Important: This article is not a recommendation to buy or sell shares in Aberforth Smaller Companies Trust. I am a private investor, storing and sharing my notes. Please read my disclaimer.

Name: Aberforth Smaller Companies Trust
Ticker: ASL
Business: Investment trust
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Official site: Aberforth Smaller Companies

Many active stock pickers spend their days trawling in the lower reaches of the index, searching for small cap bargains to boost their returns.

As we’ve written many times on Monevator, most of these would-be Mini Buffetts will fail to beat the index. Stock picking is immensely hard (although that doesn’t stop me trying it). Most readers will be better off with index funds.

However UK investors looking to hang up their small cap Geiger counters face a stiffer challenge than mere self-awareness.

Whereas lucky US investors can choose from small cap index funds and value-based ETFs galore, here in Britain it’s like shopping for bread in Soviet Moscow during a farmer’s strike. Blindfolded.

Recent developments haven’t really helped matters. My co-blogger The Accumulator rejected Credit Suisse’s CUKS ETF as an expensive-ish mid cap tracker disguised as a small company affair, and the RBS Hoare Govett Smaller Company tracker got the thumbs down for being a synthetic exchange traded note (ETN) that suffers from a lack of transparency.

So whether you’re a small cap sniffer-outer tired of the game or a passive investor looking to bolt-on value via the little companies, what are you to do?

Enter the Aberforth Smaller Companies Trust

I’ve several times suggested that readers, friends – and The Accumulator for that matter – do some research into the Aberforth Smaller Companies Trust (ASCoT), to see if it can plug this gap in their portfolios.

As Aberforth reported its full-year results to December 31 this week, I thought I’d offer a quick summary here, too.

Now let me be very clear – this is no index fund. It’s a managed investment trust, and while the TER of 0.85% isn’t too bad compared to the worst of those beasts, this is no low cost vehicle scooping off market returns like an elegant crane dipping its beak into an unruffled lake to skim a sliver of water.

But it’s no hippo executing a belly flop, either.

Investing in smaller companies is always more expensive than buying liquid large caps, so you’d expect the TER to be larger than, say, the blue chip buying income investment trusts.

A TER of 0.85% is much less too than what the average small stock picker pays in dealing fees and spreads to execute their own trades – though buying either the trust or the companies it buys on your behalf will cost you the same initial 0.5% in stamp duty.

That TER doesn’t include the cost of interest. ASCoT’s portfolio was on average geared to the tune of 10% throughout 2011, and it’s currently running at 13%.¹.

It also doesn’t include the underlying transaction costs paid by the fund manager in turning over the portfolio as it dives in and out of positions.

While the manager talks a good long-term game, the trust turned over 29% of its portfolio in 2011, so these costs will not be inconsequential.

They will ultimately be paid from out of your returns, either by reducing the underlying NAV, or through shareholders being paid a lower annual dividend yield if the costs are met out of income.

Enter the Hoare-Govett Smaller Companies Index

Costs are a drag on a trust’s performance, which means managers need to offset them through some winning picks if they’re not to fall behind their benchmark.

ASCoT’s chosen benchmark is that already-mentioned RBS Hoare Govett Smaller Companies Index (HGSC) (excluding investment companies).

Encouragingly (unless you’re a conspiracy theorist) the trust’s chairman Paul Marsh is one of the two professors who spend much of their working days monitoring this index. He should certainly know his small caps, as well as his benchmark!

Indeed, Marsh and his colleague Elroy Dimson spend a lot of time delving into past returns from Britain’s little companies. They tracked returns from the HGSC index back to 1955 and found that:

… if you’d put £1,000 into the HGSC index in 1955 and then reinvested your dividends thereafter, by the end of 2010 you’d have a pot worth £3.25 million.

That smashed the returns from the wider FTSE All-Share by 3.4% a year; playing safe and investing £1,000 then reinvesting dividends into the All-Share instead would have delivered just £620,000.

Nice returns if you can get them, although past performance isn’t a guarantee of future returns. And given the paucity of small trackers in the UK, unless you fancy that synthetic ETN mentioned I cited earlier there’s no way to easily capture them anyway.

In some ways then, we’re not even asking for ASCoT to beat the index in return for gobbling up some of our return as fees, like you’d normally demand (/hope!) for from a managed fund. Just matching the HGSC index would be nice.

So how’s it done?

On a total return² basis:

Note: C.A.G.R. is Compound Annual Growth Rate.

For my money, Aberforth has made a pretty good fist of at least tracking the index over the long-term.

In recent years though it’s clearly struggled, which is reflected in growing investor disenchantment with the trust.

Absolute performance relative to HGSC Index; rebased to 100 at 31 December 2001

The discount to NAV has widened to nearly 17%, and on a share price return basis, that’s meant an investment made at the start of 2011 had fallen even more than NAV in cash terms by year-end – you’d have been down some 18.5% on your initial stake.

Value shares out of favour

The managers claim their recent run of under-performance is due to the trust’s value investing style.

Over the long-term, they say, analysis by Paul Marsh’s London Business School points to value shares in the HGSC beating its growth shares by a thumping 5% per year since 1955.

Sometimes value stops working, however – one reason why people find it hard to stick with for the long-term.

During the dotcom boom, ASCoT did poorly as investors bought companies that weren’t even making profits, but then rebounded when those companies failed, for example. The managers claim that for whatever reason, the past five years have been similar, with their research showing HGSC growth shares have beaten value shares by 10% per annum.

Clearly that’s a big headwind to performance. But if you believe in mean reversion in markets then the trust should turnaround when the wind changes.

Cheap small cap value shares

We won’t run through all 89 companies that Aberforth Smaller Companies had invested in at the last count, but I will state I like its style.

The trust is currently particularly weighted towards the smallest small companies, where I agree valuations look most compelling.

What’s more these shares don’t look particularly imperiled. Some 43% of the companies ASCoT has bought have net cash, meaning that at the very least they’re unlikely to go bust any time soon.

You may think it’s bizarre that lowly-rated cash-rich companies are among the cheapest you can buy currently, given all the dire headlines about the economy.

The managers agree, stating in their annual report:

…during the bear market of the second half of the year, the correlation between balance sheet strength and share price performance within the benchmark was remarkably low – the relationship between the two was effectively random. This frustrating lack of discernment can probably be attributed to the prevailing climate of extreme risk aversion, which has, so far, out-weighed other considerations.

I concur, having seen various small cap shares pummeled in late 2011, and liquidity so constrained that I’ve had to buy or sell some investments in blocks of £1,000 or less to avoid moving the price. Bearishness still reigns in this stock market.

ASCoT’s holdings also look cheap on other measures. As of December 31st:

• Their average P/E rating was just 9.0, compared to 11.8 a year ago and 10.5 for the HGSC index.

• The companies’ dividend yield was 3.4%, compared to 3.2% for the index. This yield was 3.3x covered by profits.

• On an EV/EBIDTA basis, the trust’s portfolio is valued at 6.9x, compared to 8.9x for the HGSC as a whole.

The trust was yielding 4% in December (thanks to the amplifying affect of the discount), and it’s still yielding 3.6% after a strong run in the share price in January.

Equally, the discount remains elevated at 15.3%.

The managers believe that the trust’s fortunes will reverse in time (and I agree) stating:

The present gulf between the valuations of value and growth stocks is exaggerated. History suggests that the relationship between the two groups will not stay at such stretched levels. The process of normalisation will be advantageous to the value investment style.

Investors who are prepared to wait can enjoy a decent dividend income, which in recent years has grown much faster than inflation:

Dividends versus RPI growth; Figures rebased to 100 at 31 December 2001

Why I hold Aberforth Smaller Companies Trust

I’ve almost always held Aberforth Smaller Companies Trust shares in the past 4-5 years, although residing in my active portfolio the position is liable to be trimmed and expanded as I see fit.

My current holding is the largest I’ve ever had, representing around 5% of my total net worth.

As with Caledonia Investments, I like the underlying companies, and the long-term record and approach of the managers. I think they’ll do well eventually. Both trusts are on large discounts, and I think in time they’ll close, which will amplify returns.

Passive investors looking for a straight proxy for the HGSC index shouldn’t be interested in such speculation, of course, and will rightly be wary of investing in ASCoT given its relatively high costs.

But I think one shouldn’t let perfect be the enemy of the good.

In the absence of a cheap small cap value tracker, I think a small deviation from the righteous passive way to invest say 5% of your portfolio in this small cap trust is likely to prove more rewarding than skipping past the small cap segment of the market altogether.

Note: As with all our specific share write-ups, I can take no responsibility for the accuracy of this post. Please do your own research on Aberforth Smaller Companies Trust and read my disclaimer.

1. Using debt to buy shares will boost returns when the markets do well, but exacerbate losses in a downturn
2. Total return is underlying net asset value growth plus dividends paid.

Further reading:

1. Buying small caps to gear up for the recovery
2. Buying an investment trust on a discount versus a premium
3. Six small cap property companies

Important: This is not a recommendation for you personally to buy or sell any small cap property companies. I’m just a private investor, storing and sharing notes for wider interest. Read my disclaimer.

We’ve seen how most of the UK’s big commercial property companies are trading at discounts. If you believe the pessimism about Europe and the global economy is overdone, then some offer good yields as well as seemingly undervalued assets for you to snap up.

There is also a plethora of small cap property companies and developers in the FTSE All-Share – although fewer than before the 2008/9 downturn, which inflicted several fatalities in the sector.

In many cases the surviving small cap property companies appear to be even more attractively valued than their larger brethren. But with the greater potential of small caps comes more risk, too.

Of the various elements I suggested you dig into when we looked at the large REITs, I’d say you should pay extra attention to management, insider ownership, and any funding commitments or requirements.

For example many private investors follow London developer Quintain Estates, which has residential sites in Greenwich and Wembley, and other assets and operations besides. On a net assets basis, it seems hugely undervalued. It has also attracted the interest of the well-regarded active investor Laxey Partners, which is now the major shareholder.

