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Peter Rae
Expert
+ About Peter Rae

Peter Rae joined Independent Investment Research as a supervisory analyst covering listed managed investments in March 2016. Peter has 35 years’ experience in the banking and finance industry, including 15 years as an equities analyst. Peter was a sector head in the equities research team at Morningstar with a focus on consumer and industrial companies. Peter joined Aegis Equities Research, subsequently acquired by Morningstar, a leading global provider of independent investment research, in 1999. At Aegis, he held a number of positions including Team Leader, Financial Services and Head of Equities. Before joining Aegis, Peter had an extensive career in the banking industry working in various treasury and balance sheet management roles at St.George Bank, National Australia Bank and Advance Bank. Peter is a Fellow of FINSIA.

Top ten yielding LICs

Wednesday, October 11, 2017

By Peter Rae

Recently we wrote about the fact that few listed investment companies (LICs) reduced their dividends during the recent reporting season despite many reporting lower earnings. This reflected the fact that most LICs have a level of profit reserves that enables them to smooth dividends by holding back when profits are strong.

Our key measure for assessing LIC performance is total portfolio return, being growth in pre-tax net tangible assets (NTA) plus dividends, however, we understand that many investors in LICs are also focused on receiving attractive, fully franked dividends. So this month we take a look at the 10 highest yielding LICs in our coverage universe (refer to below table) and consider the outlook and sustainability of these dividends.

In order to be able to pay dividends, LICs need to generate profits. However, it is possible for LICs to pay out more than they generate in profits in a given year by dipping into retained profit or dividend reserves from prior years. So it is possible for LICs to smooth dividend payments to their shareholders by retaining profits rather than simply paying out 100% of earnings each year. The table above shows our estimates (based on published accounts) of the number of years each LIC could retain its current dividend payments without generating any additional profits. This is a good indicator of dividend sustainability when markets turn down.

Coverage of one means that an LIC could maintain its current dividend payout for one year without generating any profit in the current year.

Contango MicroCap dividend could be at risk of a cut

The highest yielding LICs in our coverage universe are the two Contango Asset Management (ASX:CGA) managed LICs, Contango MicroCap (ASX:CTN) and Contango Income Generator (ASX:CIE) with yields of 7.0% and 6.6% respectively, albeit only 50% franked. Whilst CTN appears to have reasonable profit reserve cover of 1.8 years, we think this dividend may be under threat given poor performance of the portfolio. CTN has delivered negative portfolio returns of 11.3% and 1.7% p.a. on a one and three-year basis. Whilst performance has been positive in the last three months, we think the performance of recent years could prompt a dividend reduction.

Although CIE has slightly less coverage at 1.4 years, we think the dividend is more sustainable. It generated a 5.5% portfolio return on a 12-months basis and many of its portfolio holdings are in companies that deliver stable, relatively attractive dividends (in many cases fully franked) and can to be passed on to CIE’s shareholders.

Hunter Hall Global Value has the strongest cover

Hunter Hall Global Value (ASX:HHV) has undergone a period of significant turmoil since the departure of its founder, Peter Hall in December 2016. However, stability seems to have returned since the merger of its manager with Pengana Capital. Like CTN, HHV generated a significant portfolio decline in the past 12 months. However, the new manager has unwound most of the old portfolio and re-established the portfolio in accordance with its own processes, so hopefully some stability will return. We believe the new manager has stronger risk disciplines around the portfolio, so volatility of return should be reduced. Despite the poor portfolio performance over the past year, we think the fully franked dividend is reasonably safe given more than six years of profit reserve cover.

Whilst Asian Masters Fund (ASX:AUF) shows up with a high yield, we note that this is due to a special dividend payment of 5 cents per share in May 2017 versus ordinary dividends of 2.2 cents per share. The LIC doesn’t have a history of paying special dividends, so we would not be assuming further specials. The LIC does however appear to have good reserve coverage.

Westoz Investment Company (ASX:WIC) also has good coverage at 3.3 years. With this LIC exposed to the West Australian resources driven economy, its returns and earnings can be volatile. It performed strongly over the past year on a rebound in resources but the five-year portfolio return is just 3.3%. The full year dividend was dropped back from 9 cents per share to its current level of 6 cents per share in FY2016 and looks sustainable at that level for a time, unless there is another major downturn in resources. The board is targeting a dividend of 6 cents per share for FY2018.

