- Monevator - https://monevator.com -

How subscription shares multiply your gains

I have previously discussed the high risk/return [1] nature of subscription shares. (Please do read my first article on subscription shares [2] to get you up to speed).

These niche investments give you the opportunity to earn a geared return on the underlying investment trust [3], and so can increase the money you make by investing.

But there’s a catch – you risk losing your entire investment if the trust’s share price doesn’t rise sufficiently high before the day its subscription shares expire.

Note: Gearing in investing means getting more exposure to an underlying asset for the money you put up. When you buy a house, you gear up your initial downpayment with a mortgage. If you put in say a 10% deposit, then a subsequent 10% rise in the house price will multiply your deposit by 100%, while a 10% drop will wipe it out. That’s the risk/reward of gearing!

Usually when you want to gear up you have to borrow to invest [4], which is rarely a good idea.

However subscription shares enable you to gear up and multiply your gains without taking on debt. The big risk is that instead of multiplying your gains, you multiply your losses – although your maximum loss is limited to the amount you invest in the subscription shares.1 [5]

Warning: Subscription shares are very risky. Don’t even consider them unless you’re a seasoned investor with plenty of experience. I take zero responsibility for any money, fingers, houses or spouses you lose!

Understanding the price of a subscription share

Imagine two kind of shares that give you exposure to the (fictional!) Monevator investment trust:

What price will the MSS subscription shares trade at?

The easy answer is that MSS should cost you very close to 50p. That’s because instead of buying MIT in the open market for £1.50, you could buy MSS for just under 50p, and convert them into MIT shares for £1, and so make a tiny profit (because £1 plus nearly 50p is less than the £1.50 that MIT shares would cost you).

The price of MSS will therefore rise or fall as the market arbitrages [6] away any potential anomaly vs. the price of MIT.

In reality, however, MSS’ price will not be exactly 50p unless it’s just a few days – or even hours – before the exercise date. Here’s why.

You know those science fiction films where halfway through a crazy (yet strangely handsome) science geek writes an impossibly complex equation on a blackboard that might just save the world?

That’s the sort of equation that would be required to work out the exactly ‘correct’ price of a subscription share.2 [7]

Until the moment it can be exercised, the price of MSS in our example will tend towards the price implied by the trust’s share price and the subscription share’s exercise price but it will also be affected by:

Let’s leave all that for part three, though, since the ‘easy’ price (rounded up to 50p) is close enough to understand the basics of the geared return you’ll get.

How subscription shares multiply your gains

Sticking with our simplified example then, let’s now see how buying the subscription shares gears up the returns you make on the investment trust.

First, let’s suppose that as above:

Now imagine that one of the Monevator Investment Trust’s core holdings invents a cure for cancer / baldness / middle-class ennui, which sends its value soaring.

Let’s say that as result, MIT’s share price doubles from £1.50 to £3.

That’s a 100% return. Nice! But if you were holding the subscription shares you’d have done even better:

So if you’d previously bought MSS shares for 50p, that would be a 300% return – or three times better than if you’d merely bought the MIT shares.

What about losing money?

On the other hand, let’s pretend the cure for cancer kills people, or the baldness cure turns people’s heads purple (and middle-class ennui is obviously unsolvable).

Let’s imagine as a result MIT shares crash from £1.50 to 50p, for a loss of 66%.

Bad – but it will be much worse if you bought the MSS sub shares:

Ouch – you’ve lost 100% of your investment in the subscription shares.

In a complicated relationship

Now, as I stressed above this example is overly simplified.

In reality MSS wouldn’t go to zero, because until the exercise date had passed there would be some chance of the trust recovering its value.

Equally, MSS wouldn’t post an exactly 300% gain, because MIT’s share price could still fall at any point until the date when the subscription shares can be exercised.

But the rule of thumb, ignoring those complications, is that:

The gearing = (Trust share price / subscription share price)

So in the example above, the MSS shares were three times geared (£1.50/50p), which sure enough we saw with the 300% gain.

In practice, subscription shares can be especially volatile while the underlying trust’s price is below the exercise price. But once it rises above the exercise price, you can roughly assume the subscription shares should move in step penny for penny with the underlying trust.

The gearing on offer, then, depends on how cheaply you can buy the subscription shares versus the trust’s current share price. And that depends on many factors that we’ll consider in part three. (Subscribe [10] to ensure you get it!)

  1. In contrast, if you borrow to invest and your investment goes to zero, you can still be left with a big debt to pay off. [ [15]]
  2. Assuming you believe such precision is possible, which I do not. [ [16]]
  3. £3-£1. [ [17]]