Welcome to the next instalment of our analysis of the Thornhill Method. In the last post, we looked at dividends and showed that there is no difference between selling shares for income and living off a dividend stream. This is because any benefit of dividends is immediately arbitraged away in an efficient market.
But some readers correctly pointed out that, although we looked at high yield shares, we didn’t specifically look at listed investment companies. So in this article we’ll take a closer look at LICs.
In this article, we’ll break down how LICs were able to maintain strong dividends during the GFC. And then we’ll take a more philosophical look at “what you must believe” in order to advocate for LICs, and whether that actually makes sense.
I’m conscious that we still haven’t modelled out the performance of a pure LIC strategy (i.e. ignoring capital gains and focusing on dividend income) and a pure ETF strategy during the GFC. We’ll do that in the next post.
What is a listed investment company?
First, a little background on listed investment companies (LICs). In many ways they’re similar to managed funds, as they are actively managed portfolios that give investors exposure to a diversified basket of assets. These assets may include domestic shares, international shares, bills/bonds, and others.
The big difference between an LIC and a managed fund is the structure of each entity. On the one hand, purchasing units of a managed fund is the equivalent to giving the fund some money to invest. And this means that exiting the fund requires the fund to sell off some assets to give back to the investor.
On the other hand, the LIC funds its portfolio during an IPO. Purchasing a share of an LIC on the share market is purchasing the ownership of part of the LIC. This gives you the right to receive dividends and sell the share to somebody else later on. No funds flow in or out of the LIC portfolio when shares are bought or sold.
Traditional LICs generally invest in companies with a strong and growing dividend stream. In a general sense, this dividend stream is passed through to investors as dividends from the LICs and typically as fully franked dividends.
It’s important to remember that there is almost as much variation within LICs as there is between LICs and other investment types. So let’s narrow our focus to the specific type of LIC that Thornhill advocates. Our criteria are:
- Active for over 50 years
- A conservative investment philosophy that identifies value and holds for the long term
- Management fees less than 30bps
- No performance fees
This article will focus on LICs that meet these criteria, such as AFI, Argo (ARG) and Milton (MLT). Let’s call these ‘Thornhillian LICs’.
How did listed investment companies perform so well during the GFC?
One of the most common claims of Thornhill advocates is that listed investment companies were able to sustain dividends during the GFC. This kind of argument pops up in a bunch of ways, here’s a couple of comments from the previous post:
The preference in the bear market is perhaps based on company dividends tending to fall less than market prices.
Spending dividends is seen by many as ‘safe’, the dividends also grow over time in line with inflation or better and even in a really bad year (or years) seldom have huge immediate drops that impact.
To start with, let’s take a cursory glance to confirm that this is correct. How did our three Thornhillian LICs perform?
- AFI did not cut their dividend at all during the GFC! Perfect start!
- ARG cut their dividend slightly between 2008 and 2010, reaching 17% below the previous peak
- MLT reduced their dividend quite severely in 2009 and 2010, reaching 26% below the previous peak
So the ‘average’ (and I’ll use this term loosely with a sample of three!) Thornhillian LIC did cut its dividends. But to be fair, the cut was probably less than the capital loss over as similar period. At its maximum (i.e. from pre-GFC peak to trough) the index dropped by over 50%!
We will use AFI as our test case
Of the Thornhillian LICs that we selected above, it’s clear that AFI is the best performer. And to silence any cynics, in the rest of the article we’ll assume that AFI represents a typical Thornhillian LIC. This actually biases our analysis in favour of LICs. No straw men here!
In the chart below you can see AFI’s dividends per share between 2005 and 2018. And it’s true, they held it steady at 21c between 2007 and 2012.
But now we need to figure out how were they able to maintain their dividend payouts during the GFC. We will test two hypotheses:
- LICs were able to maintain sufficient earnings during the GFC, so they didn’t need to cut dividends at all.
- LICs didn’t maintain sufficient earnings during GFC but retained prior earnings on their balance sheet that were used to ‘beef up’ dividends during the GFC.
Hypothesis 1: LICs were able to maintain sufficient returns during the GFC
We know that LICs invest their funds in other companies with the aim of building a large and growing stream of dividends to pass onto investors. We also showed in our last post that ASX-listed company dividends were down during the GFC and stayed below the previous peak for years.
