Summary: More than half of the market cap of the entire ASX Closed End Fund sector is in about 15 LICs (AFI, ARG, WAM, WLE, BKI, AUI, DUI, PL8, DJW, CIN, WHF, MIR, PIC, FGX, AMH) that are heavily favoured by retirees who largely hold them in superannuation pension accounts that are tax-free. Many of these retirees are narrowly focused on the reliable, fully-franked income these LICs generate rather than the Total Shareholder Return (which includes the change in share price). I refer to these LICs as Income LICs.
Marcus Padley recently wrote an article about similar retirees. It unintentionally exposes how irrational and lazy such retirees are if investing in LICs (not directly in shares). The catch-cry is "Marcus, I don't care about share prices, the kids are going to get those." Let's assume that's true, but are the "kids" going to keep them? My view is that they'll sell out; to pay down mortgages or for other purposes. Those who do wish to stay invested in shares are likely to switch to simpler, lower-cost, better performing ETFs like A200, VAS and VGS. So where is the new demand for these Income LICs going to come from?
In this post, I argue that because these Income LICs have, in performance terms, been made redundant by very low-cost, passive ETFs with none of their pitfalls, that eventually all are destined to spiral into discounts as sellers outweigh buyers. The long-term challenge for underperforming Closed End Funds (as almost all are) is to continuously create new demand. However, the same laziness that leads these Income LIC investors not to care about Total Shareholder Return, also explains their laziness in not switching to ETFs. This has made the Income LICs complacent, but when a discount eventually starts to spiral downwards, the extent of the implosion can be surprising. For example, AFI has 1.2 billion shares and eventually they all have to find brand new owners not just hang on to their existing owners.
Nevertheless, in the near term, the Income LIC discounts/premiums will continue to be primarily driven by relative dividend yield, reliability and franking. This presents opportunities and risks for those not monitoring these levels compared to peers, as well as the underlying performance and tax payments that make it possible.
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| No one wants to maintain your antiquated LIC portfolio! |
Details:
1. Why do retiree investors in Income Stocks/LICs not care about Total Shareholder Return?
Marcus Padley explains they are solely focused on the income their shares generate, not their share prices as they don't have to sell shares for income:
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| Livewire - The 8 traits of a retiree investor |
Marcus goes on to explore the characteristics of these retiree income-focused investors:
- They are rich. (They don't have to sell shares to fund their lifestyles, so as long as the dividends don't get cut, they can live off the income. The shares are a nest egg to pass on as inheritance.)
- They stick to a budget. (Excess capital gains aren't spent and so poor years for their shares are expected too. The impact is on the nest egg, but they aren't too bothered about maximising it.)
- They aren't interested in monitoring or worrying about the stock market. (It isn't their hobby, they enjoy not stressing, and they just milk it for a higher income than alternatives like term deposits.)
- They invest for the long run and set and forget. (Trading or changing cash proportions to try and optimise returns is not their wheelhouse and considered a waste of time. They have confidence the long run will grow the nest egg.)
- They hold stocks in superannuation pension tax-free accounts. (They pay no capital gains tax but also don't benefit from harvesting tax losses. Tax concerns don't instigate share trading.)
- They are highly focused on Cash Franking Credits. (They view this as extra income that makes living off their share portfolios feasible and appealing.)
Looked at from the perspective of this cohort, one can see the appeal of the boring, slightly underperforming Income LICs. The LICs try to keep the income stable, predictable and slightly increasing over time (dipping into capital when necessary). And they focus on returning Cash Franking Credits which seems (to the naive) like free money.
If they invested in A200 or VAS instead of say AFI, they'd have different levels of income each quarter, and even though Total Shareholder Return is higher, may occasionally need to sell to smooth out income, or reinvest to continue growing the nest egg.