However I’ve not been able to reconcile myself to the seemingly large amount of money Quintain will need to complete work at its sites (at least when I last looked at them a year or so ago). I did hold the shares briefly, but I sold them for a small loss as I decided I wasn’t very comfortable.

Similarly, while I’ve owned shares in the first three of the following six firms at some point or another, I don’t currently hold any of them, as I’ve reshuffled the active portion of my portfolio to try to take advantage of the ongoing volatility (remember: don’t do this at home!)

Small cap property companies I like

I think all these companies have some attractive qualities and good potential, but obviously also risks. Please remember to do a lot more research before even considering investing – these are just jumping off points for further research.

Mountview Estates: This interesting company buys residential property that is blighted by legacy rent controls. (Blighted from our perspective, not the tenants’!) These rights eventually lapse with the death of tenants, and the property can be refurbished and/or resold. Mountview is potentially a very undervalued play on residential property paying a reasonable 4% yield, but you’ll have to think long-term.

Daejan: A family dominated FTSE 250 firm with residential and commercial property interests in UK and the US, especially London. Very steep discount to NAV (it’s priced at 0.5x book value) but the dominant family aspect and the more second tier assets it holds (in my personal opinion) means it very rarely trades at a premium. Perhaps also worth considering for the great long-term dividend record, though the starting yield is only 2.8%. Suffered recently in the fall out from the collapse from Southern Cross care homes.

Mucklow: Sort of a mini-Segro at £180 million but mainly focused in the Midlands region, Mucklow is another conservatively run family affair with a superb dividend record. The yield is currently 6.2%. I held until a few months ago, when I swapped it for something more volatile that has since fallen. The sort of company I should try to tuck away for the long term.

Panther Securities: A £52 million small cap run by wily veteran Andrew Perloff, who is noted for his hilarious and strident annual reports as much as his good long-term results. Almost like investing in a private company run by your clever uncle. Horrible spread, so try a limit order or a ‘real’ broker.

McKay Securities: Another £52 million outfit, this time focused on commercial property in the south east and around London. It’s priced at 0.6x book value but there’s around £120 million of debt, secured against just under £220 million of assets. That looks a bit precarious, but the managers do inspire some confidence. They didn’t raise cash in the downturn, and they recently spent £2.7 million on a new modern office in Bracknell that is being let for a yield of over 12%, even though it’s not yet fully occupied. Risky but could be very rewarding.

J Smart: An even smaller cap property developer with plain speaking management. It recently issued a mild profit warning as occupancy levels fell and construction remains subdued. Looks cheap, but under the cosh and will need a turnaround in UK PLC to get going.

Finally, a reader asked about commercial property investment trusts. The only big one I’ve ever invested in is £700 million F&C Commercial Property. It’s on a small 6% discount and pays a 5.8% yield. I suspect it’s becoming popular with income seekers at present, though that’s just a hunch. About four-fifths of the portfolio is in London, with the rest spread about the UK. As with nearly all property companies there’s a fair bit of debt, with gearing near 30%.

Of course, mainstream investment trusts might also invest in commercial property. The currently much-hated Caledonia trust has money in London & Stamford and the aforementioned Quintain, for example. Beware, Caledonia’s shares languish on a 25% discount, so while I continue to hold myself, the market clearly doesn’t think much of its manager’s judgement!

Final warning: All small cap property firms are likely to suffer badly if there’s a renewed and prolonged UK recession. I still don’t expect that myself, but the odds have undoubtedly risen sharply in the past six months.

Further reading:

1. UK commercial property trading at a discount
2. Commercial property is an attractive asset to own
3. Five reasons to buy commercial property

Important: This is not a recommendation for you to buy or sell any shares or to invest in commercial property. I’m just a private investor, storing and sharing notes for wider interest. Please read my disclaimer.

A couple of years ago I made the case for buying commercial property listed on the UK stock market.

The various UK REITs¹ had been hammered by big writedowns that downsized their net assets (NAVs). They looked vulnerable against the large loans they’d secured against those depreciating assets. Some had to raise extra cash via rights issues.

There were also fears that banks would dump property they acquired in the boom years (or been lumbered with after loans turned sour) as they desperately tried to shrink their own books.

Buying into this scenario might have seemed as appealing as elbowing past widows and orphans for last-minute tickets onto the Titanic. But there were reasons to be positive.

Rents for the better REITs had held up more than their plunging share prices suggested. Share prices had also fallen far below NAVs. At the bear market low you could buy £1 of Land Securities’ assets for as little as 36p!

Obviously, investors feared commercial property prices would fall further, taking NAVs with them. But as it turned out, the steep fall to 2001 levels in the prices of offices, warehouses and shops was enough to tempt in bargain hunters.

From 2009, commercial property prices firmed and then began rising, especially in the South East, and the REITS followed. (Some vulture funds set-up specifically to buy distressed property in London were complaining when prices bounced back too quickly!) It proved a great time to buy.

As well as traditional property players mopping up unfairly reviled assets, I suspect the QE operations began by central banks in early 2009 also helped stabilise the market.

Commercial property is an inflation-resistant asset, since both property values and rents should increase broadly in-line with general inflation. If you fear higher inflation down the tracks, it’s a good asset class to be in.

The idea is to buy cheap

Today REITs seem to have fallen out of favour again, perhaps due to fears over Europe. Well, that and the UK economy, which is now doing a good job of impersonating a hit-and-run driver reversing to make sure.

But I think the market is again being too pessimistic about commercial property.

Only a few years ago, investors couldn’t get enough of it, with new funds raising billions of pounds and helping to inflate a bubble that slashed yields and primed the crash to come. Price seemed irrelevant. Yet now commercial property looks pretty good value and the market seems to be taking a more balanced view of its prospects, the average investor doesn’t want to know!

That’s their loss. Commercial property is an attractive asset class to own, whether you’re a passive or an active investor, and I think now looks a good time to buy – not as cheap as in 2009, granted, but unless you expect a European blow-up not as risky, either.

The big players certainly haven’t capitulated; work on new skyscrapers in London is continuing apace. While I don’t think this expansion is due to any pressing shortage of floor space, I do think such confidence in the future of the UK capital is a handy wake-up call.

Commercial property for passive investors

Many passive portfolios include a substantial allocation to commercial property. David Swensen’s Ivy League portfolio suggests a big 20% holding, for example. Several other lazy portfolios have significant allocations.

Note that UK index trackers will give you some exposure to commercial property, since big REITs like British Land, Land Securities and Hammerson are all in the FTSE 100.

But the real estate sector is relatively tiny – less than 2% or so of the FTSE 100 – and dwarfed by basic resources, energy, banks and the like. Personally I’d add a specific property allocation to any passive portfolio, which I’d expect to dampen volatility and increase my income over time.

The iShares UK Property ETF (ticker IUKP) is an easy place to start. It’s yielding 3.1%.

(Note that very nearly 50% of that ETF is invested in the three largest REITs, which some may consider excessively risky, though it’s a fair reflection of the UK listed real estate market).

Active investing in property REITs

Those of us who undertake the dark practice of active investing should certainly consider the commercial property market at present.

• If you tilt your portfolio towards income, the sector offers plenty of potential to grab higher yields for the long term.

• Value investors might consider the discounts to NAV as attractive, though I don’t deny they could get a lot wider in the more dire scenarios.

• If you have your own theme or pet view on where the economy is going, there may be a REIT for you. It’s easy to bet on London, for example. If you’re more optimistic about UK retail than most (I’m not!) then that’s another possibility.

• Some investors might prefer to hold commercial property REITs directly rather than via dividend-paying ETFs for tax reasons, due to how property income distributions (PIDs) are treated.

UK commercial property trading at a discount

Here’s a summary of the ten largest companies in the UK real estate sector by market cap, price to book value (P to BV in the table), and forward yield.

(Data as of lunchtime on December 14^th)

As you can see most commercial property companies are trading at a discount to their net assets again (prices went above net assets earlier in 2011) and there are tasty yields on offer. Companies on lower yields tend to be either owners of only prime London assets or more development-orientated companies, or both.

Please note you’ll want to check all these figures – and a lot more – before considering an investment. Various data services define net assets / book value in different ways, and forward yields also vary. Download the REIT’s latest annual results and do your own research.

While you’re at it you should also evaluate:

Debt: How much does the company owe, how heavily is it geared against assets, and how comfortably can it meet interest payments? When do loan to value covenants kick in? (They could trigger rights issues).

Rent: How much of the portfolio is let out? Is that number rising or falling? How bad did it get in the last slump?

Earnings and dividend: REITs must pay out most of their earnings as a dividend, so dividend cover is of little use here. Instead look at how earnings are growing, in conjunction with your rent research. How hard was the dividend cut last time?

Development: To what extent are upcoming developments pre-let? Does the company have the funding to complete its work? (Not a problem with big REITs, but a factor for smaller developers with money still tight).

Sector and geography: What are you buying into, and where is it? If you’re bullish on a bounce back in The City, you don’t want to buy a load of shops in the North.

Management: Subjective and difficult, perhaps the best thing to do is look back through management’s statements in the last downturn. Many key players have moved on, however.

Which UK commercial property companies look attractive?

Personally I like the look of the big two – British Land and Land Securities – which offer the chance to buy into incredibly diversified property portfolios at a discount and to hopefully secure a long-term growing income.

The most contrarian play is probably Segro, which focuses on industrial warehouses and the like. Not a happy sector, hence the high yield. Could be worth investigating if you sense the economy bottoming out.

The big London specialists such as Derwent London and Great Portland look pretty fully priced already. British Land and Land Securities have substantial London assets, too, albeit with plenty else besides.

London & Stamford is interesting. Veteran real estate moguls established the company just ahead of the slump, but they didn’t get a chance to deploy much of their funds before the recovery began. They’ve been very cautious about investing into the rising market, and have plenty of firepower left. Could be a good option if you’re cautious on the short-term but would like some professionals running your money. Great yield.

Price is the firmest foundation

None of the commercial property companies are going to thrive if the UK enters a deep recession or the Eurozone blows up.