This means that LICs would have experience a reduction in earnings during the GFC (plus a fall in their trading portfolio). If this fall is significant enough, ceteris paribus, the LIC would need to cut their dividend.
We can see in the chart above that, although AFI was able to outperform the market during the GFC, they still suffered from significant losses in 2008. This was due to a reduction in dividends they received from companies they invested in.
So the next question is whether this affected their ability to sustain their own dividend in subsequent years.
The chart above compares AFI’s dividends per share and earnings per share between 2008 and 2010. As we can see, in 2009 and 2010 earnings per share was lower than dividends per share. The implication being that they were not able to generate enough earnings to cover the amount of capital returned to investors via dividends.
Hypothesis 2: LICs were able to artificially smooth returns
So we know that the best performing LIC during the GFC (AFI) was not able to generate sufficient earnings to maintain its dividend throughout the GFC, so now let’s figure out how they overcame it.
LICs have a unique legal structure which allows them to retain earnings on their balance sheet to pay out in later years (on the other hand, managed funds must pay out all their earnings immediately). So our second hypothesis is that LICs were able to artificially smooth returns by ‘saving up’ some dividends during good times and then using that surplus to maintain dividends during the GFC.
In the chart below we extended our AFI EPS/DPS chart to include three years leading up the the GFC.
There are a couple of things to note here:
- During the period 2005-07 you can see that earnings per share was higher than dividends per share. This implies that AFI retained some of those earnings on their balance sheet to pay out at a later date.
- Then in 2009-10 earnings per share fell below dividends per share. This means that AFI paid out more than they earned those years. In other words, they dipped into the retained earnings that they saved up in earlier years.
It’s unfortunate that AFI only adopted the relevant AASB accounting standards in 2009, as we can actually see the growth in retained earnings after that date. Here’s a peak at what it looks like:
What does this all mean?
What do we know? We know that LICs are actively managed and can outperform the market, but still need to retain earnings to maintain their dividends during bear markets.
So any investor in LICs must believe that:
- Active management outperforms passive investments over the long term; and
- Artificial smoothing during a bear market is beneficial for an investor
As FIExporer noted in his great article on LICs, observing that some LICs may have outperformed the index over any period of time does not tell us anything about whether it was due to skill or luck. And as a follow-on, it certainly doesn’t tell us whether outperformance was identifiable in advance.
If we were to look at the evidence, we can see that over rolling 10 year period about 75% of Australian funds underperform their benchmark. The chart below is from Vanguard’s highly informative paper on indexing versus active management.
Personally, I’m not a proponent of active management, even for LICs with low fees, a long history, and a conservative approach. There are a number of reasons for this, including:
- I am an empricist at heart and the data tells me three things. Firstly, most funds managers will underperform the index in any given year. Secondly, fund managers that outperformed the index this year are unlikely to outperform it again next year. And thirdly, I am unreliable at picking which fund manager will outperform at any time!
- A conservative approach is no panacea to active management. There’s no way to eliminate manager risk (i.e. the risk that a manager selects the wrong stock or doesn’t select the right stock).
- A long history is indicative of very little, as by definition all LICs with a long history will have be well-performing due to the effect of extinction. And, of course, most managed funds do perform well… until they don’t!
I’ve also heard that argument that artificial smoothing is beneficial, as it guarantees that we won’t waste or misuse our income when times are good, leaving us with nothing for when times are bad.
Some of may be aware of the time value of money. The time value of money states that money today is worth more than money tomorrow. And importantly for the current discussion: money tomorrow is worth less than money today.
There are two reasons for this:
- There is a true opportunity cost of not having the money to invest. It’s like leaving your investment money in a transaction account that generates 0% interest when it could be in bonds or equities earning 4%+
- Inflation will slowly but surely erode the purchasing power of money not being invested. So you’re not just making 0%, you’re making negative 1-3% (probably)!
So to bring it back to our discussion, instead of the LIC paying out dividends, it may decide to wait for the next bear market. This means that we miss out the opportunity to invest that money and the potential years of compound interest associated with that investment. The so-called benefit of dividend smoothing is really a cost.
It’s clear that, although some LICs performed well during the GFC, that performance is contingent on two principles that aren’t entirely rational.
The outperformance of LICs during bear markets is dependent on them outperforming the market in earlier periods and retaining those earnings. Without that outperformance due to active management, retaining earnings will result in the LIC underperforming the index and the investor losing out in net present value terms.