Harvesting discounts from LICs and other stocks

Our next presenter is Daryl Wilson, CEO and Portfolio Manager at Affluence Funds Management.

Daryl founded Affluence in 2015 and has over 25 years experience across all aspects of funds management, including investment, operations and capital raising.

His presentation topic today is harvesting discounts from LICs and other stocks.

Welcome to the presentation Daryl.

Thanks very much Angelina, pleasure to be here and hopefully today we can give everyone a look at something a little bit different that we think is a real interesting opportunity right now.

I'm going to talk through harvesting discounts.

We obviously have the standard disclaimer.

This is not personal advice.

Everything we say is general advice.

It's designed to educate and to give you a bit of an understanding of what's going on.

For those of you who haven't heard of Affluence before, we offer four funds and all of those four funds have three things in common.

We're targeting to deliver better than average returns over three years and longer.

We try to do that with regular income, so at least 5% per annum, either monthly or quarterly.

depending on the fund.

And we try to smooth those returns, particularly when markets are a little bit volatile to make that ride a little bit better for our investors.

So that ends the background.

We've been going since 2014 as affluent and for 10 years prior to that, Greg and I worked together for another investment manager in Brisbane.

So we've been doing this for quite some time.

Now I'm here to talk to you about discount capture, discount harvesting, it goes by various different names.

One of our funds, our affluence LIC fund is best known for this strategy.

And that's really the main focus of that fund.

So I'm going to refer to that a little bit today.

This is an example of how it might work.

So an LIC stands for listed investment company.

And essentially, it's a listed investment fund.

The difference between LIX or LICs and perhaps an ETF or an unlisted managed fund is that it doesn't necessarily trade at its net asset value, at the value of its investments.

It trades at the whims of the market.

Okay, so this is an example of the largest LIC.

This is Affic.

Affic's been going for about 40 years.

And you can see at various times, the blue bars show periods when the affect was trading above the value of its assets.

And then you can see where we're below the line here, it's trading at a discount to its assets.

And that's fluctuated over time.

This shows you from 2008 until now.

The largest premium has been 10 or 15%.

The largest discount is actually about now at about five to 8%.

So in essence, what we're trying to do by capturing a discount is we're trying to buy in these periods when the discount is near the larger end of the market, like now, and we'd like to sell it perhaps when it goes to a premium, or when that discount falls to a lower amount.

And by doing that, what you're doing is you're adding additional value to the returns that this LIC itself has generated from its investing activities.

So we're trying to top up the returns you're getting anyway from the investment team by adding our own returns through catching some of those discounts.

Now the interesting thing is that can work both ways.

What we think now is a good opportunity to look at buying Affic and we don't actually own it in the portfolio yet, but it does look attractive.

If you look over the last 12 months, it's actually underperformed because that discount expanded.

So the investment team at Affic delivered about a 15% return over the last 12 months.

But if you were a shareholder, you only got six and a half percent of that because it's gone from net asset value

a discount.

Okay so the important thing about discount capture is that it can work both ways we obviously want to get the upside here so that's what we focused on.

For us it's been a fairly consistent source of additional returns so in this case the orange line or the orange section is the returns we've received from the LICs themselves

The grey section is the additional value we've been able to add through capturing those discounts through buying well and selling well in that space.

And in our case, that adds up to about an extra 6% per annum before fees over the last eight or nine years since this fund's been going.

do we find these opportunities?

I mentioned the LIC space and that is the main place we look.

There's about a hundred of those on the ASX and that's a pretty decent sort of investment universe for us.

We also look at REITs and other types of

infrastructure funds where again you've got a hard asset price, you've got an underlying property portfolio and then there's all sorts of other eclectic opportunities which pop up from time to time.

So for example in the last month or so we bought for one of our funds a retailer which was trading at a discount to the value of its cash and inventories, no debt.

So those sorts of opportunities pop up from time to time.

Generally speaking, there's probably a couple of hundred of those at any given time on the ASX.

And essentially, we're looking for three things.

We're looking for obviously an abnormally large discount.

We're looking for perhaps an opportunity where the underlying assets themselves are trading cheaper than they should be.

And finally, there's those special situations, corporate events, restructures, which throw up one-off opportunities from time to time.

at any given time we've generally got between 20 and 30 different individual opportunities in our portfolios.

Now I mentioned now is perhaps a good time to look at it and obviously at the moment the market's been pretty soft for small caps and for a lot of these types of discount capture vehicles for LICs themselves they haven't recovered to anywhere near the extent that the market itself has and in fact

in the case of the LIC market, it's remained under a fair bit of pressure.

So at the moment, the average discount across our portfolio is about 24%.

So that means you're getting about $1 of value for about 76 cents.

And the important thing about that is that can go the other way.

So if that 76 cents went back to $1, you actually got a 32 or 33% upside.

So the discounts in aggregate are about as large as they've been.

since we started doing this back in 2016.

Couple of live holdings for us at the moment, just with an outline of why we like it.

So this is Rider Capital.

Rider is a $93 million market cap LIC.

There's four reasons we like it right now.

We believe the underlying portfolio, which is predominantly ASX small caps, is pretty attractively valued.

Small caps have not recovered.

There's still a lot of opportunities in that space, and we like the portfolio Rider has at the moment.