I don’t think either is likely, and I’d argue the general gloomy sentiment makes it a good time to be hunting for bargains. I am not claiming prices will soar next month, or even next year.

Property has generally rewarded those who think long-term – provided they’ve bought into the sector at decent prices – so even if the immediate outlook isn’t great, I think valuation makes it a good time to consider investing.

In part two: A few ways to invest in small cap commercial property companies.

1. Real Estate Investment Trusts

Further reading:

1. Commercial property is an attractive asset to own
2. Five reasons to buy commercial property
3. Commercial property: I’m buying

The government has revealed a new plan to get more houses built – and to enable more of us to buy them.

But I think it’s better news for shares in house builders than for the young, would-be home-owning masses.

Theoretically, first-time buyers will benefit from the new scheme to get the market for 95% mortgages going again.

The plan will see the government acting as guarantor of high loan-to-value mortgages, in conjunction with house builders, as The Independent reports:

The Government will underwrite a small percentage of each loan on newly built property. Banks are typically demanding a deposit of 20 per cent on loans to first-time buyers and, by guaranteeing a portion of the loan, the Government will in effect be shifting that “loan-to-value” ratio so that the borrower needs a smaller deposit – possibly as little as 5 per cent.

That, it hopes, will lead to more demand and provide a boost to the construction industry in terms of sales and employment.

As I understand it, the government is proposing that in order to achieve a 95% loan-to-value mortgage, a house builder would contribute say 3.5% of the property price and the government another 5.5%.

Together they’d be putting up 9% of the purchase price. Therefore to grant a buyer with a 5% deposit a mortgage, the lender would only need to put up 86% of the purchase price (100-9-5 = 86%).

With banks still hoarding all the cash they can, that’s a much more attractive deal for them than having 95% of their capital at risk.

High loan-to-value mortgages mean big risks

As a potential home buyer, however, the first thing to note is it’s you – not the government – who is first in line for losses should you sell your house for less than you paid for it.

I think that’s only right – a scheme protecting buyers 5% deposits would be untenable, giving a free option on house price rises.

Still, it’s likely to be misunderstood by some people. I remember that when so-called Mortgage Indemnity Guarantees (MIG) were in vogue in the 1990s – before reckless banks stopped bothering to account for the extra risks of high loans – there was little clarification in the mortgage documentation that the MIG protected the lender, not the person paying it.

But a more important question is whether new home owners should actually be risking taking out a 95% mortgage on a new build property, even as prices stagnate across much of the UK.

New build houses generally have a premium price, which lasts about as long as the leathery smell of a new car before they start depreciating.

Banks therefore don’t like lending 95% against the value of a new build property, for the very sound reason that any particular aggregation of laminate flooring and beech kitchen units is unlikely to be worth quite as much again until house price appreciation papers over that lost premium.

And outside of prime London, house price appreciation is notable by its absence.

While I understand the frustration many feel at not being able to buy a home, taking out a 95% mortgage on a new build property that the government is effectively bribing banks to lend on seems a risky way to go about it.

Buying the shortage of houses

Given the new climate of financial responsibility, it seems strange that the government wants to encourage high loan-to-value mortgages just a few years after the collapse of Northern Rock.

A cynic might say it amounts to State-sponsored negative equity!

A few years ago I would have suspected it was all part of a ruse to prop up high house prices. But having been repeatedly humbled by the strength of the London housing market – easily my most costly financial misjudgement – I’m nowadays less cocksure about the path of house prices.

Specifically, I now accept that there’s a structural shortage of homes for people to buy.

Note that’s subtly different from saying there’s a lack of places to live in. While rents have increased in the past couple of years as up to one million people have had to rent a home who would previously have bought a house, I’m not convinced there’s not enough rooms with beds in them for the UK population.

I now agree though that there’s probably a lack of properties that people want to buy, in the places that people want to live.

And while you might argue market forces should be the best way to fix this, I’ve come to the view that there are structural reasons why this isn’t happening.

Some evidence for this is the difference between the path of prices in the US and the UK.

Both countries experienced booms – indeed ours was much bigger – and both have seen new housing ‘starts’ derailed in the recession. In both countries mortgage holders have benefited from cheap money, too (at the expense of prudent savers, but that’s another issue).

Yet whereas US prices have fallen back to more sustainable levels in most areas, in the UK prices still seem stuck above both historical price-to-earnings ratios, and also higher than many pundits would have predicted given the low turnover of property.

The rise in the cost of renting – while clearly egged on by an influx of thwarted first-time buyers – also indicates that at the least there’s not a surplus of houses sitting empty.

All this was pretty much outlined in the much-cited Barker review of 2004, but I have to admit I was an avowed housing bear in the mid-2000s when it was released, and I thought Barker had under-estimated the impact of easy credit on house prices.

While I haven’t exactly done a U-turn, the housing market hasn’t crashed as I’d predicted it would once the taps were turned off, especially here in London.

When the facts change, you have to consider changing your mind.

The case for investing in house builders

Perhaps easier to predict than the path of house prices though is the fortunes of UK house builders.

House building volumes have collapsed from pre-crisis levels, which were themselves too low for all the new household formation going on in Britain:

With divorce and single living still in the ascendant and net inward migration hitting a new high of 252,000 in 2010, the need for extra homes just keeps on rising.

I therefore think house builders will enjoy plenty of demand for new houses to keep them in business for the next few years, even without a return to go-go price rises.

The share prices of house builders collapsed by 90% or more in 2008 and 2009. While they have recovered a bit, they still look cheap given that most now have far stronger balance sheets thanks to big rights issues and asset sales.

All the main builders have now returned to making profits, with their margins being helped along by the cheaper land they bought in the downturn. Margins are also up because today’s lower levels of activity enables them to haggle with their suppliers, and with the various tradesmen.

Yet the price-to-book values of house builders – a measure of how much you pay for a company’s assets – are still well below 0.5 in the case of the volume players like Taylor Wimpey and Barratt Developments.

Theoretically that means you get £2 of assets (such as land and properties in development) for every £1 of shares you buy.

True, these volume builders still carry a fair bit of debt. If you’re more risk averse you might want to investigate shares in the likes of Bellway and Redrow. They are more lightly-geared, and should better withstand the impact of a renewed recession.

Alternatively, you could wait for a dip and consider buying my favourite company in the sector, Berkeley Group. You’ve already missed a nice rise though, and the company doesn’t look half so cheap as its rivals. I continue to hold its shares for the long-term, and consider management in a different league to the competition.

Investing in property mad Britain

Interestingly, share prices in the builders actually fell on the news of the government’s plans.

Perhaps the market expected more of a bail out from Cameron and Co, or perhaps investors are concerned about the money that builders will need to invest as their part of the guarantee scheme.

It’s worth noting, however, that most house builders are already on the hook should house prices fall with renewed vigour.

Not only will their land holdings be written down in value again, but many have been undertaking shared equity and part-exchange business, which has seen them retain housing assets on their books. You should definitely dig deeper into the accounts if this makes you nervous and you’re considering investing; my point is the few percentage points of extra risk they’d retain with the new scheme isn’t wildly different to what some are already doing.

Whatever the stock market thought this week, though, I think the outlook for shares in house builders in the medium term from today’s depressed levels is pretty bright.

The government clearly wants more houses to be built – if only for the economic activity it generates – and most of us seem happy to keep paying an awful lot for those houses. Planning changes should also play into the house builders’ hands.

No guarantees, but I think their share prices will likely be much more upwardly mobile than general house price inflation over the next few years.

Further reading:

1. New stamp duty bands for UK houses
2. Reasons to buy a house instead of renting
3. Playing chicken with house prices

Warning: This post is me at my most disreputable. Not only do I report on actively trading bank preference shares as frantically as a ping pong champion paddling towards a Pyrrhic Victory, but the trades weren’t great, either! Trackers are a better bet for most.

One of my least glorious capital allocation decisions of the past couple of years was a belated foray into preference shares.

Various bank preference shares have been intermittently hammered by the banking whirl-y-gig of the past four years. Some private investors made fortunes in 2009 through the time-honoured method of buying low and selling high. I bought middling and sold middling, and in doing so missed the opportunity to put that money into something more profitable.

In May 2010 I bought into the Natwest preference shares with the NWBD for a running yield of around 9% and a troubled parent in the form of RBS. A little later in July 2010 I bought the Lloyds 9.25% issue with the ticker LLPC, sold out later that year before they fell out of sheer luck (I wanted the money to invest in something else), bought again in February 2011, then sold a bit more ‘skillfully’ (quotes to admit I might also have been lucky again) before they got truly bashed by this summer’s Banking Crisis Mark 2.

I sold my last batch of LLPC for 86p back in June, and while that’s much more than you’d get for them now it’s also less than the 92p I paid for a few thousand of them in February! I did better with the earlier batch that I reported on here on Monevator, but overall I lost money on these. There was no dividend from LLPC, of course, as the coupon is suspended.

I sold a little over half the NWBD for a penny down, then the rest in April 2011 – for a few pence more than I paid for them, and with a bit of income in the bag – after I got frightened off by RBS revealing that Natwest made a loss in 2010, thanks to the dreadful Ulster Bank. RBS stepped up and injected more money into its Natwest subsidiary, which might seem positive. However my comfort blanket had been that Natwest was somewhat insulated from the wider turmoil at RBS, so being bailed out by that basket case wasn’t exactly reassuring.

Overall I made a tiny amount of money on NWBD, thanks partly to the big dividend, but lost more on LLPC. And my broker probably had a pretty good steak dinner on my shenanigans.

Preference shares cheap again

The good news from my perspective is that if I’d held on to either preference share I’d be much further underwater. Bank preference shares have fallen with bank shares on summer’s worries – to the extent that they’re tempting me back for a second look.

This may surprise you, given the largely success-free first jaunt I’ve just recounted. But my motto in investing is never say never again. (Besides, I’ve done far worse from some stock picks – 100% worse in fact!)

