many reasons.
One important thing to note, overwhelmingly, LICs are owned by retail investors, not so much by institutions or professional investors.
Since retail investors often have a different set of criteria for buying shares, demand for those shares is often based on popularity with retail investors.
This can probably be seen as an imperfect corner of the market, where there’s little, if any interest in buying and selling to profit from a small spread or opportunity until it’s gone. Hence, these LICs do not trade exactly in line with their NTA.
Some LICs trade at a premium for long periods of time, others at a discount.
And many will dance from premium to discount and back, depending on lots of factors – most of which are unpredictable.
— Solid track record of performance over a decent time period (5+ years).
— Proven to be a reliable dividend payer, or offers higher than average fully franked yield.
— Retail investors are simply topping up their holdings and don’t track NTA closely (or at all).
— Deemed to be a very safe and stable investment option. Perceived higher quality.
The opposite of above…
— Poor level of performance over recent or long term history.
— Unreliable dividends or low level of yield.
— Management have proven to be less trustworthy or not always acted in shareholders best interest.
— Simply less popular, less liquid, or deemed to be higher risk investment option. Perceived lower quality.
A fair chunk of this factor comes down to popularity.
For example, at the time of writing the most popular LICs like Argo & AFIC have tended to, on average, trade at a small premium much of the time (+1% to +3%).
Some of the better performing small/mid cap LICs which pay high dividends can often trade at very large premiums of over 20%. Because many retail investors are buying based on the expectation of getting a high and reliable yield.
Personally, I’ve paid large premiums in the past for high yielding LICs like this. But I’m just no longer comfortable doing that. There’s no need. Often if you’re patient the extreme premium will come back down. Or you can simply find an alternative LIC to invest in!
Another reason for the premium/discount factor is simply because LICs don’t precisely follow the market. Their share prices tend to move in a slower fashion than the market does.
So if the market is rising, LICs share prices tend to rise slower and often trade at a discount. And in a falling market, they tend to fall slower so often trade at a premium.
Many shareholders probably don’t worry about NTA too much, so it takes a while for the market moves to be reflected in the share price of these LICs.
Other than the above, your guess is as good as mine! There’s a realm of possibilities as to ‘why’.
Unless you survey everyone, you’re not going to know exactly why they bought or sold at the price they did.
So now you know what happens and why it occurs. The next logical thing to wonder is, how do you approach it when building a portfolio?
The way I see it, you have a few options…
The first option, of course, is to not even look. Just forget about it and go do something else!
Although it sounds reckless, experienced investors (like Peter Thornhill) realise that LIC premiums and discounts tend to even out over time. See exactly what Peter says about this approach in my interview with him.
If we’re buying shares for the next 30+ years, we’ll probably buy at a premium and also at a discount, many times over. So does it really matter?
Here’s an example…
Let’s say over 30 years you achieve a return of roughly 8% per annum. Your investment will grow 10 times in value.
To be exact: $100 will become $1000, at a return of 7.98% per annum.
If you pay a premium of 2% for those shares – $102 instead of $100 – and again end up with $1000, your return is 7.91% per annum.
So you’ve just multiplied your money by 10x! Hopefully you won’t be freaking out about the tiny fraction you missed out on!
If this relaxed approach sounds best to you, how do you apply it?
Choose which holdings you’d like to have in your portfolio. Then put them in order (any order) and buy one each month. Simply take it in turns, for an easy set-and-forget accumulation strategy.
Next, you can follow the approach above, but mildly optimise.
Realise you’ll still pay a premium sometimes and that it probably won’t matter that much over the long term. But being mindful of this factor and making a rough guesstimate to make sure you don’t pay way too much.
You can use the manual approach to figure out the premium/discount, or use Pat’s LIC Estimator.
Again, choose which LICs you want in your portfolio. Then buy the LIC trading at the largest discount first. The following month, you’d simply buy the next cheapest one on the list. And so on.
You’ll probably still pay a premium sometimes as you work down your list. But this approach is still pretty relaxed and easy to follow.
For the classic over-thinkers and over-analysers. You can watch the premiums/discounts relentlessly, making sure you never pay more than NTA value, and always buy the LIC trading at the largest discount.
