LIC discounts give investors optionality
One thing that gets forgotten in bull markets is that good investing is primarily about limiting risk. The reality of investing is that participating in the game in a sensible way will deliver excellent results, but take too much risk and you end up out of the game.
That’s why I like to keep my risks as low as possible. And one of the ways I do that is by insisting on hefty discounts on my investments!
Why do LIC discounts exist?
In general, I believe that the listed market is broadly efficient. While opportunities and pricing inefficiencies occasionally occur, in general, the market pricing of most securities is broadly accurate.
LICs, on the other hand, are rarely priced properly in my opinion. And its largely because the vast majority of LIC ownership sits in the hands of retail investors, who in generally are far more fickle and driven by sentiment than institutional investors. LICs are also reasonably small, and trading volumes are low, meaning that inefficiencies may exist simply because it is not an area where institutions can participate.
How do discounts give optionality?
The two paradigms we see in LICs over and over are as follows:
- A fund underperforms or becomes unfashionable, leading to investor disappointment, leading to a discount. This discount can often further affect investor sentiment, leading to further indiscriminate selling, widening the discount; or
- A fund manager performs well or the strategy becomes increasingly fashionable, leading to the fund trading at a premium. Investors become more positive on the fund, driving the premium up further.
The optionality we want to capture in the market is as follows:
We want to find funds that are trading at discounts to underlying NTA, which have either demonstrated a commitment to removing the discount (via buybacks, etc), have evidence of improving performance (or stabilising performance), or have an upcoming catalyst to reduce or eliminate the discount. Ideally, we want to compound an increasing NTA with a reduction in the discount between the price of the LIC and NTA.
Even if the discount never narrows, a high discount can be beneficial. This is due to the compounding of dividends, with a 3 cent dividend on a 90 cent share price worth more than on the $1 NTA. Compounding this over time leads to benefits for investors.
By buying quality LICs at discounts, we give ourselves two ways to win – the fund can continue to perform well, delivering returns in line with performance, or the discount can close, given a boost to returns.