A New Way to Play Australia’s High-Yielding Mid-Caps

By Ari Charney • November 14, 2012 • Pacific Digest

Australia’s third-largest initial public offering of 2012 is slated to start trading in late December. Nevertheless, most investors are likely unaware of the forthcoming launch of Contango MidCap Income Limited (CMIL). As a listed investment company (LIC), this security occupies an obscure corner of the financial markets, not unlike its closed-end fund (CEF) counterparts in the US.

Like mutual funds, LICs offer their shareholders the opportunity to invest in an actively managed portfolio. And like CEFs, LICs issue a fixed number of shares that trade on a securities exchange. However, these entities can raise additional capital through subsequent offerings, though the CMIL prospectus indicates that the asset manager is precluded from doing so for at least two years.

Contango Asset Management seeks at least AUD30 million in assets from the IPO, but hopes to raise as much as AUD200 million. Each share will be priced at AUD1. The IPO is only open to Australian residents, though obviously once shares start trading on the Australian Securities Exchange (ASX), they’ll be available to all investors.

Management will run a concentrated portfolio of 30 to 40 stocks drawn from the high-yielding, mid-cap names of the S&P/ASX 300 index. The asset manager’s investment process starts with a top-down analysis of the business cycle to guide asset allocation and sector focus, then it uses bottom-up, fundamental analysis for individual security selection.

Contango aims to achieve a minimum return of 1.8 percent quarterly and 7.2 percent annually, with most gains distributed in the form of quarterly dividends derived from income and capital gains. While setting a minimum target for quarterly payouts may be of comfort to income investors, the major drawback of such a policy is that if management is unable to meet the threshold for a payout, the dividend may take the form of the dreaded return of capital.

There’s also the question of how long investors will tolerate an LIC whose price doesn’t reflect the value of its underlying portfolio. Investors buy and sell their shares of an LIC on the market, so the performance of its portfolio isn’t subject to the inflow and outflow of investor dollars with which a mutual fund must contend.

On the other hand, when a pooled investment vehicle is listed on an exchange, it can actually trade at a premium or discount to the net asset value (NAV) of its portfolio. In the case of the most liquid exchange-traded funds (ETF), any deviation from the NAV is typically fleeting. By contrast, CEFs and LICs can trade at persistent premiums or discounts to their NAV.

Though any security that trades at a premium to its NAV should likely be avoided, a discount does offer an investor the opportunity to buy a stake in a portfolio that’s actually worth more than what they paid for it. Even so, investors should be prepared for such discounts to last for quite some time.

However, Contango is attempting to mitigate this risk by including two unique features with this latest offering:

  1. At the end of five years, shareholders can vote to have CMIL liquidate its portfolio, which means that those who purchased shares of LIC at a discount to NAV would presumably receive a modest premium from the sale of its underlying assets.
  2. The asset manager will also repurchase as much as 1 percent of shares outstanding per month following any six-week period during which CMIL consistently trades at a discount to NAV of 10 percent or more. Buybacks would be limited to 10 percent of shares outstanding in any one 12-month period.

For the first two years, fees will be performance-based and capped at 1 percent of assets. In other words, the fees management receives during this period will be based on the extent to which the investment objective is met or exceeded. Thereafter, the annual expense ratio will rise to 1.67 percent.

Contango is certainly offering an enticing investment product, but it’s difficult to assess its future prospects until it establishes a record of performance data. Although the management company runs roughly AUD650 million, its only other publicly traded investment product is Contango MicroCap Limited (ASX: CTN).

CTN was launched in early 2004, and since then, it managed to beat the dividend-reinvested return of its benchmark S&P/ASX Small Ordinaries index by a wide margin over the trailing eight-plus years, as well as over the trailing one- and three-year time periods, while keeping pace with the index over the past five years. In USD terms, CTN gained 12.7 percent annualized since 2004 vs. a 10.3 percent return for its benchmark.

Note that the aforementioned performance data were based on share price appreciation, as opposed to changes in the NAV. Because CTN traded at an average 22.1 percent discount to NAV over the past year and at a 17.9 percent discount more recently, my assumption is that it’s underlying portfolio performed even better than these data reflect.

Unfortunately, this performance can’t necessarily be extrapolated to Contango’s latest product. The micro-cap space behaves quite differently from the mid-cap space. Still, CMIL bears watching. Once it has at least three years of performance data, then we’ll know better if it’s a worthwhile investment.

The Roundup

For the latest information on our Portfolio Holdings, please see the forthcoming issue of Australian Edge, which should be posted to the website on the evening of Friday, Nov. 16.

Following are links to our discussion and analysis of the most recently announced financial and operating results for Portfolio Holdings.

Conservative Holdings

Aggressive Holdings

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