Your spreadsheet or Pat’s tool will be your best friend. However, there’s still no guarantees your performance will be much better than the comatose investors taking Option #1.
It may help a fraction over the long term, looking back at the calculation above. But one thing’s certain, you’ll probably be spending more time, effort and worry on it.
Here’s the issue for the discount chasers…
You’ll likely only ever buy LICs which regularly trade at a discount. And those LICs may be trading at a discount for good reasons.
So you may not be able to build your portfolio in the way you’d hoped. You’ll simply end up buying Whitefield every month because it appears the cheapest, when you’d really prefer to buy Argo or AFIC, for example.
This approach creates the most anxiety and can cause investing to become less enjoyable. All this effort for no certain reward!
Do you really think that’s the best way to go about investing and building a portfolio?
Now I know some people won’t want to pay a premium out of principle. That’s OK, I get that. But most people are better off doing other things in life, than agonising over whether they’re paying a 1% premium or which LIC they should buy this time vs next time.
Take a step back for a minute. And recognise we can probably use our time and energy in a more productive way. So we need to let go of that control freak inside us and approach this more casually. You’ll enjoy investing a whole lot more, trust me.
And in case you haven’t heard, Perfection is Our Enemy.
If you’ve got a headache right now, then I’ve got a solution for you…
Buy the index! That’s right. Simply buy shares in an Aussie index fund (for example, Vanguard’s fund VAS) and you’ll never have to think about LIC premiums and discounts again.
As much as I like LICs, I think some people are better off with this approach. One big reason is, this way they won’t worry about what to buy and then second-guess themselves.
Buying the index will make the investing process a whole lot easier. Your returns will be similar over time, possibly higher. Dividends will be similar, just fluctuate more.
So if these things keep you up at night, please feel free to say “stuff this” and go for an index fund. You’ve gotta do what feels right for you.
Lastly, we can take a hybrid approach to LICs and indexing, by combining them!
Before you switch off, thinking I’ve just made this more complex, hear me out.
These two investment vehicles aren’t opposites. Actually, they’re quite similar.
Both are a low cost way of owning a large portfolio of Aussie shares. And both serve our purpose of providing a good level of income which grows over time. LICs are just a more targeted way to achieve that goal since it’s their primary objective.
The index has no such goal. But by tracking the performance of the top 300 companies in Australia, as those companies earnings grow and they pay larger dividends, the index will naturally pay out higher dividends as a result.
So Option #5 is simply this: Buy your chosen LICs when they’re trading at a discount or close to their NTA. And if they’re trading at a premium you don’t want to pay (say over 2-3%), then buy the index.
Honestly, I used to think about this stuff a lot at the start. But after realising it was making the whole process of investing less enjoyable, I took a step back.
And I started to see for the effort spent over-analysing LIC premiums and discounts, the long term result wasn’t likely to be much different.
So I don’t mind paying a small premium to buy the holding I really want. This helps me keep balance in the portfolio as it grows. Otherwise I’ll end up with a weird and lopsided looking portfolio, that isn’t what I want.
My attitude is that of Option #2 – the Mild Optimiser.
But now that I’ve recently added an index fund (VAS) to my portfolio, I’m mostly in the Option #5 camp.
Pretty simple. Pretty relaxed. And only takes an extra minute or two, for each purchase.
Like many things, this can be as simple or as complicated as you like!
Hopefully you’ve now got a good handle on LIC premiums and discounts, why they occur, and which approach suits you best when building your portfolio.
Remember, the point isn’t to buy at a discount and sell it later at a premium. That’s a trader mentality. The benefit is simply buying a diversified basket of shares at a discount to their market value. Thereby getting the long term income stream from those shares at a slightly cheaper price.
Now you’re probably wondering, what does my portfolio look like? Why have I added the index to my portfolio? And how do you decide what to invest in each holding?
Well, each of these topics will be covered very soon in future blog posts – so stay tuned!
However you choose to approach LIC premiums and discounts, and the rest of your investing, there’s one thing I’ve learned – lean towards simplicity.
Instead, spend more time focusing on bigger impact stuff. Like increasing your savings rate. Building an enjoyable low-cost lifestyle. Or just enjoying your home life, family and hobbies.
Whatever you do, just keep investing and focus on the long term! Which approach are you taking? Let me know in the comments.