The Experts

Peter Rae
+ 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.

WCM Global Growth increases scale

Friday, July 19, 2019

WCM Global Growth Limited (ASX:WQG) has seen a significant increase in its portfolio size following the exercise and partial underwriting of its options, which were set to expire on 24 June 2019. When it listed in June 2017, WQG issued 90.9 million options on a 1 for 1 basis with its ordinary shares.

Almost half these options were exercised by the holders before the expiry date, with the Board entering into an underwriting agreement for the remaining options. An additional 41.9 million shares were exercised as part of the underwriting agreement leaving 3.8 million options to lapse. This led to a total of circa $96 million of additional capital being raised via the option issue, pushing the LIC’s portfolio value to approximately $230 million. We expect the proceeds to be invested in accordance with WQG’s mandate to invest in quality global growth stocks.

We do not generally favour options underwriting arrangements by LICs as they can be dilutive to shareholders that don’t take up options. This was particularly so with WQG given the option exercise price of $1.10 was below the 30 June pre-tax NTA of $1.347. Diluted pre-tax NTA was $1.288 after the options exercise. We do note that the market price was at a very small premium to the options exercise price, with the shares trading at a sizable discount to pre-tax NTA. Despite the dilutive nature of the options underwriting arrangement, we acknowledge that the larger capital base increases scale which should improve market liquidity, lower fixed costs per share and increase the LIC’s profile with investors and advisors. This, along with the continued strong portfolio outperformance (7% outperformance since inception to 30 June 2019) may go some way towards narrowing the current discount to pre-tax NTA over the medium-term

WQG will pay its maiden dividend in August with a final FY2019 dividend of 2cps unfranked. The Board announced its intentions to make ongoing interim and final dividend payments with the intention to pay 2cps interim and final dividends for FY2020. WQG also announced an extension of its on-market buy back for a further 12 months. Our rating for WQG is Recommended Plus.


Final episode: What’s happening in LIC land?

Wednesday, March 27, 2019

Magellan Global Trust (ASX:MGG) is the largest listed investment vehicle that invests in global shares. Managed by the experienced global equities team at Magellan Financial Group (ASX:MFG), MGG is a relatively recent addition to the listed investment trust universe. It listed on the ASX in October 2017 after raising $1.55bn in an initial public offer. With dividend reinvestment plan proceeds and a recent $277m unit purchase plan offer, the fund size is now around $2bn.

The Manager has a solid track record of outperformance and its disciplined investment processes focus on investing in high quality companies with sustainable competitive advantages that enable the businesses to generate excess returns on capital and predictable cash flow streams. It seeks to purchase investments when they are trading at a discount to the Manager’s assessment of their intrinsic value. Although MGG has a relatively short history since listing, it has delivered a portfolio return (net asset value plus distributions) of 13.0% p.a. since inception to February 2019, an excess return of 1.5% relative to the benchmark return.

The portfolio is concentrated and typically consists of 15-35 stocks. The Manager releases details of its stock holdings on a quarterly basis and at 31 December 2018 there were 19 stocks in the portfolio. The portfolio is essentially a large cap portfolio and its top five holdings were Alphabet (owner of Google), Facebook, HCA Healthcare, Starbucks and Apple. The portfolio has a strong bias to US companies and at 28 February 2019 the geographic exposure by revenue sources was US 48%, Emerging Markets 15%, Western Europe 12%, Rest of World 10% and 15% in cash. The largest sector exposures were Information Technology 20% and Internet & eCommerce 15%.

MGG targets a cash distribution of 4% per annum with investors expected to also benefit from capital growth over the medium to long term. The target cash distribution of 4% will appeal to income investors, but investors should be aware this may involve capital drawdown, particularly in a poorly performing market environment. Since listing MGG has paid three semi-annual distributions of three cents per share, with the next distribution likely to be paid in July.

One of the things we like about the trust is that its Manager is unitholder friendly. On listing, the Manager paid all the costs of the listing upfront and funded a loyalty bonus for unitholders that remained as investors in January 2018. The Manager also compensates the trust for all DRP units issued at a discount to NAV and did the same for the recent unit purchase plan. This ensures that unitholders that don’t participate in DRPs and SPPs are not diluted.

