If you're looking at investing money in one of the many well-regarded Listed Investment Companies (LICs) on the ASX, it is important to ask, "What is a fair price?" Here is a relatively straightforward way to think about it.
Each LIC invests in assets, usually shares in listed companies like Wesfarmers Ltd (ASX: WES). Each company owns $X worth of assets, and has liabilities like tax. After all its liabilities are accounted for, the company is left with Net Tangible Assets, or NTA.
For example, Australian Foundation Investment Co. Ltd. (ASX: AFI) has net tangible assets (NTA) per share of $5.09 after tax as of 31 October 2017. If the company was wound up today and its assets sold, this is roughly what you would expect to get if the LIC liquidated its portfolio and returned the cash to shareholders. Yet Australian Foundation shares sell for $5.98 apiece.
This means that buyers today are paying a 17% 'premium' to the LICs net tangible assets.
What is a fair price to pay for an LIC?
For simplicity's sake, imagine that an investment company's only asset is CSL Limited (ASX: CSL) shares. The company has net tangible assets of $1 per share after tax, although its shares themselves are changing hands for $1.20. This means that you are paying a 20% premium for owning CSL Limited shares – it's like buying CSL for $169 even though its current price is $141. Instead, you could just buy CSL shares directly.
However, there's another consideration. Imagine that CSL shares are destined to return 10% per annum every year for the next 10 years. The above LIC would expect an identical rate of return, however, imagine that it has also a management fee of around 1% per year.
In simple terms, a 10% return for 10 years works out to a 259% overall return for CSL shares. However, if you decrease the return to 9% (after fees) for 10 years, the overall return falls to 237% for the LIC.
More crucially, if you overpaid for CSL shares by 20%, your total return falls to 181%. Overpaying for an LIC could cost you ¼ of your total returns over a 10-year period. It's the difference between $10,000 turning into $25,900 versus $18,100. That's a very rough example, but should serve as an illustration of what overpaying can cost.
There are ways to calculate this yourself, but a reasonable rule of thumb would be that for a standard ~1% management fee, aim for a 10% discount to NTA. Under this rule, Australian Foundation Investment Co., above, would become a 'buy' at around $4.58.
What should you consider when deciding on a buy price?
In today's market environment it is very difficult to find an LIC trading at the appropriate discount to NTA. There are a few things to consider when thinking about your buy price. First, most of the time an individual cannot replicate an LICs portfolio, so you will not be able to achieve the exact returns that the LIC does. In this sense, it may not be necessary to be overly strict on the discount to NTA, especially if the LIC has a diverse group of holdings.
Second, if you are confident in the manager's process and have a long term time-frame (~10 years), the discount becomes less important if you are expecting solid performance. Third, share prices can move up and down, sometimes rapidly in a short time frame. Even if you don't get a discount, you can get a more representative buy price by breaking your purchase up into quarters or thirds over an extended period. Lastly, if you are investing for a long time and intend to add to your investment later, it may be OK to pay a small premium to NTA, especially if shares are tightly held.
Depending on the fees, performance, reputation of the manager and so on, I would consider paying up to a 5% premium to NTA, although a discount is definitely preferred. Paying too much at the start can permanently hurt your performance, and can make great returns into mediocre ones.
