Australian Foundation Investment : Other factors matter aside from ‘premium’ and ‘discount’

Listed Investment Companies (LICs) such as AFIC are often referred to as trading at 'a discount' or 'a premium'. In the current period of strong inflation, high interest rates and investor uncertainty, many ASX-listed LICs are trading at discounts. It's an opportune time to revisit what this means and consider how AFIC is valued so that investors are better placed to analyse an LIC.

What is trading at a discount or premium to NTA?

Trading at a discount or at a premium refers to an LIC's share price compared to its underlying value or NTA (net tangible assets per share). NTA is the total value of the portfolio divided by the number of shares on issue. If an LIC has a $100 portfolio and 100 shares outstanding, the NTA per share is $1.

The NTA does not always reflect the market price of the shares. If the share price is higher than NTA per share (say at $1.05 from the example above), the stock is said to be trading at a premium relative to the value of the portfolio per share. Conversely, if the share price is lower than the NTA per share (say at $0.95 from the example above), the stock is trading at a discount.

Long-established funds with a good record of investment management often trade at a premium while newer funds which don't have an established performance history typically trade at a discount. But this is not necessarily constant. The times when a fund trades at premium or a discount will fluctuate, for example AFIC traded at a discount back in late 2019 and then traded at a substantial premium until June this year.

The share price can be influenced by factors such as investor sentiment and market cycles, and the supply and demand for shares. But history shows that over the longer term, LICs like AFIC normally return to trade at or around their NTA.

Given that we are a long-term investor that is our preferred position.

Share price is not the only factor for investors to consider

Whether an LIC is currently trading at a premium or discount, it's important for investors to consider factors other than the share price, such as fund performance over time and management expenses charged by the portfolio manager, consistency of dividends, and the size of the fund.

• Investment performance and costs

Good management and track record are important factors when we consider our investments, and we expect that many investors are equally as rigorous when evaluating an LIC.

A track record of good performance combined with low fees makes an LIC an attractive investment and helps drive awareness and demand for shares. Consequently, the share price will usually trade in line with the NTA over the long term.

When fees are considered, some investors may be willing to pay a small premium if the managers can deliver excellent performance in relation to the lower fees over the long term.

• Dividends

Many LIC investors are looking for stable fully franked dividends as part of their investment strategy - especially for SMSF investors who can take advantage of these dividends and are looking for income in retirement. As a result, those LICs that have stable or growing fully franked dividends sometimes trade at a premium.

On the other hand, there are LICs that have variable dividends or no dividends at all, which can often lead to greater fluctuations between the price of shares and the NTA and can result in a persistent discount. An LIC trading at a persistent discount suggests that the market is worried about the manager's performance, the LIC's portfolio, or an inconsistent dividend record.

Whether its shares trade at a discount or premium, AFIC has a track record of providing attractive and stable income for investors over the long term. Many long-standing LICS, such as AFIC, have profit and franking credit reserves that they can draw upon in more difficult times. We have been able to draw on these reserves to distribute attractive dividends to our shareholders even when companies are delivering subdued dividends.

• Size of the fund

Generally, there is a correlation between the size of an LIC and the long-term position of its share price relative to the NTA. Many small LICs have traded at a discount for long periods of time. This may be because of a lack of liquidity in the shares, a small shareholder base which means a reduced pool of buyers and sellers, or limited general investor awareness.

With a shareholder base of more than 160,000, we know that word of mouth is an important driver of demand for our shares. Because of this, periods where the share price trades at a discount to NTA can be short-lived.

• Capital Gains Tax advantage

Tax can be a significant drain on the returns to investors. The long-term buy-and-hold approach adopted by AFIC typically results in a low level of capital gains tax payable because few positions are sold each year. Where AFIC does realise a capital gain, we aim to pass on any LIC credits generated by these capital gains as part of the dividend, thereby providing the opportunity for shareholders to potentially claim a tax deduction.

Considering AFIC

Our share price relative to NTA per share often correlates to the current state of the market, including the outlook for income across companies, the level of interest rates, and investor sentiment towards risk. The general market sentiment now is one of caution because of increasing interest rates.

But rather than the short-term focus on discounts and premiums, we see more value in considering factors that contribute to the long-term performance of an LIC. Share price relative to NTA is a relevant consideration when looking for the right time to buy, but it is not the only consideration.

Whether we trade at a premium or a discount, we remain assured of the quality of the companies within our portfolio, and we are still well placed to navigate the ongoing market uncertainty.