Magnify your gains with investment trust subscription shares.
Many holders of investment trusts will have been given subscription shares over the last 12 months. A few investors may be a little puzzled as to what rights these small parcels of shares convey, and may have sold them shortly after issue. However, more astute individuals have collected together a portfolio of subscription shares. And they could have done exceptionally well over the last year.
JPMorgan Indian (LSE: JII)(LSE: JIIS) is an excellent example. The subscription shares are currently 143p but nine months ago were as low as 22p. That's a gain of 550%. The investment trust itself has risen 88%, from 200p to 376p. Pretty good, but a long way short of the gains from the subscription shares.
What are subscription shares?
A subscription share is a separate class of share issued by a company with its own distinct rights. Subscription shares carry the right (but not the obligation) to convert into ordinary shares on pre-determined future dates, or during a pre-determined future period, at pre-determined prices.
They are similar to investment trust warrants, but they qualify for share ISAs and may also be held in a SIPP.
Some shareholders are concerned about the dilutive effect of subscription shares. Issuers argue there would be a minimal effect on shareholders, if they hold, rather than sell, their subscription shares and then go on to exercise their conversion rights.
Geared plays on the market
But what makes these subscription shares an interesting bet in their own right? Mainly it has to be the opportunity with the gearing ratio, that in a rising market you can significantly multiply gains made on the ordinary share price.
The gearing ratio is different on different subscription shares. Throgmorton Trust (LSE: THRG)(LSE: THRS) subscription shares currently have a conversion price of 146p up to 30 October 2011. The ordinary shares are 116.5p and the subscription shares are 7.63p. So the gearing ratio, calculated by dividing the ordinary price by the subscription price, is over 15.
Say the ordinary share price was to increase 50% to 175p before the exercise deadline. The subscription price could hit 29p in this instance, a gain of 280%.
The other key calculation potential investors need to know is the premium, which is expressed as a percentage. The premium is the amount more (or occasionally less) that you pay for the subscription shares and the conversion price added together over the current share price. A low premium gives more value.
The premium for Throgmorton for example is 32% -- calculated as (146p+7.63p)/116.5p.
Going back to JPMorgan India, its the gearing ratio is only 2.6 and its premium is 2% (assuming the exercise option at 241p from January 2010 to January 2012 is used). These figures would appear to give both greater value and lower risk, as a higher gearing ratio works against an investor when shares fall.
Looking for value
I've started to keep a watchlist of about 30 subscription shares about three months ago, trying to put together a well-diversified portfolio to spread risk and make a small investment in each.
Firstly I am interested in those with a reasonable term before the exercise date -- around two years -- to give a chance for growth. Second, I'm interested if the premium is fairly low -- probably less than 25% -- or annualised at 10% or less.
My third 'screen' is that I like the share price to be close to the exercise price -- there is a comfort in seeing that there is not a great deal of distance to go to get in to positive territory. Additionally, I like a decent gearing ratio, and also the ordinary shares to be at a discount to the net asset value (NAV), and ideally the NAV to be currently higher than the exercise price.
Lastly, the investment trust should have a good performance record and a promising medium-term growth story.
Going East
As you might imagine not many subs come through this filter intact. Let me leave you with one to consider, which I also hold. It's Invesco Asia (LSE: IAT)(LSE: IATS). These run until 31 August 2012, and the subscription price is 125p. The premium is 13.3%, which is great over the period to conversion, and gearing is 5.9.
The current share price is 129.75p and the subscription share price is 22p. The ordinary shares are at a 7% discount to the NAV of 139.3p, the trust's long-term performance has been good and the Asia story over the next few years is very promising. All my boxes are ticked. Should the ordinary shares rise 30% before the exercise date, to 185p, then the subs could get to 60p -- a potential gain of over 170%.
So if you're still bullish on the stock market, subscription shares are certainly worth a look.
More on investment trusts:
Phil McSweeney holds subscriptions shares in Invesco Asia and Throgmorton.