Today LLPC is trading at 68p mid-price¹. NWBD has a mid-price of  87.5p, which is 14p cheaper than when I first wrote about it last year. In both cases there is a hefty spread of about 4p. You may do well to use a limit order to try to knock a penny off the price you pay.

Turning to the yield spreadsheet at the enthusiast-run Fixed Income Investments website, you can see that the Natwest issue NWBD is now yielding over 10% on the mid-price – quite a bargain, on the face of it.

There’s no yield given for LLPC because the coupon is still suspended until 2012. With a coupon of 9.25%, an overly-simplified calculation of the yield indicates that at 68p a fully-functioning LLPC share would be yielding over 13%!

I won’t go through all the particulars of the two issues again, so please see my original articles on LLPC and on NWBD for the detail (some of which will now be outdated, given developments since then).

Risks, risks, everywhere

In a world where benchmark government bonds are yielding less than 2%, you don’t need Jim Cramer screaming to tell you something is up when NWBD is offering a yield of over 10% in perpetuity, and LLPC the prospect of a 13% yield.

In my view the reasons are a combination of:

• The Irish exposure that hit both RBS and Lloyds around Christmas 2010. Previously, these banks had been seen to be already moving into profit, but they were forced to take huge writedowns by their duff Irish loans.

• The more recent resumption of the Greek crisis. Disorderly disintegration of the Eurozone is now perceived to be a real possibility, and in that case banks would be hammered. Lloyds for one has very little Greek exposure, but it is exposed to other PIIGS. And then there’s the issue of contagion. In this post-Lehman’s era, everyone fears counterparty risk.

• The wider despondent stock market of the past few months that has sent various European indices down 20% or more. Preference share holders have been reminded that despite their fixed coupons, these securities behave much more like equities than bonds – as they should, because their coupons are not as secure as with bonds, and they come straight after equities in the firing line in the event of a bankruptcy.

• There are fears that both RBS and Lloyds may need to raise more capital – even independent of a European implosion – due to further government bank regulation. Some fear such capital raising could impact the rights of existing preference share holders, or in the case of LLPC that it could delay resumption of the dividend.

• I’d add that Irish meddling with the usual rights of bond holders hasn’t improved the backdrop for investing in these exotic instruments. On the contrary, shareholders now believe they need to be more vigilant.

• Finally, remember these securities are very illiquid – you can easily move the price of LLPD, the smaller Lloyds preference share issue, with a relatively trivial purchase or sale.

No preference for preference shares… yet

Are all these fears and risks adequately reflected in the price of bank preference shares today?

That’s the £64,000 question, and I don’t have a firm answer.

When I was originally interested in bank preference shares, it was because I believed the banks’ worst problems were behind them. That proved highly optimistic.

Having said that, Europe-aside the banks do seem to be getting their books in order. For instance Lloyds (which I still own ordinary shares in, and have traded heavily for a similarly turbulent ride) has been paying back tens of billions of pounds worth of special government support. And for what it’s worth analysts are still forecasting a modest return to profit for both it and RBS for 2011.

On balance, with the FTSE 100 down around 5,200 and plenty of ordinary shares I like looking good value, I’m not currently buying these bank preference shares against the backdrop of increased uncertainty.

If Europe was to resolve its problems quickly (I for one expect them to be solved eventually) and/or the wider market was to rally strongly without carrying up the bank prefs with it, then I might change that stance and have a nibble.

For what it’s worth (read my disclaimer!) my gut feeling is NWBD will continue to pay its coupon, and that one day its share price will be a lot higher. I’m not quite so confident as I was in summer last year, however, given how hard Natwest was hit by Ireland’s woes in 2010, though one would hope this has now been sufficiently discounted by the big writedowns the UK banks have taken on those Irish loans.

The situation with LLPC is more intriguing. When I first wrote about them they were two years away from a potential resumption in paying their dividend (due to the expiry of the EU’s block on the payment). Now they’re only eight months away. In other words, we could be getting to the point where we don’t have to factor in missed coupon payments when calculating the effective yield on the purchase of LLPC.

Of course there’s no guarantee that LLPC will resume payments in May – Lloyds may not make a profit, it may decide it’s not politically expedient to pay shareholders cash while still being seen as ‘saved by the taxpayer’, or it may try to ride roughshod over shareholder rights.

But Lloyds has reaffirmed its commitment to dividends, and it’s theoretically on track to make a profit. And according to the rules governing its preference shares it can’t pay ordinary shares a dividend until the preference shares are paying again, which is the number one bull case for owning them.

This resumption of payments was at least as uncertain when I wrote about them in early 2010. Yet given that the shares are 15p cheaper and the first resumed payment is potentially much closer, then all things being equal they are more of a bargain than they were back then.

If you expect a European meltdown and another full-blown banking crisis, all things definitely aren’t equal! I don’t, which means I’ll be keeping a close eye on the Lloyds preference shares in the weeks and months ahead. I’m also monitoring Santander preference shares, though they have fiddly withholding tax to contend with.

Finally, I’d stress these bank preference shares are risky investments that should not make up more than a small portion of an overall portfolio. You could quite possibly lose the lot.

1. There is another popular issue with the ticker LLPD, but I prefer LLPC as it is much larger issue which may help if things turn nasty for holders and it is also more liquid.

Further reading:

1. Bank preference shares: A brief history
2. The bewitching appeal of Lloyds suspended preference shares
3. What first attracted me to the 9%-yielding Natwest preference shares

The more opportunistic London rioters have been grabbing plasma TVs and trainers in the mayhem. While it’s pure burglary, at least there’s some rationale to their criminality.

Do you want to snag a bargain in the equivalent stock market furore? I’ll quickly run through a few things I’ve been looking at or even buying, just to give you some food for thought.

Disclaimer and warning: These are NOT recommendations for you to buy. They are at most a few ideas for further research. As ever any decisions you make are your own, and your trades are not my responsibility. I’ve written what I believe to be true, but it might be wrong. These are fast markets¹ and there’s no reason why you have to get involved.

Lower risk ideas

All shares are much higher risk than cash or bonds, and you can lose all your money. That said, the following look good opportunities for more risk-averse equity investors.

Tesco

You can now buy Tesco at around the same price Warren Buffett paid when he first bought into the supermarket everyone loves to hate. Stonking 4.3% forward yield from one of Britain’s most consistent dividend risers. Great overseas prospects, and solid asset backing.

Weir Group

This FTSE 100 engineer fell nearly 9% on Monday, just a few days after it reported record orders and great profit and sales growth. It is closely tied to the commodities industry that was flavor of the month a month ago. Looks cheap, on a PEG rating 0.5. I suspect hedge fund dumping.

iShares’ Australia ETF

A few weeks ago Australia was a safe haven. Now its stock market is officially in bear mode, with 20%+ declines in the past three months. The iShares Australia ETF (Ticker: SAUS) is an easy way to buy into this commodity rich list.

RIT Capital Partners

I’ve written about RIT Capital Partners before. The Rothchild investment trust is one of the nimblest out there, but it’s falling like a stone and is now back on an estimated discount to NAV of nearly 7% – that’s quite big for this trust. Some of the income investment trusts are moving to a discount, too.

Halma

The share price of this superb manufacturer of safety-orientated devices (Ticker: HLMA) soared out of the recession, yet profits didn’t stop growing even during the worst of the downturn. It’s got one of the UK’s best dividend records, too, and although the forward yield is only 2.7% it has grown strongly in the past and is more than twice covered.

Medium risk ideas

A trio of ideas here.

Tullow Oil

Down nearly 25% in five days and more than a third off its highs in April, Tullow (LSE: TLW) is an £8.5 billion oil and gas explorer with operations right around the world. A fair bit of debt, true, but if you are one of the legions of peak oilers, it could be a fresh opportunity to pick up a quality asset.

Xstrata

Xstrata has moved almost in lockstep with Tullow, despite being in the mining sector and again reporting positive results. Funny how China has suddenly stopped industrializing, eh? I’ve avoided these sorts of companies for years (and before the 2008 crash if I’m honest) but they’re getting interesting. Again I suspect hedge fund dumping.

City Natural Resources High Yield Trust

This investment trust (Ticker: CYN) could be a good way to get into commodities if you don’t want to invest in individual shares. Be warned it’s very volatile, and despite the name the yield is tiny. Indeed, it harks back to a time when commodity companies paid big dividends, which shows how far they could yet fall. BHP Billiton (Ticker: BLT) could be a better bet for income seekers – massively diversified, and the yield is back above 3%.

High risk ideas

I repeat, shares could easily fall another 10-20% or more from here. But if you want to take a chance, here’s a few risky things I’ve been looking at.

Polar Capital Technology Trust Subscription Shares

A few weeks ago there was a new tech bubble in full swing, although everyone has seemingly forgotten about that now. If you want to take a big punt on things going back to usual, then these subscription shares (Ticker: PCTS), which key off the Polar Capital Technology Trust (Ticker: PCT), could prove lucrative – they were trading nearly four times higher a few months ago. They expire in March 2014, with the option to buy PCT shares at 478p. That trust currently costs 310p, so it’s a not inconsiderable mountain to climb in two and a half years.

Artemis Alpha Trust Subscription Shares

Artemis Alpha Trust (Ticker: ATS) is a global fund with a bias towards energy and commodity companies. The trust’s subscription shares (Ticker: ATSS) have until 2017 to run, so plenty of time to recover. For that reason there’s a lot of time value in the share price, but that hasn’t stopped them moving in a very volatile fashion in the past few days.

Medusa Mining

Gold is at an all-time high in dollar terms, yet Medusa Mining (Ticker: MML) is down 25% since the end of May. In the 2008 downturn miners were dumped because of funding fears, but Medusa has over $100 million in cash. The price has run up sharply in the past year, but if you’re late getting gold exposure (like me) it might be an option. Centamin (Ticker: CEY) is similar, and similarly risky in terms of emerging market exposure.

Finally, given all the various potential bargains around and about, you could obviously do worse than just buy an index tracker. Pound cost averaging is a good approach when buying in volatile markets.

