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Fear and loathing in the split-cap market

It has become apparent, following the Treasury select committee, that some of the professionals who were involved in the split-capital market did not really fully understand some of the risks that investors were taking when they bought shares in a split-capital investment trust. This begs the question – what hope did the rest of us ever have?

However, the split-capital sector is not as complex as it first appears so long as you avoid split-capital trusts which invest in other split caps. This situation created multi-tiers of debt upon debt, leading to a cocktail of risks, including illiquidity within the underlying portfolios and the well documented collapse of several split-capital trusts. There are plenty which do not purely invest in other investment trusts.

The real problem for investors is that the sector is not homogeneous. There exists a vast array of capital structures and it is impossible to generalise about them. Therefore, just because you understand how one trust ticks, this does not help you to understand the sector in its entirety. There are no easy answers. To find the opportunities in this sector requires significant and time-consuming legwork but the rewards justify the effort.

Fear and loathing surrounds the sector but this in turn creates value and consequently creates the opportunity. All investment trust share prices are determined by the forces of supply and demand and the dire market sentiment has lead to an oversupply of shares compared with demand.

In any market where there are more sellers than buyers, the share price must fall until sufficient buyers are attracted.

Most opportunities in the split-capital trust sector are to be found in zeros. The original investors in zeros were interested in predetermined growth. Instead, following the three-year bear market, they now realise that they have ended up with investments that are in reality giving them geared exposure to equities.

This is a far cry from their investment objective and, therefore, the natural reaction is not to ask questions and sell. This has merely added to the mountain of unwanted zero-preference shares engulfing the market and, until recently, driving their share prices ever lower.

The first step for an investor looking to identify opportunities in this sector is to make sure that they fully understand the investment trusts&#39 capital structure. Once that has been achieved, they should analyse the underlying port-folios and make assumptions about the returns that these are likely to generate.

This will give an investor a far better indication of the likely payouts at the trusts&#39 fixed wind-up date than using standard industry ratios such as hurdle rates. This allows investors to use common sense in making judgements.

It is always easier to use a real example and one of my current favourites is BFS absolute return. Using figures as at the end of January, the trust&#39s total assets were £74m and the debt owed to the bank was £33.5m.

At the end of the trust&#39s life, once the bank has been paid off in full, the next £59m will be paid to the zero holders. It will take a steep recovery in equity markets to see the full entitlement of 152p being paid out but the shares recently stood at 66p in the market.

Therefore, somebody today making a purchase could, assuming no recovery in the underlying portfolio, see a return of around 50 per cent. Simplistically, this is arrived at by deducting the bank loan from current assets and then dividing by the 39 million zeros in issue.

If the £74m of assets increases to £84m by the wind-up date of January 2005, the payout could be as much as £1.25. Conversely, a 10 per cent decline in the pot would still see zero holders paid around 87p – not a bad return in the event of continued market weakness.

The flip side of all the grief that surrounds the investment trust industry at the moment is that the buyers&#39 strike from investment trust shares has left me rather like a child in a chocolate shop. The table above comprises a few trusts that should be at the front of the queue for those investors willing to do their homework.

The art of exploiting inefficiencies within the investment trust sector is arbitraging between perception and reality. The open market price of investment trusts is usually driven by perception within the market place. Often, this is slow to move with developments in the real world.

Split caps represent an extreme example of this phenomenon as sentiment could not possibly be worse than it is at present. The reality is that market prices are discounting the possibility that the problems of the last three years will continue for the next few years.

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