We also like the fact that the Trust has a dual performance hurdle so that the Manager is only rewarded for outperformance when returns exceed an absolute return benchmark as well as a market index. This means the Manager is not rewarded for outperformance in a negative returns environment.

Our rating for MGG is Recommended Plus. The Trust provides investors with access to a well-managed portfolio of global equities, predominantly mega and large-cap stocks. We would prefer to buy MGG at close to, or a discount to NAV. The company releases a weekly NAV, so there is greater transparency than for many LICs and LITs. At 15 March 2019 the NAV was $1.7076 per unit and the closing market price was $1.65, presenting investors with an opportunity to buy in below NAV. Potential investors need to make their own decisions on timing and be comfortable obtaining an exposure to global equities.


Next episode of “What’s happening in LIC land?”

Tuesday, March 26, 2019

Last November in our monthly update, we wrote about the number of corporate actions underway and also discussed the fact that many small, sub-scale LICs trade at large discounts to NTA. In December, the two Watermark Fund Management managed LICs, Watermark Global Leaders Fund (ASX:WGF) and Watermark Market Neutral Fund (ASX:WMK) announced that they will be restructured into a single unlisted trust. Watermark also announced it would be withdrawing from global equities and would focus on two core strategies in Australian shares, equity long/short and market neutral.

Both LICs said the restructure provides a solution to the issues of the sub-optimal size and illiquidity in the in the current listed format. Both LICs are relatively small and at 30 November (prior to the restructure announcement) WMK had a market cap of $71.4m and WGF a market cap of $65.2m. They were trading at discounts to pre-tax NTA of 12.4% and 16.7% respectively but this has largely corrected since the announcements. Shareholders in both LICs will be issued units in a new trust with a value that reflects NTA, less transaction costs. Shareholders will be asked to approve the restructure at meetings to be held in March.

We note that both LICs have not performed particularly well since listing with the WMK delivering a portfolio return of 3.1% p.a. since inception to December 2018 and WGF a negative return of 3.8% p.a. Whilst the WMK return is above its RBA cash rate benchmark of 1.9%, it is well below equity market returns over the period.

Watermark also manages another LIC, Australian Leaders Fund (ASX:ALF), but has not announced any changes to this entity. It is a larger fund with a market cap of $260m but even so has also been trading at a significant discount to NTA. Based on the Manager’s figures the portfolio has underperformed the All Ordinaries Index over the past seven years but outperformed since inception.

As we noted in our November report, there were 28 LICs with sub- $100m market caps trading at discounts to pre-tax NTA of more than 10%. We continue to believe that this part of the market remains open to further corporate action over the coming year either through mergers and acquisitions or restructures into unlisted trusts as per the Watermark proposals.

Dividends up despite tough 6 months

When reporting season ended  we took a look at how the listed investment companies under our coverage fared over that time. We continue to remind investors that the best way to measure performance of LICs is to look at total returns, either portfolio returns or share price returns. We prefer to focus on portfolio returns, which we measure as pre-tax NTA returns plus dividends, as this is more an indication of the performance of the underlying investments and the Manager’s ability to manage the portfolio. Share price return on the other hand can be affected by movements in discounts and premiums to NTA which are more a function of the market and not directly controlled by the Manager. Whilst we continue to remind investors of the need to focus on total returns, we also understand that dividends are important to many LIC investors who rely on their LIC shares to generate a stable income stream.

The six months to 31 December was a difficult time for LIC portfolios, with both domestic and international equity markets suffering large declines. The S&P/ASX 200 index fell 8.8% over that time and the Dow Jones Industrial Average was down 3.9% over the same time period. Most of the falls occurred in the December 2018 quarter.

We note that most of the falls have since reversed in the early part of calendar 2019, although the S&P/ASX 200, Dow Jones Industrial Average and the Nasdaq all remain below their 12 month peaks.