At 3.6 years, WAM Research (ASX:WAX) also has strong dividend profit reserve cover. The LIC has been steadily increasing its dividends for a number of years and with a history of delivering strong portfolio returns we don’t see any immediate threat to the dividend. WAM Capital (ASX:WAM) has much slimmer reserve cover at 1.1 times, although we note that it too has a history of delivering strong portfolio returns and so is continuously generating new profits from which to pay dividends. However, the dividend could come under threat of a reduction in a severe market downturn.

Cadence Capital (ASX:CDM) had a good FY2017 with a portfolio return of 10.0%. However, it was one of the few LICs to reduce its dividend in FY2017 with the full year dividend of 8 cents per share down from 9 cents per share in the prior year. Dividend cover from profit reserves is just one year which doesn’t leave much in reserve in the event of a severe and prolonged market downturn.

Djerriwarrh Investments was another LIC to reduce its dividend payments in FY2017 due to lower dividend options income. The reduction had been well flagged. Whilst the outlook for DJW’s dividend income is slightly better, with 1.1 years of profit reserve cover, there is the risk of a further reduction in its dividend payments to shareholders if its own dividend income declines and/or volatility remains low.

 

Microcaps: Year in review

Thursday, August 10, 2017

by Peter Rae

While the financial year 2017 may not have been overly pleasing (with the performance of the ASX emerging companies index returning a dismal -2.3% for the year), a different picture emerges when looking at the performance of active managers in the space.

The majority of microcap managers outperformed the Index, which shows why this is an attractive hunting ground for alpha for fund managers and investors.

Below is a table illustrating the returns of managed funds (which actively focus on microcaps or the bottom end of the small-cap space), together with the performance of their listed microcap LIC counterparts.

Some analysis of the results reveals some interesting facts.

While some managed funds had negative returns for the year (for example, Acorn and Ausbil), the vast majority of fund managers had a positive performance for the year, and not a single one of the 19 fund managers in the aforementioned table underperformed the ASX microcap index.

Despite the “great rotation” or the “silent crash” in small caps/microcaps during the year, we did see two new microcap funds launch (Perennial and Eley Griffiths) and a new LIC from Wilson Asset Management. The more players in this space the better, as it improves overall liquidity in the market. It also broadens the spectrum of managers available to both advisers and self-directed investors who are looking to allocate capital to the space as part of their overall asset allocation.

Yet again, the majority of active managers easily outperformed the Index, demonstrating that this part of the market can be a great alpha generator for managers who put the work in. Aside from that, their investors would have also been handsomely rewarded in terms of performance. Based on information published by Perennial earlier in the year, the median microcap manager had delivered 18.8% annualised over five years, versus the -4.8% for the microcap index over the same period.

The SPIVA reports that track how active managers perform versus the index noted that Australian small cap managers outperformed the index 52% of the time over five years and 67% of the time over 10 years. However, my suspicion is that if SPIVA looked at microcap managers in Australia, the results would be equal, if not higher, than the small cap performance.

Of course, academics will tell us active managers can’t add alpha and index fund promotors will tell us active management is dead. Oh, and just as an FYI, for large cap managers, it’s 30% and 25% respectively.

The performance of most microcap managers also handily outperformed the ASX Small Ords index, and generated returns in line with the ASX All Ords index and the ASX 300/200 index, which is a fine effort.

Top of the pops in FY 2017 was the Forager Australian Share Fund, followed by Cromwell Phoenix Opportunities Fund and the Terra Capital New Horizons. All delivering portfolio returns in excess of 20%.

A corollary to good performance by one market participant means poor performance for other market participants. Here, the Monash Absolute Investment Company, Contango Microcap and Ausbil Microcap all had an “annus horribilis”, as her majesty would say.

However, judging any manager on a single year performance, either positive or negative, is short sighted. All managers need to be judged over a reasonable timeframe and taking into account a more holistic view of their investment philosophy and process. This year’s underperformers could be next year’s star performers.

