Today, I wanted to let you guys know about another slightly more active strategy I use in my investing. Its known as LIC Discount investing (or, for the international readers, CEF Discount Investing), and it has long been a favourite strategy of some fantastic investors with enviable long term track records. The good news is this: individual investors can get the exact same results as some of these investors with far less work! In this article, I’m going to talk about what the strategy is and how you could potentially implement it.
As we know from my LIC primer, LIC’s (listed investment companies, or closed end funds, or CEF’s) can trade at both a discount or premium to the net asset values of the companies. This is because once listed, LIC’s do not issue new shares in the market for redemptions – instead, those wishing to buy shares in the LIC transact directly with current owners. If more people wish to buy then sell (or vice versa), LICs can trade at persistent premiums (or discounts) to net asset value.
There have been journals full of articles written about why LICs trade at discounts or premiums. Why, after all, would any sane investors sell generally liquid traded assets at prices below net asset value? Why would anyone willingly buy a collection of assets at prices higher than what they can be purchased at, at that very same moment, on market for? Its an interesting question, and a bit out of scope for this article. For our purposes, it simply doesn’t matter that much why a LIC trades at a persistent discount to NAV, only that it does.
Buying at a discount can deliver attractive returns in a variety of situations:
For a number a reasons, LICs with large discounts can provide outsized returns. The mechanisms by which these occur are as follows:
- Large discounts tend to narrow
- Prior research has shown that large discounts from NAV tend to narrow. This assumes that the fund is reasonably well run, and that nothing shady is going on. There are certainly examples of funds in Australia that trade at exceptionally large discounts which will never close due to management actions. You need to do your own research and be wary in these instances.
- Listed Investment Companies can convert to open ended funds
- Converting a fund to open end will eliminate the discount, as the fund manager will then stand ready in the market to exchange shares at NAV(technically they will sell at slightly more expensive than NAV and redeem at slightly lower, pocketing a buy and sell spread).
- A fund manager may liquidate the fund and return capital to investors.
- Although this wont technically eliminate the dscount, the discount will certainly cease to matter! There may be some costs associated with winding a fund up and distributing assets to shareholders, but shareholders receive almost-NAV, providing a boost to returns.
- LICs may buy back their shares.
- A LIC can stand in market ready to purchase and retire shares from existing holders. This is typically done at a slight discount to NAV, although typically at a premium to the current trading price. If this is done under NAV, shareholders who remain will see an increase in NAV. Alternatively, a shareholder can simply tender all of their shares and realise an instant uplift.
Its important to note:
A very important point is that a fund is under no obligation typically to do any of the above. As an individual investor, you could simply assemble a number of LICs that trade at reasonable discounts, and assume, probably correctly, that at least some of the above will occur in some of your holdings. This will improve returns.
There is a better method than buying and hoping however, and that’s what I wanted to talk about today.
Activist Investing, without any Activity!
Closed End Fund Activism, Or LIC Activism in Australia, is becoming far more prevalent with the explosion of listed investment companies. One of the fund firms I have long admired is a company called Bulldog Investors. These guys participate in these situations all the time, and it is the main driver of their fund returns. They have delivered excellent returns over a long period of time with low volatility.
Bulldog Investors has engaged in a number of proxy fights at LICs over the years. Most of these campaigns kick off with Bulldog buying a significant amount of stock, and then lobbying management for either seats on the board or changes to the way the fund operates. Bulldog are on the record as stating that they love these type of investments because LICs are incredibly transparent and it is very easy to determine the valuation of the underlying assets. In simple terms, Bulldog buys assets at below their stated valuations, then agitates for a removal of the LIC discount. By using activist methods, Bulldog is able to cliose the discount to NAV much quicker, resulting in better annualised returns.
As a warning: Bulldog noted that buying a heavily discounted fund with large insider ownership and a group of shareholders friendly to management is a very bad situation to be in and typically results in poor returns.
After accumulating their position, Bulldog approaches amangement to talk about ways to narrow the discount. Typically, share buybacks and tender offers are the preferred ways to close the discount – in Australia, another typical strategy is to institute a sensible and progressive dividend policy.
While Bulldog is a global investor, they primarily operate in US markets. In Australia, there are anumber of managers worth watching – Wilsons, Sandon Capital and Global Value Fund. All are managers who have participated in LIC discount arbitrage over time. As individual investors, we can participate in this by what I call activist coat tailing – simply waiting for these managers to indicate substantial ownership in a LIC at a discount, and following management in.
By adding weight to the agitators, you make it more likely (however small) that the activist succeeds, plus you benefit from the activists efforts on your behalf to narrow the discount. Best of all – you don’t have to pay fund manager fees!
Hey ADI – show me an example!
A prime example is the wind up of AMP’s China Fund – listed on the ASX for many years, a number of activist investors managed to get the fund wound up and cash returned to investors for a nice profit.
A more contemporary example? Wilsons have recently gone substantial on Wealth Defender Equities (WDE). This may be worth watching for interested investors.