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

These niche investments give you the opportunity to earn a geared return on the underlying investment trust, 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, 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

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:

• Monevator Investment Trust shares (MIT), which have a price of £1.50.

• Monevator Investment Trust Subscription Shares (MSS), each one of which grants you the right to buy one MIT share for £1 on a certain exercise date.

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 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

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:

• How much time there is to go until the exercise date
• Supply and demand
• The spread on the shares
• How volatile the underlying investment trust share price is
• And more!

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:

• MIT is priced at £1.50.

• MSS (the subscription shares) can be exercised for £1.

• MSS is therefore currently trading at 50p.

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:

• MIT is now priced at £3.

• MSS can still be exercised for £1.

• The price of MSS will therefore now rise to £2.3

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:

• MIT is now priced at 50p.

• MSS can still be exercised for £1, which is more than you need to pay to buy MIT in the open market.

• MSS are therefore currently worthless.

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 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. [↩]
2. Assuming you believe such precision is possible, which I do not. [↩]
3. £3-£1. [↩]

Some good money reads from around the web.

I was going to focus this week on the truly bonkers ruling from the European Court of Justice regarding gender discrimination and financial services:

Taking the gender of the insured individual into account as a risk factor in insurance contracts constitutes discrimination.

This isn’t so much a case of political correctness gone mad as political correctness gone to visit Alice in Wonderland!

• Go to any old person’s home, or take your own oldest relatives a piece of cake this weekend. Generally you’ll see women, because women on average live five years longer than men.

• When was the last time you heard about ‘girl racers’ crashing into a tight corner on a country lane? Overwhelmingly the worst young drives (under 25) are young men.

These are facts, not opinions or biases. Insurance is about weighting facts to balance risk and reward for both those seeking insurance and those providing.

If it impacts the insurance business, then this ruling can only mean more expensive car insurance for everyone – except for young boy racers, who’ll now find it more affordable to run a car into a wall. And it can only mean lower annuity payments for everyone. What nonsense.

However I’d rather focus on a clever verdict than this sort of silliness, and it was provided by Felix Salmon, writing for Reuters.

Talking about new academic research that shows you should concentrate on consistent saving, Salmon says that:

Investing can be exciting, especially when it’s done wrong.

You follow the markets rising and falling, you obsess about your retirement-fund balance, you rotate out of this and into that, you read books and magazines and blogs to try to learn more about what to do. You might even, in a moment of weakness, find yourself watching CNBC.

Budgeting, by contrast, is like going on a diet: it’s a drag, and it’s hard to get any pleasure or excitement out of it. But the latter is much more likely to get you well-set in retirement than the former.

Well said, even if somewhat ignored by myself with some of my money. So please do read my co-blogger The Accumulator’s take on passive investing for boring strategies that should form the bulk of your saving plan.

Finally, a reminder that you only have one month from today to use up your ISA allowance for 2010 to 2011.

[continue reading…]

I always make time to read Warren Buffett’s annual letter to his Berkshire Hathaway shareholders.

In contrast to the usual dry company reports, his letters read like a warm Buffett family Christmas newsletter, with a cast of familiar characters, recurring japes – and, okay, a fairly detailed description of how an insurance free float works.

And digesting the latest 2010 Berkshire letter with a nice glass of Australian Shiraz, I discovered a fabulous gem tucked amongst all the usual investing wisdom that surprised even a Buffett fanboy like me.

It was a modest letter within the main letter that Warren Buffett has republished, which was originally written by his grandfather, Ernest Buffett.

The Buffett family money gene

Anyone who has read The Snowball will know how Buffett’s early experiences and family life shaped his financial character.

But what this new Buffett letter reveals is that being careful with money – and feeling the urge to teach others how to shepherd it, too – runs deep in the Buffett family.

The letter was written in 1939 by Buffett’s grandfather Ernest, to his youngest son (and Buffett’s uncle) Fred, and his wife.

It reads (with idiosyncratic grammar) as follows:

Dear Fred & Catherine,

Over a period of a good many years I have known a great many people who at some time or another have suffered in various ways simply because they did not have ready cash. I have known people who have had to sacrifice some of their holdings in order to have money that was necessary to have at that time.