2. Are the Income LICs less complex to manage than A200 or VAS?
Closed End Funds can have many issues and the 15 Income LICs are no exceptions. I detail some of these pitfalls, leakages and complexities for two of them in these posts:
> AFI - Australian Foundation Investment Co - Cheat Sheet
> PL8 - Plato Income Maximiser - Cheat Sheet
If you have your head buried in the sand, then you don't know what you don't know, and you never find out. But, if you do get across the reality, it's clear that the Income LICs are actually more complex than A200 or VAS.
3. Are the Income LICs actually higher yielding than A200 or VAS?
The following Dividend yields and Gross yields (includes franking) were taken from www.marketindex.com.au on 13 Oct 2023. All LICs had 100% franking for their most recent 12 month's of dividends (they vary a lot in future franking coverage though). A200 and VAS are never 100% franked and are currently around 80%.
A200: Dividend yield 4.22%; Gross yield 5.71%
VAS: Dividend yield 4.21%; Gross yield 5.75%
Income LICs:
AFI: Market cap: $8,440m Dividend yield 3.69%; Gross yield 5.28%
ARG: Market cap: $6,490m Dividend yield 4.03%; Gross yield 5.76%
WAM: Market cap: $1,870m Dividend yield 9.14%; Gross yield 13.06%
WLE: Market cap: $1,870m Dividend yield 5.72%; Gross yield 8.18%
BKI: Market cap: $1,390m Dividend yield 4.74%; Gross yield 6.77%
AUI: Market cap: $1,210m Dividend yield 3.88%; Gross yield 5.55%
DUI: Market cap: $1,040m Dividend yield 3.35%; Gross yield 4.78%
PL8: Market cap: $780m Dividend yield 5.34%; Gross yield 7.63%
DJW: Market cap: $750m Dividend yield 5.24%; Gross yield 7.49%
CIN: Market cap: $721m Dividend yield 4.00%; Gross yield 5.72%
WHF: Market cap: $591m Dividend yield 4.04%; Gross yield 5.78%
MIR: Market cap: $542m Dividend yield 5.16%; Gross yield 7.37%
PIC: Market cap: $435m Dividend yield 5.74%; Gross yield 8.20%
FGX: Market cap: $455m Dividend yield 5.80%; Gross yield 8.29%
AMH: Market cap: $300m Dividend yield 5.24%; Gross yield 7.48%
Note: Not all Income LICs above aim for exposure similar to the ASX200/300. Some like AFI are index huggers, but others target mid caps or small caps (MIR, WAM) or have significantly different weights to the index (AMH). However, all of the above are using a LIC structure exposed to the ASX All Ordinaries (primarily ASX300) to focus on delivering reliable, fully-franked income higher than alternatives like term deposits. Most are aiming to deliver gross yields higher than the ASX200 index.
It's pretty clear that the Gross yield's vary significantly. AFI, DUI, AUI, CIN, ARG and WHF all have Gross yields below 5.8% (no advantage over A200 or VAS) and yet suffer from many of the issues I detail for AFI here.
On the other side, there are LICs like WAM, PL8, DJW, FGX and AMH that pay high Gross yields, but given their NTA performance over the last 5yrs is lower than their payout, they are paying some of this yield out of capital.
4. Why does WAM pay such a high dividend given the difference is all coming out of capital?
Beginning 12/04/2018, WAM started paying a dividend of 7.75c/share, which on a share price of $2.50 (30 Mar 2018) was a Dividend yield of 6.2% and Gross yield of 8.86%.
However, WAM's NTA performance (including franking) since 30 June 2018 has only delivered a return of 4.38% annualised, significantly underperforming VAS at 7.12%:
Consequently, WAM has been dipping significantly into capital to maintain the 7.75c/share dividend. It's NTA has proportionately been driven down and this is reflected in its share price chart:
The interesting question is why WAM has not cut its dividend to a more reasonable and sustainable proportion of NTA? After all, it is sacrificing a huge amount of fee revenue over this period by returning so much capital.