Looking at the group overall, we can see that the average performance achieved by all the managers was +10.8%, which represented a 13.6% outperformance versus the microcap index and 3.8% outperformance versus the small cap index.

 

Five LICs at a discount to NTA

Monday, July 17, 2017

VGI to Launch a New Global LIC

VGI Partners, a Sydney and New York based global equity manager, has flagged its intention to create a new listed investment company. VGI Partners Global Investments could potentially raise between A$100m to A$300m, plus up to A$100m in oversubscriptions, to invest in a portfolio of global equities. VGI currently manages money primarily for high net worth individuals, family offices and endowment funds. It has over US$800m in funds under management and has a stated target of closing its funds to new investment when it reaches US$1,250m. VGI believes a LIC would help it achieve its fund target earlier, which would then allow the team to focus on managing the portfolio rather than chasing new money. The LIC would also provide the opportunity for retail investors to access VGI’s global investing strategies. The current minimum investment in its funds is $1m.

VGI’s investment philosophy focuses on capital preservation and achieving superior long-term growth by investing in high quality businesses. It is often contrarian and will move to cash when a sufficient margin of safety does not exist. It invests in a concentrated portfolio of 10-15 core stocks. Whilst we have not seen any published data, we understand VGI has outperformed the MSCI World Index by close to 4% p.a. since its inception in 2008.

A key feature of the initial public offer is that VGI will pay all the offer expenses so the LIC will start day one with a net asset value equivalent to the offer price. This will favourably differentiate it from most LIC IPOs where the investors wear the up-front costs. This means there will not be the need for attaching options. A prospectus is expected to be available in late July with the shares listing in October 2017. We will be undertaking research on VGI Partners Global Investments and will publish a report in due course.

New Listed Fund to Focus on Disruption

Specialist global fund manager, Walsh & Company, has issued a product disclosure statement for a new fund that will focus on the disruption theme. The Evans & Partners Global Disruption Fund (proposed ASX code: EGD) will be a listed investment trust that invests in a concentrated portfolio of largely listed international shares. As well as investing in companies that have proven abilities to disrupt, and the potential to continue to disrupt, the fund will invest in a selection of smaller innovators who have the potential to successfully disrupt existing industries and companies. It is our expectation that the portfolio may have something of a core-satellite characteristic, representing a mix of larger, established companies (Alphabet, Apple, for example) and smaller less established companies. Evans and Partners Investment Management will be the investment manager for the fund and Walsh & Company will be the responsible entity. The investment committee will comprise a number of leading industry figures with experience in technology, innovation and disruptive enterprises.

The offer, expected to close on 18 July 2017, is for 62.5m units at $1.60 to raise $100m, with the ability to raise an additional $50m through oversubscriptions. We have published a full research report on EGD and our rating for the fund is Recommended.

HHV Announces Strategic Initiatives

On 6 June the Board of HHV announced a number of new strategic initiatives aimed at delivering shareholder value. These initiatives include changes to the Board, lower directors’ fees, a reduced base investment fee, changes to the investment mandate and tweaking of the dividend policy. Frank Gooch, currently Managing Director of Milton Corporation (ASX: MLT) has joined the Board and will become Chairman of HHV after the next AGM. Frank has considerable experience in the investment industry and has been CEO of MLT since 1999. Russel Pillemer, CEO of Pengana Capital also joins the HHV Board whilst interim Director, Rob Millner leaves the Board.

The HHV mandate will be changed to replicate the Pengana strategy which has a focus on investing in a well-constructed portfolio of growing businesses at reasonable valuations. The portfolio is typically segmented into core, cyclical and opportunistic components with core stocks providing stability with a weighting between 60-80%. HHV will retain its ethical focus with Pengana applying ethical screens across the portfolio. The HHV portfolio will be managed by the merged investment team which is led by Pengana Chief Investment Officer & Portfolio Manager, Jordan Cvetanovski and Steven Glass, Head of Research & Portfolio Manager. Former Hunter Hall CIO, James McDonald is also a member of the investment team.