Readers, what have you been doing in the crash? If you’ve been buying or selling anything please let us know below.

1. Yields and prices are as of close on 8 August.

Further reading:

1. Subscription shares
2. How subscription shares multiply your gains
3. Are BP shares a buy?

Important: What follows is not a recommendation to buy or sell shares in Caledonia Investments. I am just a private investor, storing and sharing my notes. Read my disclaimer.

Name: Caledonia Investments
Ticker: CLDN
Business: Investment trust
More: Trustnet / Google Finance
Official site: Caledonia Investments

I have a soft spot for family vehicles like Caledonia Investments. I’m reassured to think that crusty old Barons and Earls are keeping a gimlet eye on the same investment that I’m in.

These trusts also appeal to me because:

• I believe wealthy old money knows how to stay wealthy.
• Big investment trusts are a relatively economical way to buy active management, if that’s your wont.
• They are invariably interestingly diversified.
• I’m a sucker for the romance.

Like anything on the stock market, investment trusts can attract their fair share of flighty managers and corporate conquistadors — or sometimes they simply bungle badly. With a wealthy family trust, I’m more confident that I can wait out misadventures knowing that seriously rich people are batting for the same cause as me – but with rather bigger bats!

For all these reasons and one more, I’ve made a substantial investment over the past few months in Caledonia Investments.

The extra kicker is that as I write, this investment trust stands at a discount of nearly 20% to its Net Asset Value (NAV). I consider this discount very likely to narrow over the medium term.

Wiping out the discount so that the shares traded at the estimated value of their underlying assets as of today, I’d see a 31% uplift to my shareholding’s value, even if Caledonia’s own investments did not to rise in value at all!

In reality, however, I expect Caledonia’s assets to at least keep track with the UK stock market; the trust has beaten the FTSE All-Share index in all but one year out of the past ten.

On a total return basis, Caledonia outperformed the same index by 113.5% over ten years, as of 31 March this year — a superb result! No lost decade for investors in Caledonia.

Past performance doesn’t guarantee anything, but I believe the combination of what I consider an unwarranted large discount, the strong family interest, and a track record of good asset allocation is a recipe for decent returns from here.

A potted history of Caledonia

Caledonia arose from the wealth of the Cayzer family, which made a mint or two from steamships in the 19^th Century.

The Cayzers bought the wonderfully named Foreign Railways Investment Trust in 1951 as a holding vehicle for their family wealth, though they showed rather less sentimentality than me when they renamed it Caledonia Investments Ltd.

In 1955, Caledonia then gobbled up the Cayzer family’s interest in the British and Commonwealth Shipping Company, and the resultant entity was floated on the London Stock Exchange in 1960.

Caledonia subsequently divested itself of the British and Commonwealth holding in 1987, and became more like the opportunity-seeking investment vehicle it is today.

It was restructured as a formal investment trust in 2003.

Don’t discount the family factor

Now, there are some investors who would say this convoluted history justifies a discount on the trust, especially when added to the ongoing involvement of the Cayzer family, who have their own colourful back stories.

But as I’ve said above I’m in the opposite camp, in that I like the family factor.

I’d also note that the share has sometimes traded at a slight premium to net assets in the past, so clearly the Cayzer family effect alone can’t explain the discount:

Caledonia has traded above net assets, though not in the past few torrid years for equities.

It has to be admitted though that Caledonia’s family owners have been a fiery lot over the years: More 1980s Dynasty than 19^th Century dynasty.

The turn of the 20^th century was marked by a big bust-up, which this article from The Telegraph from 2004 captures:

One of the City’s most bitter family feuds moved towards peace yesterday when Caledonia Investments announced a special dividend costing at least £64m to buy out dissident members of the Cayzer shipping dynasty.

The scheme has been devised to end three years of feuding in the family, which owns 37.5pc of Caledonia via the Cayzer Trust Company and 12pc through individual family members.

Rebels led by Sir James Cayzer, the 72-year-old patriarch who gives his address as Kinpurnie Castle, in Angus, and has a fleet of Rolls-Royces but no driving licence, have campaigned for Caledonia to be broken up and its assets distributed.

Rows and power struggles have turned on matters ranging from a controversial investment in a boat by the trust for the millennium celebrations to Dotcom-era underperformance.

And while those fractious days would seem to be behind it, various offshoots of the Cayzer family still own 46% of the trust’s shares. What’s more, last year Will Wyatt, the distant grandson of clan founder Charles Cayzer, took over as CEO, returning the trust to direct family control.

For some this sort of thing – and the potential for another flare-up — is untenable.

For me it’s all part of the fun of investing in family houses. But if it doesn’t float your steamboat, then you should certainly look elsewhere; the Cayzer involvement is surely here to stay.

No big buybacks

The family holding presents a more concrete concern, however, even for us spreadsheet-wielding romantics.

An undertaking to the UK’s Takeover Panel means Caledonia is unable to execute any share buybacks that would take the Cayzer concert party’s holding above 49.5%.

That’s important because — as investors at rival mega-trust Alliance are presently discovering — buying back shares can be an effective way of narrowing a large discount to a trust’s net assets.

Personally, I don’t think it does much good for ongoing shareholders. Yes, your shares are rising in value, but your company is spending your assets to get that result. It’s all rather circular.

The hope of course is that the discount will narrow faster than the rate you’re spending money to narrow it, as other investors should buy the shares if the discount widens too much, anticipating it will be closed again by buybacks.

But it doesn’t always work that way.

Worries about what’s under Caledonia’s kilt

It’s all rather moot, anyway, because Caledonia isn’t buying back substantial amounts of shares.

Instead, we’ll need to see a decent investing performance and a change in sentiment to narrow the discount.

The key to the latter, it seems to me, is that a big slug of Caledonia’s money is in private equity funds or directly invested in unlisted companies (including, rather fittingly, 100% ownership of The Sloane Club in London) and the market seems to lack confidence in these unlisted holdings.

A similar argument was made a couple of years ago to justify the discount at RIT Capital Partners, the family vehicle of the Rothchilds.

Indeed, I discussed RIT Capital Partners on Monevator when it was trading on a double-digit discount in 2009. Since then the discount on Jacob Rothchilds’ warchest has turned into a premium, and anyone who bought the shares when I wrote has seen a return of around 46%, versus less than 29% in the FTSE 100¹.

This return is especially impressive when you consider that RCP was holding plenty of cash at times – although equally it was also invested in flightier foreign markets, too, so the comparison with the FTSE is a crude one.

My highland fling with Caledonia

While RIT has an even more stellar ten-year record than Caledonia on most measures, the main reason for that recent outperformance is simply that the discount on its shares disappeared to become a slight premium. This transformed the trajectory of its share price.

I think RIT has a good chance of doing well from here, too – and to retain its value better than a tracker should the market dive — and I still hold some.

What I’d class as the easy justification for investing in those shares has passed, however. If anything, the slight premium bothers me.

But the window has not yet passed for Caledonia. The fund sits at a 20% discount despite the fact that net assets were ahead 6.5% over the past year, versus a 5.4% performance from the All-Share. Consider that it has 6% or more of its money in cash, and the 20% discount looks even more untenable.

Yes, Caledonia has a new manager, who seems to favour resource companies over the financial firms that long dominated Caledonia’s roster (and the CVs of some of his aristocratic forebears).

And yes, he’s also reshaping the trust’s strategy to concentrate on fewer holdings, where Caledonia’s investment can result in a more meaningful influence at board level, as well as looking to boost the trust’s market-lagging 2.2% dividend yield.

Even on this last point, Caledonia already has a 44-year history of raising its dividend – another super achievement.

Yet the market seemingly prefers to fret that this £1 billion company has lost nearly £200 million of its value down the back of an antique sofa than to look at its medium-term history of wealth preservation, market-beating returns, and a growing income.

I think the market is wrong. It’s true that buying trusts on a discount can be a hit-and-miss affair; the market isn’t entirely dumb, and often the discount correctly anticipates dawdling performance or worse.

But I think the old money factor tilts the odds in Caledonia’s favour. In my worst case scenario, the discount doesn’t narrow much and I buy into a secure and rising dividend with one-fifth knocked off the price.

If you too are tempted to invest in Caledonia, then you’ll want to read the latest annual report to see where it is putting its money and how recent changes will affect its portfolio going forward. As ever, do your own research – I am not responsible for your actions.

My own money is where my mouth is. I’ve put roughly 6.5% of my net worth into Caledonia Investments, and writing this post I’m thinking to myself that this sum could rise still higher!

Note: I take no responsibility for the accuracy of this post. Read my disclaimer.

1. excluding dividends

Further reading:

1. Buying an investment trust on a discount versus a premium
2. Could Scottish independence upend your investments?
3. Investment trust discounts and premiums

The first dividend income from the high yield portfolio (HYP) I set-up in May has already begun trickling into my clammy hands!

More precisely, the dividend income has been paid into the Halifax Sharebuilder account where I hold the portfolio. It will stay there until I withdraw it.

So far I’ve received a total of £14.50 in income, paid by four constituents: Royal Dutch Shell, Aberdeen Asset Management, Unilever, and Admiral. Not much of a haul from the £5,000 I invested but it’s early days. A full 16 companies are yet to make any payment, and all pay at least twice a year.

I calculate the HYP’s starting forecast yield to be around 4.3%. Therefore, we might expect at least £215 over a full 12 months to 6th May – though in the first year it’s certain to fall below that because some companies would have been trading ex-dividend when I jumped into these shares, and other payments due won’t actually make it into my account until the second year.

What I’ll do with the dividend income

As previously explained, I do not intend to reinvest the dividend income from this demo HYP back into these shares.

Partly that’s to reinforce a point: I think HYP’s are best thought of as income vehicles, rather than as necessarily a good route to growing a capital sum (although that said there’s nothing wrong with targeting income from day one and avoiding onerous switching costs and hassle later on, even if it’s potentially not a winning strategy in total return terms. There’s more than one way to skin cats).

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in…”

– J.D. Rockefeller.