The decline in markets over the six months to 31 December was reflected in LIC portfolio returns, with most reporting negative returns for the period. This meant that, from a reported profit perspective, those LICs that report portfolio movements above the line reported significant falls in earnings and, in many instances, large losses. Those LICs that report on capital account and do not report revaluations as part of statutory earnings, such as the long established, internally managed LICs, mostly reported increased earnings due to higher dividend income from their underlying investment portfolios.

A majority of the 34 LICs in our coverage that paid dividends for the six months to 31 December lifted their payouts to shareholders. 19 LICs increased dividends, 11 held dividends flat and just four reduced dividends. Six LICs paid out special dividends, which benefits shareholders ahead of any potential change in the franking credit regime. In a number of cases the special dividend was funded from special dividends received from underlying stock holdings and share buybacks.

Despite the reported losses from many LICs, most of those that reported losses were able to at least hold flat, or in some instances, increase dividends. One of the benefits of the listed investment company structure is that the LICs are able to smooth dividends across the cycle and, providing there is sufficient reserve coverage, can at least maintain dividends during weak markets. The four LICs that reduced dividends were Contango Income Generator (ASX:CIE), Cadence Capital (ASX:CDM), Platinum Capital (ASX:PMC) and Platinum Asia Investments. However, we note that PMC did pay a special dividend of three cents per share which more than offset the one cent drop in its ordinary dividend.

Looking forward to the six months to 30 June 2019, in the absence of any major market downturn, we would expect that a majority of LICs will increase dividends for the FY2019 year. Those LICs with relatively small profit/dividend reserve coverage are most at risk of dividend reductions.


What’s happening in LIC land?

Monday, March 25, 2019

Pengana Private Equity Offer Opens

The Pengana Private Equity Trust (ASX:PE1) offer opened on 4 March 2019 with a target raising of $100m to $600m. The fund will be a listed investment trust that invests in a diversified portfolio of private equity and private credit assets. Whilst Pengana Capital will be the manager of the Trust, the portfolio will be managed by Grosvenor Capital Management, LP as the investment manager. Grosvenor is an established US based asset management firm with in excess of US$52bn in assets under management across a range of alternative asset classes including over US$24bn in private equity, infrastructure and real estate. It has significant experience in private equity markets and is one of the longest continuously operational alternative asset managers globally and possesses a track record in private markets investing back to 1999. Grosvenor will source assets for the Trust’s portfolio and, once fully invested, the Trust is expected to provide exposure to more than 500 underlying investments through around 100 underlying funds.

Private equity requires a long-term commitment as returns are lumpy and take time to emerge. However, the Trust will seek to stagger the investments across short-duration credit investments as well as private equity co-investments and secondary investments until the portfolio can be fully allocated to private equity investments with the aim of generating a return from the time of investment. The Trust will seek to pay a semi-annual distribution of 4% p.a, thereby providing a regular income stream to investors with the first distribution to be for the period ending 31 December 2019. While the Trust will have ASX liquidity, the underlying investments will be largely illiquid.

The Manager will pay all upfront issue costs associated with the offer and NAV at listing will be at a 5% premium to the offer price due to the issue of “Alignment Shares” in Pengana Capital (ASX:PCG) to PE1.

Our rating for PE1 is Recommended Plus but please refer to our full report on PE1 for more details. Potential investors should understand the specific risks associated with private equity before investing. The offer is expected to close on 10 April 2019, unless fully allocated prior. The minimum subscription of $100m has already been surpassed through applications and binding commitments.

Perpetual Launches Credit Income Fund

Perpetual is planning to list the Perpetual Credit Income Trust (expected ASX Code: PCI) with a raising of between $200-440m including oversubscriptions. The Trust will invest in a well-diversified, actively managed portfolio of credit and fixed income assets issued by Australian domiciled entities. PCI will add another option for investors looking for a listed investment vehicle that pays regular stable income from a portfolio of fixed income assets. It targets stable monthly income at RBA Cash Rate plus 3.25% p.a. (net of fees), the equivalent of 4.75% p.a. Currently.