The dividend policy has been revised slightly with the words “consistent and regular” replaced with “regular and growing”, the emphasis being on “growing”. The Board anticipates it will pay a 3.5 cents per share final 2017 dividend but said it will confirm this in July. This is consistent with previous comments and would take the FY2017 dividend to 7cps, up from 6cps in FY2016. This represents a yield of 6.4% on the current share price of $1.10.

We have commenced a detailed review of HHV and will publish a report and revised investment rating in the coming weeks.

New Listings - Contango Global Growth & WAM Microcap

Contango Global Growth (ASX: CQG) shares listed in June after the company raised $100m through the issue of 90.9m shares at $1.10. An equivalent number of attaching options were also issued. CQG joins the ranks of LICs focused on international equities with the company planning to invest in a concentrated portfolio of quality global growth equities. Our rating for CQG is Recommended Plus.

WAM Microcap (ASX: WMI) successfully raised $154m through an initial public offer and the shares commenced trading on 28 June. The offer was oversubscribed and, whilst existing investors in Wilson Asset Management LICs received their full allocations under the priority offer, other applicants were scaled back. WMI will invest the proceeds of the offer in a portfolio of undervalued ASX listed companies with a market cap less than $300m at the time of investing. The Manager, Wilson Asset Management, will use its proven research-driven and market-driven processes to select stocks for the portfolio. IIR has not undertaken any research on WMI and we make no recommendation in relation to the LIC.

Initiating Coverage of Switzer Dividend Growth Fund

IIR has initiated coverage of Switzer Dividend Growth Fund (ASX: SWTZ) an Active ETF that listed in February 2017. SWTZ seeks to provide investors exposure to a portfolio of actively managed large cap stocks with a focus on providing an attractive income stream with the benefits of high levels of franking. Given this objective, we would expect the trust to provide an above market dividend yield over the long-term. The trust will also be seeking to provide capital growth over the long-term through active management of the portfolio. Switzer Asset Management is the Investment Manager for SWTZ and Contango Asset Management (ASX: CGA) has been appointed Investment Adviser. IIR has assigned SWTZ a Recommended rating. For further details see our full initiation report.

Upgrading AFIC to Highly Recommended

IIR has upgraded its rating for Australian Foundation Investment Company (ASX: AFI) from Recommended Plus to Highly Recommended. This recognises its sound investment processes, highly experienced investment team and Board, transparency, exceptionally low costs and the benefits of a lengthy track-record. Investors can gain confidence from a long track-record in which the Manager has achieved its investment objectives over the long-term, particularly in delivering a stable, growing, fully-franked dividend. Refer to our full research report for details of the upgrade.

Discounts and Premiums

In this month’s LMI Update we look at premiums and discounts to NTA and profile five LICs trading at large discounts to pre-tax NTA.

In our view, there are four key factors that contribute to the extent of a LIC/LIT trading at a discount or premium to net tangible assets (NTA). These are: (1) Dividend consistency - LICs/LITs that provide a consistent and growing dividend stream tend to trade at narrower discounts or even premiums while LICs/ LITs with volatile or declining dividend payments tend to trade at heightened discounts; (2) Portfolio performance - performance of the portfolio will contribute to the discount/ premium with LICs/LITs achieving their objectives generally trading at narrower discounts (or even premiums) than those that are not achieving the stated objectives; (3) Shareholder engagement - those LIC/LITs that engage regularly with shareholders and grow the shareholder base tend not to experience the extreme discounts; and (4) Market Liquidity – LICs/LITs with a low market cap or where market liquidity is thin are more likely to trade at discounts.

As the pricing tables on the following pages show, the Australian large cap share focused LICs are mostly trading at discounts to pre-tax NTA. We see this as a reasonable entry point for long-term investors. Amongst the mid/small-cap focused LICs/LITs, there are more entities trading at discounts than premiums. However, most of the larger, better performing LICs/LITs such as WAM Capital (ASX: WAM), WAM Research (ASX: WAX), Mirrabooka Investments (ASX: MIR) and Forager Australian Shares Fund (ASX: FOR) are trading at significant premiums. We discussed this in our last monthly and noted that mid-cap focused LIC, Contango Income Generator (ASX: CIE - trading at a 7% discount at the end of May), presented an opportunity for investors looking for exposure outside the large caps.