I suspect the answer is the other side of the lazy, irrational position: "I don't care about share prices, the kids are going to get those." These retirees are equally irrational and emotional about cuts to dividends and franking, even if they are completely justified.
This was evidenced when WAM investor panic set in when Geoff Wilson flagged WAM's fully-franked dividend level was in jeopardy unless the portfolio performed well enough going forward. The share price took a massive dive (compounded by tax-loss selling), but then quickly recovered when the next dividend was confirmed at the same level, fully-franked!
The reality is that WAM has absolutely no hope of delivering 15.5c/yr on the $1.43 of portfolio assets it has left (30 Sept 2023). Indeed, 11% of this $1.43 is in cash. Even if it was fully invested, 15.5/143 = 10.8% portfolio return per year. And it has to deliver that after paying tax. Before tax it needs to deliver over 22c. Providing for just the dividend requires a portfolio return of 15%! Add in WAM's Total Expense Ratio (1.8% for 2022-23) and this requires almost 17%. Even if we ignored WAM's track record since June 2018 of 4.38%, it is abundantly clear that 17% is not remotely feasible to deliver year after year going forward.
The longer this perverse trap (paying out capital) goes on, the more impossible the task of actually earning the dividend. Consequently, WAM's charade of never cutting dividends is 100% guaranteed to come to an end very soon. Wilson Asset Management has built its reputation among retiree income-focused investors on this principle of reliable franked income (aiming for no dividend cuts), so it will be very interesting to see what happens to its stable of high yielding LICs, with WAX and WMI of particular note given their current, high dividend yields.
The 2022-23 WAM Capital Annual Report confirms the above.
By not setting its fully-franked dividend at a sustainable rate in the last four years, WAM has exhausted its franking credit reserves. It is totally dependent on realising sufficient portfolio gains and paying tax to meet the oversized requirements of each 7.75c dividend. It isn't remotely sustainable and will end shortly.
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| WAM Capital Franking Account as of 30 June 2023 after paying Oct dividend (but not including other post-June changes like tax paid) |
5. Is it actually feasible to never cut dividends and create a set and forget Income LIC?
In short: No, unless you set the Dividend yield and Gross yield below the sustainable level the market (typically the ASX200/300 or All Ords) is likely to deliver.
Some lower yielding Income LICs like AFI, DUI, AUI and WHF have done this and not had to cut dividends. Two of the lower yielding Income LICs - CIN and ARG - had to cut their dividends in recent years when the ASX200/300 had a significant downturn.
But if the dividend yield has to be set so much lower than the ASX200/300 to create this buffer during inevitable downturns, why bother with an Income LIC? In most years, A200 and VAS are going to deliver much more income, before and after franking.
As for all of the supposed Income LICs currently delivering Gross yields over 7%, these are clearly not set and forget. Their dividends are always subject to being cut if the ASX200/300 suffers significant declines.
Conclusion: Income LICs with worthwhile yields (above low-cost, passive ETFs) that never cut their dividends are a fantasy that can't be delivered. These lazy, irrational retiree LIC investors are going to learn this lesson one way or another.
6. Examples of Income LICs that have cut their dividends
Below are Income LICs (with supposedly reliable dividends) that have cut their dividends in recent years. This is already 8 out of the 15 Income LICs. I'd argue WAM will be added very soon and FGX is likely in the next downturn. Of the remainder, AFI, AUI and DUI all pay dividend yields below A200/VAS. WHF pays about the same. There's no reason to own any of these for higher income. Which leaves WLE as the only 1 of the 15 Income LICs that pays a higher Gross yield than A200/VAS but hasn't cut its dividend yet and isn't at near term risk of doing so. I do think WLE's high Total Expense Ratio will eventually eliminate its outperformance of A200/VAS, and, if its dividend keeps increasing, it too will eventually join this list.
ARG:
PL8:
BKI:
DJW:
CIN:
MIR:
PIC:
AMH:
Links:
> Livewire: The 8 traits of a retiree investor (Marcus Padley)