I’m also not reinvesting these small amounts of dividend income because I want to avoid the tedious paperwork associated with reinvesting dividends outside of an ISA should I ever need to calculate capital gains tax on the shares.

But mainly I want to ‘cleanly’ see what my initial £5,000 investment is paying out in a few year’s time, and to judge if it has achieved my target of delivering more cash in real terms (that is, inflation-adjusted) than today.

This will be trivially easy to see if I simply keep the capital investment intact, and then add up and withdraw all the income every year. I’ll report the annual dividend income sum here on Monevator, and we can ponder what a fully scaled-up equity income portfolio might mean for a pensioner currently trying to get by on a squeezed and cheapened fixed income.

Dividend income is key to long-term returns

Now, if you’re a long-term investor in the stock market, you should certainly be reinvesting your dividend income.

This is super-simple with Halifax Sharebuilder, and it only charges you 1% of the sum being reinvested. (So 10p on automatic reinvestment of £10).

Alternatively you could allow the dividend income to add up until you’ve got enough money to make another share purchase efficiently after dealing charges. I’d probably do this myself, to take the HYP to 30-odd shares, before I began to reinvest in existing holdings.

However you choose to reinvest your money from shares, make sure you do it if you’re under 60. Dividend income is extraordinarily important. While the financial media goes crazy for daily share price moves, it’s the compound impact of reinvesting dividend income over the decades that has generated the bulk of the stock market’s winning longer-term performance.

According to the infamous Barclays Equity Gilt Study 2011 edition of historical returns:

• £100 invested in UK equities in 1899 would have been worth just £180 by the end of 2010, after inflation. That’s barely doubled!

• In contrast, if you’d reinvested your dividends over the same time period, you’d have been left with an after-inflation sum of £24,133!

Spending your capital is a sin, just like the old-timers said. But spending your income too early isn’t going to lead to a heavenly retirement, either.

A fudge to track the HYP’s total return

Given the importance of dividend reinvestment, what I may do is track the year-end capital value of the demo HYP in a spreadsheet (and in an annual review on Monevator!) and then assume I reinvested that year’s dividend income into buying a fresh chunk of that same portfolio.

I’ll knock off 1.75% of the total cash amount (note: not the running yield!) of dividend income being reinvested to account for fees, spreads, and stamp duty.

For example, if I get £200 of dividends over the year, then I’ll assume £3.50 is lost to costs and add the remaining £196.50 to the ongoing portfolio value.

The next year I can simply calculate the yield due on that sum based on the actual return from the real-money portfolio, and compound again. Unless I’m missing something obvious, this should give a rough handle on how the portfolio would be growing if the money wasn’t being withdrawn to spend on whisky and women (or more likely Kindle books and Marks & Spencer canapes).

Obviously it won’t produce exactly the same result as reinvesting dividend income throughout the year would, but it will serve as a decent approximation and anomalies should balance out over time.

Further reading:

1. The Monevator HYP: It’s alive!
2. Grow your income with dividends from high yield shares: HYP Part I
3. Historical versus forecast dividend yield

I am now the proud owner of a new high yield share portfolio.

Since the method for picking the portfolio’s shares was not exciting enough to prompt Simon Cowell call me up with an offer to turn it into the new X Factor, we’ll not go through it again.

Instead, please refer back to see which high yield shares I bought and why.

This post will detail how much it cost to buy the 20 companies in my new HYP, and where I’m holding them.

In the future I’ll explain how I intend to manage the portfolio long-term, as well as what benchmarks we might use to judge its performance. Do subscribe to keep on-board with progress.

An ideal home for my High Yield Portfolio

As mentioned last time, all the online tools I tested to track a paper portfolio were flawed in some way, especially when it came to dividends.

So I decided to do it the proper way with real money. Carlsberg don’t do model share portfolios, but if they did they’d probably do the same thing.

Readers, much as I love you, I did not want to sink my entire wealth into a new portfolio, least of all one that I won’t be able to sell for years. (Houses don’t just buy themselves, you know).

I therefore limited my invested funds to £5,000.

Now, that’s not exactly a token amount of money, but it’s too modest to withstand much share purchasing at £10 or more a pop with 20 of the blighters to buy. But happily there is a cheap way to buy shares that’s worth exploring if you don’t have a lot to invest: Halifax’s Sharebuilder service.

The great attraction of Sharebuilder is it enables you to buy shares for a mere £1.50 an order – a fraction of the normal dealing fees at rival online brokers.

I have had a Halifax Sharebuilder account for many years, having originally opened it to buy a portfolio for income. (Long-time readers may remember my pain at calculating capital gains on the reinvested dividends. Not a mistake I will make again!)

Halifax enables you to run multiple accounts under the one roof, so it was a simple matter to allocate a new one for the Monevator HYP.

How to do the £1.50 share purchasing shimmy

The Sharebuilder service was conceived for people who want to transfer in perhaps £300 from their salary each month, and then build up a portfolio by regularly investing into a slate of shareholdings.

It’s a great idea in theory, and I’m all for encouraging wider share ownership. But in practice it can be costly if you invest too little per month, or if you spread yourself across too many holdings, even with just £1.50 trading fees.

For example, invest £300 across six different companies or ETFs every month, and you’ll pay £9 in dealing fees (£1.50 x 6), which is equivalent to 3% of your funds invested. That’s expensive.

But there’s a cunning plan! Rather than invest monthly, you can make a one-time investment of a larger lump sum, which is what I did. You can then turn this regularly reinvestment back off.

This is pretty much the equivalent of using the Sharebuilder like any other online broker, only it’s much cheaper. The snag is you can’t deal in real-time. Rather, you have to set up your trades the day before, and take whatever price you’re given in the market the next day.

In practice, when you’re buying a portfolio of blue chips at once, it doesn’t matter at all. Some will be higher priced on the day than you expected, and some lower, but it’s just random and nothing to worry about.

Of course, it doesn’t exactly make you feel like Gordon Gecko – more like your mum making out her Ocado grocery order. But we’re investing here, not playing Farmville for thrills, so that’s no bad thing.

Trading costs to buy my high yield shares

Faustian pacts with Mammon aside, here’s what I paid to buy my model HYP:

Dealing fees: There are 20 companies in my new high yield portfolio, and I wanted to invest equal amounts into every one. This meant putting £250 into each company, for a cost of £1.50 each time.

Stamp Duty: I also had to pay the UK’s ridiculous stamp duty tax for each transaction. This is a flat 0.5%, which came to £1.24 for each purchase.

The bid/offer spread: Market makers pay for their daughters’ school fees by charging you a bit more for shares they sell you than they will pay to buy them off you (think of a currency exchange at the airport). This bid/offer spread increases your costs, but for very big companies like those in the Monevator HYP, the spread is tiny. So tiny, in fact, that I can’t be bothered to work it out for each share – we’re talking a few pennies for each purchase.

In total, that’s £2.74 per share purchase for fees and stamp duty, plus a titchy bit more each time for the spread.

Multiply it up and you get to £54.80, or just over 1% of my £5,000, plus the price of a hamburger for that bid/offer business.

What I got for my money

Obviously I bought a different numbers of shares for each £247.26 lump sum I had left after fees to put into each company, depending on the share price.

Sharebuilder does the sums for you – you just say how much you want to invest.

For example, Vodafone had a share price of about 168p last Friday, so my £247.26 bought me nearly 148 shares in that company. In contrast, I’ve got barely 11 Royal Dutch Shell shares to my name.

I say ‘nearly’ and ‘barely’ because Halifax Sharebuilder allocates you fractional holdings of shares (behind the scenes, your shares are lumped together with other customers in a pool). As it happens, I have specifically got “11.244775″ Shell shares.

In reality, this precise number doesn’t make any odds. I’m interested in tracking the value of my shares, not the fiddly number I happen to own – as well as the total dividends they pay out, of course.

But for the record, I’ll conclude this post with a snapshot of exactly what I got for my money, and what share price I paid for them:

Note: Shareholdings and prices rounded to one decimal place. Costs include all fees.

Incidentally, having spent 30 minutes copying a load of fiddly numbers by sight from my web browser into this post – and rounding them as I go – I see one advantage of using an online tool… it would have done this for me!

Luckily I don’t plan on doing a review of the value more than every six months or so. This is a steady portfolio for income, remember, not a DIY hedge fund.

Further reading:

1. Dividend income and the Monevator HYP
2. Diversifying your high yield portfolio: HYP Part 3
3. How to choose a good high yield share for the long haul: HYP Part 2

Back in the day, before the credit crunch – before our most precocious readers were even born – I wrote a series of posts on income investing via a high yield portfolio (HYP) of shares.

I think now may be an opportune moment to create a new HYP for dividend income, and I’ll do so in an upcoming post.

But it seems only right that we first go kick the tyres of the original, four years on.

There were several parts to my HYP series:

• Grow your income with dividends from high yield shares: HYP Part 1
• Choosing a good high yield share for the long haul: HYP Part 2
• Diversifying your portfolio: HYP Part 3
• Selecting shares for your high yield portfolio: HYP Part 4

The article sequence ended with an example high yield share portfolio in Part 4, which was published on September 26th 2007. (Parts 5 and 6 have still not been completed. Blame the distracting financial crisis!)

Unfortunately I’ve discovered that the table of final picks embedded in Part 4 has been corrupted, and no longer displays. But you can still see the constituents of the portfolio in an update from February 2009.

That update, and the one I’m about to conduct today, suffers from the fact that I haven’t considered income, only the capital value of the shares.

You may argue that reviewing an income portfolio without taking into account income is like reporting from Wimbledon after all the players have gone home. I wouldn’t disagree. Income portfolios are constructed primarily for income, not for capital gain. The latter is left to fend for itself, which should hopefully happen with a well-chosen equity income portfolio, as a rising dividend stream will sooner or later mean rising share prices.

The trouble is when I picked my original demo portfolio, I didn’t consider posterity, and so it wasn’t set up for tracking.