For a good many years your grandfather kept a certain amount of money where he could put his hands on it in very short notice.

For a number of years I have made it a point to keep a reserve, should some occasion come where I would need money quickly, without disturbing the money that I have in my business. There have been a couple of occasions when I found it very convenient to go to this fund.

Thus, I feel that everyone should have a reserve. I hope it never happens to you, but the chances are that some day you will need money, and need it badly, and with this thought in view, I started a fund by placing $200 in an envelope, with your name on it, when you were married. Each year I added something to it, until there is now $1000 in the fund.

Ten years have elapsed since you were married, and this fund is now completed.

It is my wish that you place this envelope in your safety deposit box, and keep it for the purpose that it was created for. Should the time come when you need part, I would suggest you use that you use as little as possible, and replace it as soon as possible.

You might feel that this should be invested and bring you an income. Forget it – the mental satisfaction of having $1000 laid away where you can put your hands on it it, is worth more than what interest it might bring, especially if you have the investment in something that you could not realize on quickly.

If in after years you feel this has been a good idea, you might repeat it with your own children.

For your information, I might mention that there has never been a Buffett who ever left a very large estate, but there has never been one that did not leave something. They never spent all they made, but always saved part of what they made, and it has all worked out pretty well.

This letter is being written at the expiration of ten years after you were married.

Ernest Buffett

“Dad”

Isn’t it great? I absolutely love this letter: I love the formality of it, the humility, I love the thought and the care of it.

Most of all I love the hard won wisdom in it.

This is a letter by a man who lived through the Wall Street Crash and the Great Depression. When Ernest Buffett says keep the money in cash in a deposit box where it’s easily accessible, he’s partly thinking about bank runs!

And when Grandpa Buffett says he knows people who have suffered from a lack of ready cash, he doesn’t mean that they couldn’t pop to IKEA to buy a sofa bed before the guests arrived. He means destitution in a world with no credit cards and few safety nets, save family.

In praise of cash

Buffett says that it’s this sort of Buffett family thinking that explains why Berkshire Hathaway customarily has at least $20 billion on hand.

That’s a lot of cash, and it’s held despite having the world’s greatest investor at the helm, who could be expected to make far higher returns on it than the measly percentage gains Berkshire will get on short-term deposit.

For you and I (who are still in the process of proving whether we’ll be the world’s latest greatest investors) there’s no debate – we should run hefty emergency funds and also keep a chunk of our portfolio in cash.

I love cash as an asset class. When people trash cash, warning me about inflation or telling me I should put more money into government bonds instead – or worst of all borrow to invest – my eyes genuinely glaze over.

Over the long-term the returns from gilts and cash aren’t so different, especially if you’re a private investor with a relatively modest nest egg who can chase the best savings deals. Yet the flexibility1 of cash is impossible to compare with bonds, let alone equities, REITS, or whatever else might take your fancy.

Having cash on hand means you don’t have to go into debt if the boiler blows up. Having cash in reserve means you can swoop to buy cheap securities in bear markets. It means some portion of your portfolio is as unblinking as a hungry Buffett sat before an out-sized hamburger.

In fact, I think new investors could do a lot worse than simply split their investing between a main market tracker and cash, and then forget about the other asset classes for a few years. The security of the cash is very helpful while you learn to stomach the volatility of shares.

Don’t get me wrong – I’m over 90% invested in equities. Cash has its place, but it’s little use in fighting inflation, and that’s the bane of long term investment.

But whatever you do, don’t bung cash overboard in your quest for future riches or even just a nice retirement. Cash cannot be beaten for liquidity and versatility.

Investing doesn’t end with a cash savings account, but that’s certainly where it starts – whether you’re in the Buffett family or not.

And finally…

Oh yeah, and let’s not forget this bit in the letter from Ernest:

I might mention that there has never been a Buffett who ever left a very large estate, but there has never been one that did not leave something. They never spent all they made, but always saved part of what they made, and it has all worked out pretty well.

That made me smile, too. It’s a Buffett family joke we can all share!

1. Aka liquidity. [↩]