The trust is based on an unconstrained credit strategy and will typically invest in corporate bonds, floating rate notes, securitised assets and private debt, such as corporate loans. At least 25% of the portfolio must be in investment grade assets with the option to invest up to 100% in investment grade assets. The portfolio will be diversified by asset type, issuers, credit quality, maturities, country of issuance and capital structure. The Trust is a derivative of the Perpetual Pure Credit Alpha Fund which has consistently performed well since its inception in March 2012.

The unconstrained strategy and diversified portfolio of credit assets differentiates PCI from the four other listed investment trusts which are focused on particular niche segments of the fixed income market. MCP Master Income Trust (ASX:MXT) invests in Australian corporate loans; Gryphon Capital Income Trust (ASX:GCI) invests in floating rate Asset Backed Securities, with a particular focus on Residential Mortgage Backed Securities; NB Global Corporate Income Trust invests in global high yield (non-investment grade) corporate bonds; and Qualitas Real Estate Income Fund (ASX:QRI) invest in secured commercial real estate loans, predominantly in Australia.

The PCI offer is expected to open on 25 March and close on 18 April 2019. Our rating for PCI is Recommended Plus but investors should refer to our full report for more details.

Metrics Credit Partners to List New Fund

Metrics Credit Partners (MCP) has launched its second listed investment trust with the offer for the MCP Wholesale Income Opportunities Trust (ASX:MOT) now open. This will provide yet another listed fixed income option for investors. MOT is seeking to raise up to $300m to invest in a portfolio with exposure to private credit assets and other assets such as warrants, options, preference shares and equity.

The trust will achieve this exposure by investing in a number of existing MCP wholesale funds. MOT will invest in sub-investment grade debt so it will be higher risk than the MCP Master Income Trust (ASX:MXT) which invests in a mix of investment and sub-investment grade debt. The trust will provide exposure to a range of borrowers and private credit investments that are not usually available to retail investors. Given the higher risk, MOT has a target cash return of 7.0% p.a. and total return target of 8.0-10.0% p.a.

This compares with MXT’s target return of RBA cash rate plus 3.25% p.a (currently 4.75% p.a.) Distributions are expected to be paid quarterly. The offer is expected to close on 12 April 2019. We have not undertaken any research on MOT and make no recommendations in relation to the offer.


Two slick LICs

Thursday, September 13, 2018

The reporting season just ended was a good one for the listed investment company sector, with most LICs reporting growth in earnings. Of the 31 LICs we cover that paid dividends during the FY2018 period, 26 reported increased earnings whilst only five reported lower earnings. The results reflected the strong 12 months to 30 June 2018 for both the domestic and international markets. During this period, the S&P/ASX 200 Accumulation Index rose 13% and the MSCI World Total Return Index, AUD was up 15.3%. The strong earnings results saw 18 LICs increase their final dividends and 11 hold dividends flat. Two LICs paid lower final dividends. 

The LICs that largely rely on dividends from their underlying portfolios to generate profits (primarily the Australian large cap focused LICs) rather than realised and unrealised gains, all delivered earnings growth due to increased dividend income from their portfolios. 

This reflected increases in dividends by a number of companies including those in the healthcare and resources sectors. There 
were generally modest increases in dividends from the Australian large cap focused LICs, although Australian Foundation Investment Company (ASX:AFI), Argo investments (ASX:ARG), BKI Investments (ASX:BKI) and Djerriwarrh (ASX:DJW) all paid steady final dividends. Yields across the Australian large cap focused LICs generally range from 3.5% to 4.5% and in our view dividends from this sector are mostly sustainable in the absence of a severe and prolonged market correction. 

The majority of small cap focused LICs in our coverage reported higher earnings due to strong portfolio gains. Six of these LICs increased dividends, five held dividends flat and two paid lower dividends. Yields in this LIC sector are, on average, higher than those available from the large cap focused LICs. The two highest yielding LICs in our coverage both offer yields in excess of 7%, fully franked: 

1. Sandon Capital (ASX:SNC) at 7.4% 

2. Contango Income Generator (ASX:CIE) at 7.2%. 

We take a closer look at these two LICs below. 