The above table highlights LICs under our coverage that are trading at the largest discounts and premiums to pre-tax NTA. Investors need to be careful when buying LICs at a discount to NTA as many trade at significant discounts for a prolonged period and there is no guarantee the discounts will be eliminated. We provide a few comments below on the five largest discounts to NTA and look at potential catalysts that might see the discount correct.

Bailador Technology Investments (ASX: BTI)

Technology focused LIC Bailador has traded at an average discount of 14.1% since its listing in late 2014. So a 25% discount at 31 May 2017 seems excessive. The underlying portfolio of investments in expansion stage technology businesses has performed reasonably well since inception, delivering an underlying portfolio return of 14.3% p.a. to 31 December 2016, after all fees. However, pre-tax NTA per share has grown at a slower 5.1% p.a. to 31 May due to the dilutive impact of options exercised in March 2016. Over the past 12 months pre-tax NTA per share has fallen by 3.4% and this could help explain the discount. Potential catalysts for a re-rating include strong valuation uplifts of its portfolio investments and realisation of these gains over time. In a presentation earlier this year, BTI said it expects a material valuation and cash realisation over the next 24 months. We think the market will wait to see some evidence of this before undertaking a significant re-rating of the stock. In May, BTI’s investment in Lendi, an online home loan provider, saw a 42.3% uplift in valuation on the back of third-party investments. The nature of BTI’s investment portfolio means that returns are likely to be lumpy and of a capital nature, so an investment in BTI is more suited to long-term investors. Our rating for BTI is Recommended Plus.

Barrack St Investments (ASX: BST)

BST is a relatively new LIC having listed in August 2014. It invests in a portfolio of predominantly mid-to-small-cap Australian shares. The portfolio performed well in its first 18 months following inception, but performance over the past year and options dilution has significantly dragged down returns, with a portfolio return (pre-tax NTA plus dividends) of minus 10.0% over the past 12 months. Since inception the shares have traded at an average discount to pre-tax NTA of 14.5%. The key catalyst for a narrowing of the discount is likely to be evidence of improved performance. With a market cap of just $15.7m, BST is a relatively small LIC which is likely to restrict market liquidity in the shares. Our rating for BST is Recommended.

Flagship Investments (ASX: FSI)

FSI is managed by the same investment manager as BST, EC Pohl & Co, but it has a longer track record and stronger performance. The portfolio is concentrated and invested across the market, but has a heavy weighting (around 70%) to ASX 100 stocks. Whilst it has significantly underperformed over the past 12 months, performance over three and five years is more in line with the market. Over the past 12 months performance has been hurt by falls in a number of small cap exposures and underweight positions in resources and energy. The current discount to pre-tax NTA is broadly in line with the three-year average. Likely catalysts for a narrowing of the discount include a return to stronger performance and improved investor communication. Dividends have been flat over the past two years so higher dividends would likely lead to improved share price performance. Our rating for FSI is Recommended.

Hunter Hall Global Value (ASX: HHV)

The HHV discount of 13.4% at the end of May compares with an average discount over the past three years of 9.7%, although in the latter months of 2016 the discount was much lower. We believe the current discount reflects the recent instability surrounding the Investment Manager, the Board and poor portfolio performance over the past 12 months. With a return to stability following Hunter Hall International’s merger with Pengaga Capital, Board renewal and the announcement of new strategic initiatives, we see the potential for the discount to start narrowing. Our HHV rating remains suspended whilst we undertake a detailed review of the LIC and its manager.

Contango MicroCap (ASX: CTN)

CTN has also suffered a degree of instability following attempts to split the portfolio management amongst two managers and the subsequent Board instability. With the LIC returning to a one manger entity and a refreshed Board, stability seems to have returned to the company. The 31 May discount of 9.9% is close to the three-year average of 10.9% and, while the instability over the past six months no doubt plays a part, the portfolio has also underperformed over the past 12 months dragging down the longer-term performance numbers. Dividends have also fallen over the past two years. Whilst stability seems to have returned to the company, the market is likely to want to see an improvement in performance before the discount starts to narrow. Our rating for CTN remains suspended while we undertake a detailed review of the LIC.