There's strong alignment of interest because the two investment managers, Peter Constable and David Bottomley, are also the largest shareholders in the LIC.

So they've got their own money on the line.

The discount at the moment is probably coming slightly, but it's probably 12 or 13%.

And so it's near the top of its historical range.

Again, that's a good sign for us as perhaps a time to look at buying.

And finally, they've announced over the last six months or so that they're perhaps taking a look at whether some sort of restructure might be in order.

They've acknowledged that a discount has continued to be high and they should probably look at doing something about it.

And if they were to do that,

That would be a one-off event, which would perhaps close or even eliminate that discount entirely.

And we've seen a little bit of that sort of stuff happening in the LIC sector.

So again, that's perhaps both a catalyst and a potential for a little bit of extra upside.

Another example, CD one, two and three.

three different LICs, all focusing on the US private equity market.

They're what is called closed-end funds.

So as with most private equity vehicles, they go for a certain period of time.

And then what they do is they sell all of their investments over time and give the money back.

So city one and city two are both in that harvesting phase now where money's coming back over time.

City three is a little bit younger.

But again, it will go into that phase over time.

And so the beauty of these types of situations is, you know, in the case of CD1, that over the next perhaps two or three years, it's going to be fully wound down and all of the money's going to come back.

Currently,

Discounts are pretty attractive 30 to 35%.

Some of that is justified because ultimately to sell the last of the holdings, they will need to take some sort of discount.

But again, in the meantime, you're going to get returns from the underlying portfolio companies that CD1, 2 and 3 own, plus potentially profit from that discount closing.

And finally a REIT.

This is GDI.

So it's an office REIT.

Office is out of favour at the moment and indeed office valuations are still falling but in the case of GDI we think the share price has overestimated the likelihood of those valuation falls.

So right now GDI is trading at about half of its net asset value so $1.20 of net asset value and the share price is around $0.60.

gearing is reasonable.

In the case of the portfolio the Perth office market is actually the strongest of all probably.

They've done a lot of leasing up in the last 12 months and it's likely that their income will actually grow quite substantially in FY25 which is a bit of a differentiator from most other REITs which are struggling to grow earnings at the moment.

So we think that the share price fall is well over done with GDI.

And we think that over the next year, two years, three years, if you just hold that and be patient, you will do pretty well out of that one.

So that's just an example of some of the holdings that we have in the portfolio.

If you want to learn more and do it yourself, you can look to download our LIC guide from the website.

It'll give you a lot of examples of how we do it, the things we look for, what we like and don't like about the sector.

There's also links to the ASX page there as well, where you can download a list of every LIC every read.

And finally, we offer four funds.

If you are interested, the Affluence LIC fund is the one with the most focus on discount capture.

You can see there over the last five years, it's delivered about a 12 or 13% return.

It's outperformed all but five of the LICs that are out there that we monitor, and it's done so with much less volatility than average.

So we've ticked a couple of decent boxes there.

Given the size of the discounts in this sector at the moment, we think now's a good time to be thinking about that.

That is the five-year return of the fund versus a few other benchmarks there.

And as you can see, we've added fairly significant value over the last five years.

That's really all I wanted to talk about today, but hopefully that gives you a bit of a quick insight into that discount capture strategy that we use and how we feel about the LIC market and the opportunity right now.

Thank you, Daryl.

Do you have time for two questions?

Yeah, absolutely.

LIC seem to be out of favor right now.

Do you think this is a temporary issue or will more investors return to the sector over time?

Look, I think it's been quite a drawn out phase this time, but what we tend to see in the LIC market and in the REIT markets is that it's almost always cyclical.

And so, you know, what we're seeing at the moment is the sector is unloved.

There are not a lot of buyers.

We've just gone through tax loss selling season, which has made it a little bit worse.

But we're now entering that phase where we've got some activist investors starting to push some of these licks to take action.

We've got some value coming back to the sector, the discounts once they get above that 20% level.

you get benefit just from owning them because effectively the returns on the LICs are magnified by 20% to 25% because of the effect of the discount.

So for all those reasons we think a recovery will happen, they'll return to favour,

it usually takes two or three years so hence you know this is not a short-term thing this is a medium-term strategy but you know like the REIT market which is also on the doldrums at the moment we've been through three or four cycles in the last 20 years they always bounce back over time if you're prepared to be patient.

How do you decide what the right discount is when you buy and when you sell?

I could talk all day about that and I think the best way to handle that is to perhaps say if you are interested, download our guide from the website because that will give you a look at pretty much all of the factors we look at.

I think there's probably two above all others that we would say are important.

The first one which I sort of touched on a little bit is if you look at what that discount has done historically over time.

you'll get a feel for whether the current discount is attractive or not and that varies for every LIC.

So for some you know they're good value at par for others you wouldn't touch them at 25% off so it's very much personal.

And the other thing we look at closely is the alignment of interest.

So, you know, I use the Rider example where the two key portfolio managers own a large chunk of the LIC.

You know, they're aligned.

They're trying to, they've got their own money on the line and they're motivated to get a good return on their own portfolio.

So those two factors, the alignment and looking at the discount versus history, I would say are the two largest determinants of whether we think something's attractive.

Thank you, Daryl.

Thanks very much, Angelina.

It was a pleasure.