Contango Income Generator (ASX:CIE) 

CIE is suitable for investors looking for a portfolio of stocks outside the top 30 ASX-listed companies. It seeks to pay a dividend equal
to 6.5% of NTA and has been able to achieve this to date, although we would like to see dividend reserve cover a little higher than the current level. Dividend franking is 50%, but the dividend yield of 7.2% is well above the market yield. 

The portfolio (pre-tax NTA plus dividends) has significantly underperformed since its inception in August 2015 with the portfolio returning 5.9% p.a to 30 June 2018 compared to the benchmark index (ASX All Ordinaries Accumulation Index) return of 11.1%p.a. The performance of the portfolio has reflected the underperformance of the investment universe as defined by the Manager’s investment parameters. The company has achieved its objective of providing an above market dividend yield and pays dividends on a quarterly basis providing a regular income stream for shareholders. The company was trading at a discount to pre-tax NTA of 6.9% at 31 July 2018.
 We would recommend an investment in this company to those investors seeking an above market yield but note that the strategy has resulted in an underperforming portfolio to date. Our rating for CIE is Recommended. 

Sandon Capital Investments(ASX:SNC) 

SNC is a LIC managed by Sandon Capital, a deep-value Australian equities manager that uses activism as a tool to preserve or enhance the value of its investments. The Manager has a history of outperformance, although since listing in December 2013 SNC has underperformed on a pre-tax NTA basis partly due to the impact of fees and dilutive share issues. Successful activist investing requires skills and capabilities that, in our view, most professional investors do not possess. We believe the Manager has proven itself capable in this regard. SNC is a genuinely differentiated LIC and
one that provides genuine diversification benefits. The Manager takes high conviction positions and is index agnostic and therefore not concerned with the weighting of a stock in the index. This is highlighted by the top ten holdings, which account for 31.1% of
the portfolio, compared to the relevant weighting in the ASX All Ordinaries Index of 3.7%. SNC offers a high dividend yield, currently at 7.4% fully franked, and the Manager has a commitment to pay a stable and growing dividend. We recently initiated coverage of SNC with a Recommended rating. 

We continue to remind investors that it is important to focus on total returns from LICs, not just dividends. 


LIC Report: A big year for listed managed investments

Thursday, December 21, 2017

It was an exceptional year in 2017 for new listed investment company (LIC) and listed investment trust (LIT) raisings, with 14 new entities raising a total of $4.2bn via initial public offers. This significantly exceeded the funds raised by new LIC/LIT offers in the previous two years and lifted the total number of LICs & LITs on the ASX to 105 by the end of November 2017, for a total market capitalisation of $38.2bn. Three entities accounted for $2.6bn of the funds raised in 2017 with Magellan Global Trust (ASX:MGG) raising over $1.5bn, VGI Partners Global Investments (ASX:VG1) $550m and MCP Master Income Trust (ASX:MXT) $516m. 

We initiated coverage on five of the 2017 listings, URB Investments (Recommended), Contango Global Growth (Recommended Plus), Evans & Partners Global Disruption Fund (Recommended), VGI Partners Global Investments (Recommended Plus) and Magellan Global Trust (Recommended Plus). We are also undertaking research on Plato Income Maximiser and expect to initiate coverage in coming weeks. 

Investors Flocking to International Offers 

With the Australian sharemarket representing a very small proportion of global equity markets and lacking sector diversification, it has long been recognised that Australian investors need to have a reasonable exposure to international shares. Australian Taxation Office (ATO) data show that Australian SMSFs in total have just 0.65% of their assets in overseas shares, although we believe this understates international exposure as it is likely a proportion of the 15.3% invested in listed and unlisted trusts would be in international equity funds. Nonetheless, we believe total retail investor exposure to international equities is still relatively low. We believe this relative underweight position in international equities has provided an opportunity for domestic fund managers, with retail investors, including SMSF trustees, starting to recognise the need for international exposure. 