For pricing and recommendations and performance data, click here.

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.

 

LIC monthly report

Friday, June 09, 2017

By Peter Rae

K2 Asset Management reduces Small Cap Fund fees

K2 Asset Management is changing the fee structure on its K2 Australian Small Cap Fund (Hedge Fund) (ASX: KSM) from 3 July 2017. The investment management fee falls from 2.05% p.a to 1.31% p.a and the performance fee falls from 20.5% to 15.38% p.a. All fees are inclusive of GST and RITC. A new performance fee hurdle of 6% p.a absolute return will apply, as opposed to the previous arrangement, where the manager received the fee simply for increasing net asset value above its previous high.

We believe these changes are a step in the right direction, although the investment management fee is still on the high side. The Fund was established as an unlisted trust in December 2013, but converted to a listed active ETF in December 2015. Whilst KSM has underperformed the ASX Small Ordinaries Accumulation Index since listing, it has performed strongly since inception of the Fund in December 2013, outperforming the benchmark index (S&P/ASX Small Ordinaries Accumulation Index) by 5.2% to 30 April 2017. Our current rating for KSM is Recommended, however, we will be undertaking a full review given the changes to the fee structure.

Industry fees under pressure

Whilst, in our view, K2’s fees for the Australian Small Cap Fund were high, we believe the reduction in fees is indicative of a trend to lower fees for actively managed funds. Platinum Asset Management also recently announced it was lowering its management fee on its eight Platinum Trust Funds and Platinum Global Fund from 1.5-1.35% p.a. At the same time, it announced a dual fee structure option, with investors having the ability to choose between the new management fee of 1.35% p.a (and no performance fee) or a performance fee option which has a lower management fee of 1.10% p.a and performance fee of 15% p.a. The performance fee option is the same fee structure as Platinum’s two LICs, Platinum Capital (ASX: PMC) and Platinum Asia Investments (ASX: PAI).

Over the past few years, there has been significant growth in the number of passive investment strategies available to investors. Added to this, there has been considerable growth in the number of actively managed products, including unlisted funds, active ETFs and a growing number of LICs. New managers keep emerging given there are few barriers to entry in this industry. This creates new choices for investors and, in our view, investors will be become more discerning when looking at fee structures and be reluctant to pay high fees, particularly for poor or average (index hugging) performance, or poor product structures.

Contango MicroCap resolves manager arrangements

Contango MicroCap (ASX: CTN) announced it will return to being a one manager listed investment company, with OC Funds Management (OCFM) ceasing to provide investment management services to the company. Management of the entire CTN investment portfolio reverts back to Contango Asset Management (ASX: CGA). There will be a 60 business day period to allow a smooth transition of the OCFM managed portfolio to CGA.

We placed our CTN rating under review in December 2016 following the announcement that it would add an additional manager and change the LIC name. We saw this as a highly unusual step that would add new risks for shareholders. In our view, and without making any judgement about OCFM’s portfolio management capabilities, we see the reversion to a single manager as a good outcome for CTN shareholders. It removes much of the uncertainty that has surrounded the LIC since the December announcement and removes the risks and administrative complications of the two manager arrangement. Whilst we are familiar with the single manager, CGA, there have been changes at the Board level since we suspended our rating, so we will need to undertake a new review before reinstating our rating.

Hunter Hall shareholders agree to Pengana merger

Hunter Hall International (ASX: HHL) shareholders have voted in favour of the merger with unlisted fund manager, Pengana Capital. This brings to an end the instability that has surrounded HHL since the sudden departure of Peter Hall in December 2016. We outlined the details of the merger in our March 2017 LMI Monthly Update, but in broad terms, the merger will see HHL change its name to Pengana Capital Group, with Pengana Management and directors and Washington H. Soul Pattinson owning a combined 83% of the listed fund manager.

We see the resolution of the corporate action surrounding HHL as positive for its listed investment company, Hunter Hall Global Value (ASX: HHV), given that the structure of the combined investment team can now be finalised. We will be undertaking a detailed review of the new management team, which will include highly experienced HHL Interim CIO, James McDonald, who will continue to manage the HHV portfolio. However, for the time being, our rating remains suspended.

