[Editor’s Note: Do not read the following article as a recommendation to invest in LICs. Talk to a licensed financial adviser or do further research of your own before acting on themes in this article. LICs and Listed Investment Trusts on ASX provides information on the features, benefits and risks of this market. Like other equity investments, LICs cannot guarantee dividends. LIC dividends can rise or fall, and some LICs have cut their dividends over the years. The company structure of an LIC is no guarantee that dividend payments will be smooth over time or not fall.]

Investors come in all shapes and sizes. What unites them though is their requirement for a return on their investment. For an investment in equities (shares), the return usually comes in two forms – an increase (over time) in the value of that investment, and dividends.

Dividends are sometimes overlooked, particularly by institutional investors but for many, including retail investors, they are often a fundamental part of the return equation.

For a large proportion of such retail investors, it is not only the amount of the dividend that is important, but its consistency, particularly if such dividends constitute a major part of their income.

This is where LICs, or Listed Investment Companies, are worth considering, in AFIC’s opinion. 
 

What is an LIC ?

Rather than picking their own investments out of hundreds of companies listed on the ASX, many investors who want to participate in the sharemarket will pick a Collective Investment Vehicle (“CIV”) to do their picking for them. 

This means that an investor can make one investment, and managers of the CIV do all of the other work, picking the investments, voting, and paying out dividends or distributions.

However, potential investors need to be aware of a fundamental difference between CIVs that are companies (such as LICs like Australian Foundation Investment Company Ltd (ASX: AFI) and other CIVs that are structured as trusts.

This is particularly important when investors are concerned about dividends and their consistency.
 

How LICs differ from other investment vehicles?

This difference is caused by the fact that companies/LICs can create reserves whilst trusts (generally) cannot.  

What this means in practice is that trusts will pass onto their investor ALL of the income that they receive, including any capital gains from selling shares, in the year that it is received. 

An investor in a trust like this will receive a distribution that is made up of a number of different elements and will often be presented with a year-end tax statement that outlines the different components and how they need to be treated for tax.

LICs do not have to do this. Instead, they can decide how much of the income they want to pay out as a dividend, and how much they want to put aside ”for a rainy day.” An investor in an LIC gets a simple dividend statement following each payment.

An LIC can, therefore, potentially “smooth” dividends and remove the “lumpiness” that can otherwise arise as dividends from the underlying companies vary, and as companies on the ASX are sold or merged.

Example

[Editor’s Note: Do not read this below as recommendation to buy or sell BHP Group shares or LICs or Listed Investment Trusts that own BHP].
 

To take a simple example, if an investor held units in a trust that held 1,000 BHP Group (ASX: BHP) shares, in 2021/22 they would have received $4,796. In 2022/23 they would have received $3,915 – a reduction of 18%. 

An LIC, however, may not have paid all of the dividend out in 2021/22, and could have potentially paid out $4,200 each year with a bit left over for this year. Therefore, an investor in such an LIC, although they would have received less in the first year, would not be suffering the same fall in income.

It should be noted that LICs are taxed as companies, while trusts are not taxed. For an Australian investor, they get this back via franking, but for an off-shore investor it can make trusts a more attractive option. 

Also, LICs that make capital gains on “capital” account (if held for more than one year) can effectively pass on the Capital Gains Tax discount to their shareholders.
 

Dividends and pay-out ratios

Research from Goldman Sachs shows that the pay-out ratio (the proportion of a company’s profits that is paid as a dividend) for the ASX200 can be very variable, which means that the dividend income that an investor can receive is also likely to be very variable. For many, this is not an issue as they take a “holistic” view of returns.  For others it is far more important.

In FY08, the dividend payout ratio was close to 75%, according to Goldman Sachs. It went down to just over 60% in FY11, then up to 80% in FY19 and down gain to just under 65% in FY23. This is before the fluctuations in the profits themselves are considered.

With the fall in the dividend paid by formerly very high-yielding companies such as BHP – its final dividend this year is US$0.80, down 54% from US$1.75 the previous year – unit holders in some trusts listed on the ASX could potentially experience a fall in income this year, due to trusts not being able to “smooth” their dividends.

While investors in LICs are never immune from this, the ability to create and use reserves does, for many LICs, provide at least some buffer.

As many LICs invest across a broad range of Australian and New Zealand stocks, the dividend income they receive will also vary as pay-out ratios and company profits vary.  

When between 2007 and 2009 dividends paid by ASX companies fell by more than 30%, some LICs were able to maintain their dividends. Investors in these LICs, unlike an investor in the broader market (through, for example, a trust) saw no fall-off in dividend income received, although the overall returns may have been broadly similar.

Similarly, in 2020 dividends fell by 24% for ASX 300 companies. Again, some LICs were able to maintain their ordinary dividends by using their reserves.

Risks

Past performance, they say, is no indicator of future performance, and no LIC (including AFIC) would ever say that its own dividends cannot fall. Plenty [of dividends] have.

However, in an environment that is seeing lower dividend pay-out ratios and, in some sectors at least, a reduction in previous cyclical ”super” profits, an investor that is seeking some buffers against a fall in income can do worse than look at the LIC sector, in AFIC’s opinion.

They should also look at the past dividend-paying history of any particular LICs (all are different), their dividend policy (some explicitly say that it will vary) and the strength of its reserves both in terms of profits and franking credits - and remember that investments can (and will) go down as well as up.

DISCLAIMER

Australian Foundation Investment Company Limited and its subsidiary AICS (AFSL 303209), their related entities and each of their respective directors, officers and agents (together the Disclosers) have prepared the information contained in this article in good faith. However, no warranty (express or implied) is made as to the accuracy, completeness or reliability of any statements, estimates or opinions or other information contained in this article (any of which may change without notice) and to the maximum extent permitted by law, the Disclosers disclaim all liability and responsibility (including, without limitation, any liability arising from fault or negligence on the part of any or all of the Disclosers) for any direct or indirect loss or damage which may be suffered by any recipient through relying on anything contained in or omitted from the article.

This information has been prepared and provided by AICS. To the extent that it includes any financial product advice, the advice is of a general nature only and does not take into account any individual’s objectives, financial situation or particular needs. Before making an investment decision, an individual should assess whether it meets their own needs and consult a financial advisor.