During 2017, half the new LIC/LIT floats were for entities offering international exposure with a total of $2.9bn in funds raised, of which $2.1bn was for the MGG and VG1 IPOs. We believe there is still significant opportunity for new LIC/LIT offerings in the international space and Wilson Asset Management (WAM) has already flagged its intention to launch WAM Global in the first half of calendar 2018. A show of hands at the recent WAM investor day in Melbourne indicated there would likely be strong demand for such an offer. We would not be surprised to see more international LIC/LIT offers in 2018. 

SMSFs Remain Cashed Up 

ATO data also shows that SMSFs still have large holdings of cash and term deposits, with an average weighting of 22.5% at 30 September 2017, down from 24.9% at 30 September 2016. With Australian interest rates likely to remain unchanged for much of 2018, we believe there is the potential for some of this cash to shift to higher yielding assets such as LICs & LITs. 

LICs/LITs that offered high yields with regular payments were popular in 2017 with the Plato Income Maximiser (ASX:PL8) raising $326m and MCP Master Income Trust $516m. PL8 invests in a portfolio of high yielding Australian shares and aims to pay monthly dividends whilst MXT invests in a portfolio of corporate loans and targets a return of the RBA cash rate plus 3.25% per annum, with monthly distributions to its unitholders. With SMSFs holding high levels of cash in a low interest rate environment we believe there are likely to be more LIC/LIT offers focused on delivering high, regular income payments to investors. 

Few opportunities in small-caps 

Based on IIR classifications, there are 27 LICs/LITs that invest in Australian mid, small or micro-cap shares. However, in our view many of these are sub-scale and 15 of these entities have market caps below $100m. We understand that a number of small and micro-cap strategies lend themselves to smaller fund sizes, but in our view entities with market caps below $100m are likely to struggle to gain market traction unless they can deliver significant outperformance. 

Another problem for investors in the small-cap space is that, in our view, most of the better performing LICs/LITs such as WAM Capital (ASX:WAM), WAM Research (ASX:WAX), Mirrabooka Investments (ASX:MIR), QV Equities (ASX:QVE) and Forager Australian Shares Fund (ASX:FOR) are all trading at large premiums to pre-tax NTA, making it difficult for new investors to enter the sector at a reasonable price. 

There were just two new LIC’s in this space in 2017, WMI and Spheria Emerging Companies (ASX:SEC), which raised a total of $287m between them. In our view, there is opportunity for more raisings in this space in 2018. 

Fewer LIC Options in 2017 

Finally, one trend we noticed in 2017 was that there were fewer LIC IPOs with options attached. Just 5 LICs that listed in 2017 had attaching options whereas in the previous two years every new LIC issued subscribers with options. One of the reasons LICs attach free options to their IPOs is that it gives the perception of providing investors with some value to compensate for the fact that day one NTA for the LIC shares would be 2-3% below the share issue price due to the offer costs. However, as we noted in our March 2017 LMI Monthly Update, over the past few years most IPO LIC options have expired worthless. 

A number of LICs and LITs that have not issued options have put in place arrangements that have resulted in day one reported NTA or net asset value (NAV) per security being equal to the offer price. However, potential investors need to understand that this may not necessarily be a cash NTA/NAV and it does not necessarily mean the manager is paying the issue costs. In some instances the NTA/NAV has been manufactured through accounting mechanisms and loan structures between the Managers and the LICs/LITs. 

In some of the arrangements we have reviewed the LIC/LIT has paid the issue costs in cash upfront. The costs are then recovered from the Manager over time with the LIC/LIT not paying performance and/ or management fees until it has recovered all the upfront costs of the offer. The LIC/LIT balance sheet records a non-cash asset, being the amount to be recovered from the Manager. This is the case with VG1. 

We have also seen one instance where the LIT provided a loan to the Manager to pay the issue costs with the Manager repaying the loan, plus interest, over time. However, the loan repayments are to be funded by the proceeds of a special levy paid by the LIT to the Manager. In this case the LIT investors are actually paying the upfront costs. 

To our knowledge, there has been only one offer, MGG, where the Manager has paid all the issue costs upfront so that the day one cash NAV is equivalent to the offer price. 

We will continue to monitor new offers in 2018 and will write further on this matter in coming months.


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.