IIR Rates Contango Global Growth recommended plus

IIR has published a pre-IPO report on Contango Global Growth (expected ASX code: CQG). We have assigned the LIC a Recommended Plus rating. The company is seeking to raise between $55m and $330m, including oversubscriptions, through the issue of shares at $1.10. Investors will receive one free option for each share subscribed to, with an exercise price of $1.10. CQG has already received its minimum subscription of $55m. The offer closed on 8 June 2017.

CQG will invest in a concentrated portfolio of quality global growth equities, typically comprising 20 to 40 stocks. While Contango Asset Management (ASX: CGA) is the Investment Manager, it has delegated the management of the portfolio to an Investment Adviser, WCM Investment Management, an independent international equities asset management firm based in California. WCM will manage the portfolio in the same manner as the existing WCM Quality Global Growth strategy offered in the US, which was established in March 2008. WCM has met all its objectives since establishment of the strategy and has consistently outperformed the benchmark index, MSCI ACWI ex-Australia (AUD). The strategy has also offered downside protection. We are of the view that over the long-term, WCM will continue to outperform the benchmark index and provide downside protection.

WAM Microcap offer open

WAM Microcap (proposed ASX code: WMI) released its prospectus for an initial public offer to raise up to $154m through the issue of 140m shares at $1.10. The majority of shares under the offer are reserved for investors in existing Wilson Asset Management LICs, with a priority offer of up to 110m shares. The priority offer closed on 5 June with the general offer expected to close on 14 June.

WAM Microcap will invest in undervalued ASX listed companies with a market cap less than $300m at the time of investing. The Manager, Wilson Asset Management, will use its proven research-driven and market-driven processes to select stocks for the portfolio. The investment objectives are to deliver a stream of fully-franked dividends, provide capital growth over the medium-to-long term and preserve capital. There are a limited number of LICs in the micro-cap space and many of the current offerings are sub-scale and have low market liquidity.

WAM Microcap will provide investors with a new offering in this space from a manager with a proven track record of outperformance over a long period of time. IIR has not undertaken any research on WAM Microcap and we make no recommendation as to whether investors should subscribe. However, we note that with WAM Capital (ASX: WAM) and WAM Research (ASX: WAX) trading at significant premiums to NTA, WAM Microcap provides investors with access to a proven investment strategy and experienced investment management team at NTA, ignoring IPO costs.

Market under pressure after strong 12 months

Australian equities rose again in April with the S&P/ASX 200 Accumulation Index up 1% giving it a solid gain of 6.7% for the three months to 30 April 2017. For the 12 months to 30 April, the index was up 17.8%. Large caps continued to perform well and have been a key driver of the strong market performance over the past 12 months, with the S&P/ASX 50 Accumulation Index up 18.2%.

Resource stocks have come off the boil in recent months, with the S&P/ASX 200 Materials Accumulation Index down 3.0% over the past three months. Still, for the 12 months to 30 April, the resources index rose 21.5% and was one of the best performing sectors over this time.

Since the end of April, the market has struggled and has given back some of its recent gains. With many of the large cap stocks looking fully priced and the banks under pressure on a number of fronts, the next few months could be difficult for the market.

Is there value in Small Caps?

Small caps again underperformed during April, and for the three months to 30 April, the ASX Small Ordinaries Accumulation Index rose 3.7% versus the 6.7% rise for the S&P/ASX 200 Accumulation Index. This sector also underperformed over the past 12 months, with a return of 10.0% versus the 17.8% return for the top 200. This prompts the question as to whether there is value starting to emerge in the small-cap sector of the market.

One LIC manager we spoke to believes that small-cap PEs are at a 10-15% discount to larger cap PEs, implying some value. However, we note that some of the falls in small-cap share prices have been driven by earnings downgrades. A number of companies, particularly those exposed to consumer spending, are coming under revenue pressure. Some of the small-caps that have disappointed the market on the earnings front have seen significant reductions in their share prices and may take some time to regain market confidence.