Now, I could spend a few hours retrospectively rebuilding the portfolio with 2007 prices, allocate it say £100,000 of pretend money, and then manually calculate the income due in 2008, 2009, 2010 and in the year to come but, well, I’m still single and I’m not getting any younger.

If anyone out there has some spare time and would like to do so and report back in the comments below, I’m sure we’d all be very grateful!

The 2007 HYP and the subsequent bear market

Having explained (though not excused!) the lack of income monitoring with this portfolio, let’s turn to capital.

The idea, rightly or wrongly, was to buy a portfolio of blue chip shares and hold them for the long-term. For the full selection criteria, please see the posts linked to above.

The strategy in short: I selected 20 shares from the upper reaches of the index primarily by yield, looked for diversification between industry sectors, then ditched and replaced companies I didn’t like the look of for some reason (usually debt).

As we all know with hindsight, September 2007 was around the high water mark for the last stock market bull run. A few weeks later the sub-prime doodah hit the fan, making mincemeat of former FTSE darlings, including three constituents of this demo HYP: the bankers at Royal Bank of Scotland, low-end lender Cattles, and housebuilder Taylor Wimpey. Most other shares took a pounding, too.

By the time of my February 2009 update, the demo HYP had fallen in value by 44%. That was worse than the FTSE 100, which had fallen 39% over the same period. (Please read that update for full details).

The 2007 HYP in 2011

So how has the portfolio fared since those dark days of early 2009, which was pretty much the low of the past bear market?

Here’s how things stand as of Friday 15th April’s closing prices:

Note: All rounded to zero decimal places.

Looking at the portfolio, we see the usual lurches and collapses that happen in any portfolio of individual shares.

Most strikingly, two of the companies are no longer quoted: Alliance and Leicester was acquired by Santander, and Tomkins by a bunch of Canadian pensioners. Furthermore, benighted Cattles is in the process of being taken over, and its suspended listing will soon be wiped away entirely.

Of the remaining shares, the best performer has been IMI, which is 85% higher than in 2007. That’s a huge bounceback from 2009, when it was 48% lower.

InchCape might flatter to deceive if you look at my post from 2007. The share price appears to have advanced handily since then, but in reality the company did a 10-for-one share consolidation in 2010. InchCape almost went bust in 2009, and while management is to be congratulated for avoiding that fate, it’s still smells a bit to hide the body like this.

Overall, we still see the HYP is trailing the market, though only by 1% now as opposed to 5% back in 2009. This may be surprising, given the near blowouts of the likes of Cattles and that our only selection from the booming commodities sector that dominates the FTSE is error prone BP. In my experience it’s not unusual for HYPs, though, probably because the high yield is an indicator of value in some shares, as much as lurking calamity in others. Over time, it evens out.

As for income, the initial yield was almost 4.8% versus less than 3.2% for the FTSE 100, but as warned above I have no numbers on how income has done in practice. The likes of Pearson and Glaxo have kept delivering the dividends, but RBS, BP and Cattles certainly haven’t!

Final thoughts on this portfolio

This is a very rough review. Not only does it ignore income, but I’ve not included other factors such as that you would have reinvested your A&L and Tomkins takeover money back into a rising market.

That might have reduced the performance gap with the FTSE 100 a tad further. In addition, there would have been no charges to pay over the four years of holding the shares, though given the low-cost of the best FTSE 100 index trackers these days, it will have made negligible difference.

More importantly, it’s very possible I’ve missed certain critical facts out from my quick calculations above. I almost missed the InchCape share consolidation, for instance. There could have been others, or on the plus side special dividends.

While you’d have certainly been paying more attention if they were your shares, all this fuss highlights a big advantage of a passive ETF approach to investing. Another alternative is to buy income investment trusts or even white list funds (make sure you go through a discount broker to get initial charges rebated) and to let the managers worry about takeovers and bankruptcies.

But some of us will always actively enjoy owning companies. Also, income trusts are now trading at a premium, which means every £1 you invest buys less than £1 of assets. Not a great deal, considering most are only holding big liquid blue chips.

For that reason and more, I think now might be a good time for share enthusiasts to construct a new high yield portfolio. And I’ll be doing so next week!

As for the 2007 portfolio, this is probably its final public outing. The chances of introducing errors is only going to increase as the years go by, which makes the whole exercise pointless.

If anyone has a favorite online portfolio tool they can recommend for tracking the new HYP over the long-term (one that automatically accumulates dividend income please!) then do let me know below.

Further reading:

1. How the bear market hit the high yield portfolio
2. A new high yield portfolio for 2011
3. Diversifying your high yield portfolio: HYP Part 3

Important: What follows is not a recommendation to buy or sell shares. I’m just a private investor, storing and sharing notes. Read my disclaimer.

Previously I’ve written about my purchase of Natwest preference shares. I’ve now added some Lloyds TSB 9.25% Non-Cumulative Irredeemable Preference Shares to my portfolio, too.

These Lloyds preference shares – which I’ll sometimes call by their stock ticker, LLPC, below, because Lloyds TSB 9.25% Non-Cumulative Irredeemable Preference Shares isn’t the catchiest name you ever heard – are a trickier proposition than the Natwest preference shares.

For a start, LLPC shares are not currently paying an income, and almost certainly won’t for two years.

More on that in a minute. First, some details:

Lloyds 9.25% Preference Shares

Ticker: LLPC
To buy: 83.5p
Coupon: 9.25%
Running yield: 11.1% (Suspended)
Payments: Twice yearly (31/5, 30/11)
Other details: Non-cumulative, non-mandatory
LLPC summary on Digital Look

Other features of the LLPC preference shares

• Perpetual: That 9.25% coupon is payable forever (when it’s paid!)

• Non-cumulative: Investors don’t get recompense for skipped coupons.

• Non-mandatory: Because they’re discretionary, the EU has forced Lloyds to show discretion – and blocked the coupon!

• As I understand it, payment of a dividend to ordinary shareholders is not permitted unless the coupon on these preference shares is paid, too.

Please also read my introductory article on preference shares if you need to.

No income expected until 2012

Back to that snag – there’s an apparent 11.1% running yield on the prefs, but you’ll have to wait for it.

The UK government aid given to Lloyds Banking Group at the time of the banking bailout was deemed by the EU to constitute state aid. As part of the subsequent legal wrangling, it was agreed that Lloyds would not pay coupons on its non-mandatory tier 1 and upper tier 2 securities for a period of two years, starting January 31st 2010.

These LLPC Lloyds preference shares fall into that category, and so their coupon was blocked. The first payment that holders of LLPC can be pretty confident of receiving will arrive in May 2012.

A further significant point is that Lloyds cannot pay a dividend to ordinary Lloyds shareholders without also paying LLPC holders.

Could they pay out before 2012?

Some private investors have been trying to outwit the Lloyds legal department and prove that it didn’t have to suspend payments of LLPC and certain other Lloyds preference shares – or even that it legally shouldn’t have.

It’s a very fiddly debate, involving tens of thousands of words exchanged. So far Lloyds has won the day. I don’t pretend to understand the intricacies, but I’ve had some insight into how these big banks operate from a legal perspective, and unfortunately I don’t think the investors will win.

Separately, some analysts suggest Lloyds may want to resume paying ordinary dividends before 2012. The Lloyds dividend was sacrosanct for 200 years, and the board will be keen to restart a payout as soon as possible.

These observers feel there may be a way to fudge the EU ruling on Lloyds – by fiddling with its capital position or some other ruse – in order to lift the block on the preference shares coupon, and thus the effective block on ordinary dividends.

It is really more about political wrangling than law. The nutshell theory is that as EU regulations can be made on a whim, presumably some ‘fix’ can be agreed with Brussels on-the-fly, too.

I don’t think it’s very likely, but it’s an opinion in the market.

Yet more bad news: the 11.1% yield isn’t really 11.1%

If you’re wondering why I bought these shares, you should know it isn’t for the 11.1% yield – because the effective yield is smaller.

It’s true that if you take the 9.25% coupon and the bid price of 83.5p, and work out the running yield, it comes to 11.1%.

But remember, we’re not seeing payments for two years! And due to the time value of money, buying LLPC today means paying a price for waiting.

There’s a complicated way to work this out, and a down-and-dirty way that amounts to the same thing.

Here’s the dirty way:

Buying LLPC shares today means forgoing 18.5p in income.

This effectively means the price of the shares is 83.5p+18.5p = 102p.

The running yield on a bid price of 102p is then (9.25/102) = 9%

It’s no coincidence that’s the same running yield as on the Natwest preference shares. In fact, it may even suggest LLPC are over-priced, since the Natwest issue looks more secure, and is mandatory and cumulative.

Why I bought the LLPC preference shares

At this point you might be wondering if I’ve lost my marbles? These are income shares that don’t pay an income, that aren’t as attractive as an equally (ill)-liquid issue from Natwest, and which will continue to be dogged by banking wobbles.

However there are several reasons to expect a bit more reward from LLPC in return for some of the risks:

1. Capital appreciation when EU block lifts

In 2012, LLPC will hopefully be paying its coupon again and the unprecedented block will be a thing of the past. At this stage it will yield similar to other bank preference shares, such as NWBD, with perhaps a spread of 0.5% or so to allow for its less attractive status. This means the 18.5p I’m forgoing as income now I expect to make as a capital gain by 2012.

2. Capital appreciation of all fancy bank debt

As someone who is fairly bullish on the economy I don’t expect other bank prefs such as NWBD to be yielding 9% in two years time, either. If LLPC were to yield 7% (with ten-year gilts at say 5%) then perhaps 130p per share is a reasonable target. That’s potential upside of 50% over the next couple of years.

3. Lloyds’ near-term outlook looking rosier

Briefly, the Basel 3 announcement this week suggests the new regulations of banks will be less onerous than feared (or warranted, for that matter). Lloyds is tipped by analysts as one of the banks best-positioned to benefit, as it will be able to count its stake in various other business towards its capital requirements. Less onerous capital strictures means more profit for banks, which means better rewards for investors.

