With record low-interest rates guaranteeing close to zero returns on cash, investors have never been more acutely focused on sources of investment income. Given that interest rates are expected to remain at historic lows for the foreseeable future, the great hunt for yield shows no signs of abating. 

Australian Listed Investment Companies (LICs) have long been favoured by investors for their ability to provide relatively stable and predictable dividend income. In more recent years, the structure has been embraced by self-funded retirees and Self-Managed Superannuation Fund (SMSF) investors. 

Here I answer some key questions about LICs for investors seeking income. 

Where do LICs derive their income to pay dividends to shareholders?

Predominately from income received from the investments held in their portfolio (such as dividends and distributions) and profits made on the sale (or takeover) of these investments. 

LICs employ a variety of strategies with some very actively managed investment portfolios relying more on income from profitably trading their portfolio. Other LICs trade less frequently and derive most of their profits from ‘harvesting’ dividends from the underlying investments in their portfolio. 

For example, Argo Investments (ASX: ARG) invests in Australian stocks and earns income largely from the dividends they pay us. Our investment approach focuses heavily on identifying companies with sustainable earnings and, importantly, the capacity to grow their dividends. 

Additional sources of income for LICs may include interest earned on cash balances and premium income earned from selling options. 

How can LICs ‘smooth’ their dividends? 

A key strength of the LIC structure is the ability to ‘smooth’ dividends by setting aside or reserving profits which a LIC can then draw on in the future to pay out as dividends to its shareholders. 

This distinguishes LICs from managed funds using a trust structure that must distribute all profits each year. This can result in income from a trust fluctuating considerably from year to year. 

A LIC can effectively ‘save for a rainy day’ allowing it to smooth dividend payments over the market cycle and cushion the impacts of turbulent markets. This gives LICs the opportunity to provide a relatively reliable and consistent stream of income over time. 

For Argo shareholders, this benefit was aptly demonstrated following the COVID market turmoil which saw many companies cancel, postpone or significantly cut their dividends. 

Over the 2019-2020 financial year, aggregate dividends from S&P/ASX 200 companies fell by around 30%. In contrast, Argo’s annual dividend was down just around 9%. In part, this was due to the composition and management of our portfolio. Importantly, it was also because Argo was able to draw on reserves from prior years’ gains to pay its dividend.   

How regularly are LIC dividends paid?

Much like other ASX-listed companies, LICs will typically declare dividends twice yearly with their interim and full-year financial results. A minority of LICs pay dividends on a more regular basis.

Are LICs ‘dividend’ stocks?

In the current ultra-low interest rate environment, it can be expected that all LIC managers are acutely aware of the importance of dividends to their shareholders and endeavour to provide them with a sustainable yield. 

Some newer LICs have the express objective of generating income and promote themselves as income investments. Other LICs are more focused on achieving capital growth. For many LICs, their objective is to provide a combination of both capital growth and dividend income.    

Are LIC dividends guaranteed?

No. LICs are companies with oversight by a Board of directors and dividends are declared at the Board’s discretion. Directors give consideration to a range of factors, including the LIC’s capacity to pay future dividends. 

In some limited instances, LICs will provide dividend guidance. Investors should be aware that this is a forecast of expected future dividends, not a guarantee. When considering a LIC’s future dividend prospects, it can be instructive to look at its dividend track record. 

How can I find out what a LIC’s capacity is to pay future dividends?

While a LIC’s future dividends are not guaranteed, investors can assess its capacity to pay dividends by referring to relevant reserves balances, such as retained profits, which can be found in the balance sheet (often referred to as the Statement of financial position). This can be found in the LIC’s latest Annual Report which is released to the ASX each year. 

Investors should note that for the newer, ‘revenue-accounted’ LICs, reserves can include unrealised gains in the portfolio due to movements in the market prices of its investments, rather than only realised profits from the sale of assets. 

How can I find out what a LIC’s capacity is to frank future dividends?

LICs receive franking credits when/or if the underlying investments in their portfolio attach franking credits to their dividends or distributions. In turn, these franking credits can be passed on to a LIC’s shareholders in the form of fully or partially franked dividends. 

In addition, all LICs (even those with an international mandate) can generate their own franking credits when they pay tax in Australia. 

LICs can put aside franking credits for future use and the balance can be found in its Annual Report in the franking account, typically in the Notes to the financial statements section.  

What else should I be aware of before investing in a LIC for income? 

Before investing in any LIC, indeed before making any investment, conduct thorough research. If income is your focus, look at the LIC’s track record of paying dividends, consider its accounting methodology and balances, understand the underlying investments held in the portfolio and ensure its investment objectives align with your own. You may also consider seeking advice from a financial adviser before investing in a LIC.