While there may be some value starting to emerge in the small-cap space, investors need to be cautious given a backdrop of earnings weakness across a number of sectors.

In our view, LICs are one of the best ways for retail investors to gain exposure to small-caps. A LIC gives exposure to a well-diversified portfolio across numerous market sectors, with the benefits of a professional investment manager. Most small-cap LIC managers have hundreds of meetings with companies and industry contacts and are in a strong position to identify likely long-term outperformers. Still, professional investment managers don’t always get it right for each stock, and this where the benefits of a well-diversified portfolio come into play.

In the above performance table, we highlight a number of LICs that have generated the highest returns over a five-year period. The three Australian small-cap focused LICs in this table, WAM Research (ASX: WAX), Mirrabooka Investments (ASX: MIR) and WAM Capital (ASX: WAM) have all delivered five-year returns above the ASX All Ordinaries Accumulation Index (10.6%) and the Small Ordinaries Accumulation Index (2.4%).

Unfortunately, all are expensive, trading at premiums to pre-tax NTA. We would prefer to be patient and look to acquire these LICs closer to pre-tax NTA. Hunter Hall Global Value (ASX: HHV) invests in both Australian and international small-caps. Its performance has suffered over the past year, due to significant falls in a number of its largest holdings, especially Australian-listed Sirtex Medical (ASX: SRX). HHV has a stronger five-year performance, but despite beating the Australian market returns, its performance is below the MSCI World Total Return Index, AUD five-year return of 16.3%. Given a high conviction, concentrated portfolio, tracking error tends to be much higher than peers. At 30 April, HHV was trading at a discount of 8.4% to pre-tax NTA. However, as we noted on page 1, our rating remains suspended pending a review of the new management team following the merger of its Investment Manager, Hunter Hall International (ASX:HHL) with Pengana Capital.

(Note: Global Masters Fund (ASX:GFL) invests primarily in the shares of Berkshire Hathaway and is not a small-cap focused LIC).

An alternative option for Small Cap investors

There are few LICs with a long track record in the small-cap space and many of the offerings are sub-scale. We believe this is one of the reasons why those with an established track record of strong performance are trading at significant premiums to pre-tax NTA. As we noted on page 1, the new Wilson Asset Management LIC, WAM Microcap, will give investors another option in this space. It may well prove to be an opportune time to launch a micro-cap LIC given valuations of small and microcap stocks are looking more reasonable. Given the lack of opportunities in the pure small-cap LIC space, we look at an alternative option for investors seeking exposure outside the large-cap sector of the market.

Contango Income Generator (ASX: CIE)

Contango Income Generator invests in a portfolio of stocks primarily outside the large caps with a mandate to invest in ASX ex-30 stocks. At 31 March 2017, the portfolio had a weighting of 29% to small and micro-cap stocks, 43% in mid-caps and 20% in large-caps. While CIE has a short history, listing in August 2015, its Investment Manager, Contango Asset Management (ASX: CGA) has a track record in managing a portfolio with a similar strategy. One of the key objectives of CIE is to generate an above-average yield for its shareholders, so the portfolio has a high weighting to financials (32%), although it does not own the major banks and insurers as they fall outside its mandate.

CIE paid an unchanged interim FY2017 dividend of 3 cents per share, 50% franked, and is guiding for a FY2017 final of at least 3.4 cents per share. This points to a yield of around 6.5%, although franking is likely to be 50% for the full year. For the 12 months to 30 April 2017, CIE delivered a portfolio return (pre-tax NTA plus dividends) of 13.4%%. Whilst this was below the ASX All Ordinaries Accumulation Index return of 16.6% for the same period, it reflects the absence of the major banks and underweight positions in materials and energy, all sectors which performed strongly. This portfolio positioning is consistent with its strategy to invest outside the ASX top 30. Our rating for CIE is Recommended Plus. At 30 April 2017, the shares were trading at a 5.2% discount to pre-tax NTA, a reasonable entry point for investors seeking exposure to a portfolio of Australian shares outside the top 30 companies. However, we think the discount is likely to remain until the company can establish a track record of outperformance.

For pricing and recommendations and performance data, click here.

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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