4. You never know

Perhaps there will be a fudge that sees the coupon payments restarted before 2012. Two years is a long time in the markets these days.

A portfolio play

Regular readers may recall I recently bought back into Lloyds ordinary shares. So I’ve increased my exposure to Lloyds bank with these LLPC shares.

While superficially weirder, the LLPC shares are much safer than the ordinary shares – so buying these is less risky than loading up on more LLOY stock.

It also diversifies me away from my Natwest preference shares.

Please be aware these LLPC preference shares are riskier than the Natwest preference shares. And it goes without saying they’re far riskier than a savings account or gilts. My exposure to bank preference shares and to Lloyds ordinary shares accordingly only totals about 5% of my portfolio.

There’s a very real risk of losing all your money if you buy LLPC shares, as with any share. A high yield and potential capital gain doesn’t come catch-free.

That said, I’m coming to these instruments late and after the life-changing gains have already been made by braver punters. I think the risk of these bank preference shares being wiped out was reasonable 18 months ago; now the risk is much lower but so are the potential rewards.

Note: New or sensible investors shouldn’t bother with any of this stuff. Buy a tracker or a simple and cheap ETF portfolio instead.

Further reading:

1. Back into bank preference shares?
2. Bank preference shares: A brief history
3. What first attracted me to the 9%-yielding Natwest preference shares

Important: This is not a recommendation to buy Lloyds shares. I’m just a private investor, storing and sharing notes for interest and entertainment. Read my disclaimer. Your core portfolio should be in passive funds.

I see Morgan Stanley downgraded Lloyds shares (Google Finance: LLOY), and set a price target of 50p.

In contrast, I’ve built up a position in the UK bank over the past two months, paying an average price of 59p.

Lloyds closed last night at 55p. The share price has been falling for weeks.

Sovereign debt crisis? Coalition bank bashing? Fund managers who’d rather admit to crabs than owning bank shares?

Who knows and who cares? I smell an opportunity to buy a cash cow of tomorrow on the cheap.

Why buy Lloyds shares? Why buy any shares?

Let’s backtrack for a moment. Passive index funds beat most active share traders, but there are still at least four reasons to pick stocks:

• You believe you can beat the market.

• It’s fun, and you’re prepared to pay the price of under-performing.

• You want (extra) exposure to an asset class or sector not represented (sufficiently) by the market. Say forestry or gold.

• You’re hedging: for example, buying BP shares to offset the unusually high fuel costs you rack up racing dumper trucks at weekends.

I pick stocks with some of money for the first two reasons. Even after a decade it’s too early to tell if I can consistently beat the market, but I’m having fun trying.

With Lloyds though, the fourth reason – hedging – also plays a role.

Regular readers may recall I’ve long thought London property expensive and so have rented for several years. So far I’ve been wrong, with the dip in prices in 2009 quickly rebounding.

I therefore partly see my new holding of Lloyds shares as a consolation prize should I continue to be wrong:

• If UK house prices rise by 25%, I’d be gutted but I could easily see Lloyds more than doubling in such a climate.

• If UK house prices fell 25%, the money I’d potentially save on buying a home would dwarf any loss in Lloyds.

With that explained, let’s look more closely at the case for Lloyds.

The economic backdrop and Lloyds

I haven’t done my usual summary of the share price and fundamentals like P/E, price to book, earnings and so forth for this write-up.

That’s because such figures are pretty meaningless for Lloyds shares. The situation is changing fast from a capital, regulatory and political standpoint, and also in terms of the value of its assets and the outlook for its earnings.

Instead, I’ll outline what I think will happen to Lloyds over the next 1-3 years, and what it will do to the share price.

This means taking an economic view, which is always risky.

• I expect the UK to keep growing (as does the new Office of Budget Responsibility) although my view back in February looks a bit over-egged in retrospect. (I didn’t foresee snow, ash or the Euro crisis!)

This outlook is critical, because following the UK banking recapitalization and Lloyds’ withdrawal from the asset protection scheme (which prompted me to dump Lloyds for the second time in barely 12 months), the Government and the regulator insisted that Lloyds retain sufficient capital to be pretty much bombproof. Lloyds then raised £21 billion via a rights issue, and it has taken every opportunity to reduce liabilities and build up capital since then.

My main reason for thinking Lloyds is cheap today is that I am more confident than the consensus in the economic recovery, even domestically.

I am therefore more confident that Lloyds won’t need any more capital, and that it will soon be a money-printing machine rather than a money pit. (Note: by ‘soon’ I mean 1-3 years, not 1-3 months!)

Lloyds is already making a profit

I first came back to Lloyds looking for a highly-geared way to invest in commercial property. Most of Lloyds’ bad debts (acquired from the HBOS merger) have been in commercial property, so any stablisation ahead of schedule would lead to the shares re-rating.

This seemingly happened in late April, when the company said it had returned to profit in Q1 – sooner than anyone expected – largely because the flow of rising bad debts had been staunched.

So far so good. But on reading through the analysts’ reports and Lloyds’ own update, the company’s ability to throw off cash once the bad times were over really struck me.

Given that I expect a recovery quicker than almost anyone I read or talk to (i.e. I expect it this side of hell freezing over) that makes Lloyds very tempting.

One minor snag is the vast number of shares out there – 67 billion!

However, I think Lloyds will eventually have so much excess capital as a faster-than-expected recovery sees its marked down assets re-rated that it will be able to buy back lots of its own shares. (It may have to wait for EU permission to do so – I don’t expect anything until 2012).

Buying back billions of shares will go some way to driving up earnings per share and eventually the dividend.

A penny share with a massive footprint

The sheer scale of Lloyds’ business is staggering. Its dominance is even more extraordinary when you consider that we’re statistically more likely to divorce than change bank accounts.

• Lloyds has 30 million customers in the UK (more than half the population) and nearly 30% of the UK mortgage market.

True, it has been ordered to sell some 600 branches by the EU, and it will probably sell its Scottish Widows business when the market improves (which will reduce its core capital requirements further, in my view). But it will still be the nearest thing to a national banking utility the UK has ever seen.

And utility is a good word to use, because it explains why I think Lloyds will escape serious harm from Vince Cable’s banking fatwa.

The new Business Secretary is to spend a year looking for the tartan paint and a left-handed screwdriver at how to break up the banks, but the most he’s likely to establish is a case for hiving off investment banking from retail banking. That would affect the likes of Barclays and RBS, but it wouldn’t mean much for Lloyds.

A smaller fly in the ointment could be the £14 billion action being taken by former shareholders. I don’t expect it to succeed.

The evolving Lloyds business

I have created a massive spreadsheet detailing every nuance of the Lloyds’ business activities. If a secretary orders extra flowers for a bank manager’s mistress, I capture it.

Only kidding! I’ve not worked out my own projections for Lloyds’ business. Banks are incredibly complicated, and there are various analysts who do this full time. I don’t claim to know better.

Rather, I’ve looked at the picture painted by analysts through the prism of my own economic optimism.

• Lloyds is borrowing money very cheaply, and writing new business at good margins to an absolutely enormous market. In April the CEO said net interest margin would be around 2% for the year.

• It increased deposits by £5 billion in the first quarter.

• The new Lloyds 5.375% corporate bond aimed at private investors shows another way for Lloyds to raise money. Small potatoes so far, but more could follow.

• Lloyds is making big cost savings from its merger with HBOS – there’s a huge overlap in banking, compared to say digging up a road where you can’t really cut bodies. Ditto everything from marketing to databases. I think Lloyds will probably save more than its £2 billion a year target by the end of 2011.

As a result, I sense Lloyds is racking up capital. By the time any new legislation comes in (the mooted Basel-III requirements) I wouldn’t be surprised if it has much more than it needs. Bullish estimates of T1 capital of 10.5% or more by the end of this year look achievable to me.

What about impairments? Last year the bank wrote down £24 billion in impairments. It hasn’t yet given figures for 2010 – only verbal guidance – but by the first quarter this had slowed sufficiently for the bank to report a profit. The bank says impairments have ‘passed the peak’.

When you consider Lloyds made a loss of £6.3 billion last year due to those £24 billion impairments, you get a flavor for what it could achieve when it stops kitchen-sinking the HBOS loan book.

Earnings and the Lloyds share price

When will that be? I think 2010 is still a bit of a crap shoot, given all the upheavals going on in the markets (most of which are hot air).

But for what it’s worth, the consensus among analysts is for the bank to earn about 0.9p per share for this full year, putting the shares on a P/E of around 60!

From next year though (the year to the end of 2011) things get interesting. The Office of Budget Responsibility reckons the UK will be growing at 2.6%; I would expect few bad debts and big writebacks in such a climate.

The median forecast of £5.8 billion in pre-tax profits and earnings per share of 6p for 2011 looks pretty doable to me, given my economic outlook. The Lloyds portion of the business alone was earning £4 billion in pre-tax profits in 2007, and it was a very conservatively run business (so no frothy profits) that faced a lot more competition (so it’s making more from each deal now).

I’d think along the lines of Merrill Lynch’s banking analyst, who expects earnings of 12p per share by 2012, and I wouldn’t be surprised by 8-10p in 2011.

The Lloyds share price will march up just as soon as investors buy that future. If we value Lloyds shares at 10x earnings, then that would imply a share price of 120p, or more than double today’s price, within a couple of years.

That’s almost twice the government’s entry price of 64p per share, incidentally. If Cameron has any sense, he’ll wait until the recovery is in full swing before unloading the shares. The UK taxpayer owns 41% of the company, or 27 billion shares. A £30 billion windfall from selling up at around 120p would make a nice dent in the UK’s public debt.

The big risk? That the economy turns bad, writedowns resume, and Lloyds is forced to raise yet more money while postponing future profits.

Otherwise I think it’s just a mater of when, not if, the Lloyds share price doubles.

Note: I take no responsibility for the accuracy of this post. Read my disclaimer.

Further reading:

1. The bewitching appeal of Lloyds suspended preference shares
2. Why I’ve bought Lloyds Banking Group
3. Something for everyone: the new Lloyds retail bond