Want to buy some cut-price shares?

What would your reaction be if I told you I could get you some shares at a price that is significantly less than what they are actually worth?

Well, most people would say here is a wheelbarrow, fill it up with shares but as always there is something of a catch.

It is possible to buy shares that are selling for less than they are worth but the problem is that they might stay that way for quite a long time.

The stock in question is the blue chip listed investment company Australian Foundation Investment Company (ASX: AFI) which at the last official measure at the end of July was selling on the market at a full 10% below its net asset valuation.

Why such a discount?

The reason for that discount is somewhat complicated but in general terms, when the market is travelling well, investors tend to get over-confident and think they know best about which shares to buy and sell.

At such times an experienced and well-run, low-cost investment company such as Australian Foundation is less in demand.

The reverse often happens when markets turn shaky and investors are happy to let an investment team who are highly experienced and also focussed on paying fully franked dividends to take the reins.

It is hard to say when that might be but the numbers show that in the latter half of 2023 AFIC shares started to trade below their net asset valuation and that gap widened to hit 10% by the end of July.

Is Commonwealth Bank an anchor or an opportunity?

There is possibly one more thing that you might want to consider before deciding that a genuine 10% off share deal on a diversified and well-run listed investment company is a bargain that should be grabbed with both hands.

That observation is that AFIC has a very large position in one company whose share price has gone exceptionally well of late – Commonwealth Bank (ASX: CBA).

Commonwealth Bank shares now make up more than 10% of the AFIC portfolio, mainly because the CBA shares the company bought at much cheaper prices have grown in value a lot until they have become a real cornerstone of the portfolio.

Commonwealth was a great buy

That is not a terrible thing – it proves AFIC has chosen its shares wisely and has hung on to this winning trade when many others have not but it does mean that should Commonwealth Bank shares falter and return to the sort of investment multiples applying to the other three big banks that it would have an outsized effect on the investment performance of AFIC.

After all, Commonwealth shares trade at around 23 times earnings compared to between 12 to 16 times earnings for its smaller competitors.

The recent Commonwealth profit results were very solid rather than spectacular but showed some great trends, particularly in the home loan area where the bank originated an amazing 66% of its home loans through its own channels.

That compares to 72% of all mortgages being sold through home loan brokers, meaning Commonwealth is able to hang on to much more of the revenue from its customers than other banks and has a higher net interest margin.

It is a very deliberate trend to originate its own loans which I outlined here.

Commonwealth’s premium share price is hard to justify

Commonwealth is also performing very strongly in signing up new customers and now counts more than a third of Australians as customers – many of whom treat it as their primary bank.

Still, the premium price Commonwealth shares are selling for is difficult to justify on fundamentals but it is also difficult to see any factors that might be a catalyst for a negative re-rating.

In some ways AFIC should be comfortable hanging on to their Commonwealth shares because they were bought at a cheaper price, therefore have a higher dividend relative to that price and they demonstrate a highly successful purchase strategy By AFIC management.

Other large holdings include BHP (ASX: BHP), CSL (ASX: CSL), Wesfarmers (ASX: WES), National Australia Bank (ASX: NAB) and Macquarie (ASX: MQG), although Commonwealth at 10.2% is the largest holding by far.

In sector terms, financials lead with 20.4%, followed by miners (14.3%), healthcare (13.2%) and industrials (10.9%).

Double chance to make money

It seems to me that there are two ways of making money from investing in AFIC shares – firstly through positive changes in the value of its underlying shares and secondly through a swing in the perception of the company.

There have been many years when AFIC shares have traded at a premium to their net asset backing and it is not inconceivable to see that situation return at some stage on the future.

So, for the patient investor who loves a bargain, a managed expense ratio of just 0.15% and solid and rising dividends, buying AFIC shares while they are trading at a discount to net asset valuation seems like an outstanding value purchase.

However, perhaps the primary part of the purchase decision should be on the intrinsic value placed on both the core shareholdings of the company and the experience of those trusted to make the investment decisions to trim some holdings and build up others.

Banking on a sentiment change can take a long time to pay off but in brutal investment terms, if the Australian market does well then so will AFIC shares, so that must be the prime motivation.