Trusting in the Rights and Issues Trust

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

Rights, Issues and complications

The Rights and Issues Trust is a tiny, £33 million split cap investment trust focusing on UK smaller companies. It invests in small companies listed on the main London market and on the AIM market.

Split cap trusts are investment trusts that distribute dividends and capital gains arising from the portfolio differently to different classes of shareholders, according to income and capital preferences. Sometimes they involve hurdles and other redemption clauses. Split caps got a bad name after many invested in each others’ shares during the dotcom boom, and subsequently saw magnified losses in the collapse.

As I understand it, the situation with the Rights and Issues Trust is much more straightforward, and from a structural point of view (i.e. not looking at its risky small company investments, which have performed terribly in the past 12 months) it’s as safe as any other investment trust.

Name:      Rights and Issues Trust
Ticker:    RIII / RIIC
Listed:    London
Business:  Investment Trust (Split cap)
More info: Digital Look / Google Finance
Company:   Rights and Issues website

The chairman and figurehead of the Rights and Issues Trust is former chess grandmaster, Simon Knott, who enjoys a certain cult following in some quarters for his share picking skills.

Getting into Rights and Issues

From an investor’s point of view, the Rights and Issues Trust basically consists of two listed securities, with the tickers RIIC and RIII, which respectively offer more Capital or Income exposure.

(There is also a small issuance of preference shares, which I’m not familiar with).

RIIC – Capital shares

• Income entitlement – A supplementary dividend payment of 2.75% net on the capital reserves in complete units of £160,000 in excess of £382,536 and 1/31st of the distribution of all profits after the payment of preference and supplementary capital dividends by way of dividend.

• Capital entitlement – 42.2278p per share and 75% of the surplus assets on liquidation.

RIII – Income shares

• Income entitlement – 30/31st of the distribution of all profits after the payment of preference and supplementary capital dividends by way of dividend.

• Capital entitlement –  29.0650p per share and 25% of the surplus assets on liquidation.

The price of the two classes of shares pretty much track each other, so what it boils down to is that if you want more capital growth but less income, you should go for the capital shares, whereas if you prefer income over capital, you go for the income shares.

I hold Rights and Issues Income shares in an ISA. Due to steep price declines (see below) the forecast income on the capital shares is quite high, too, so you might also want to hold those in an ISA if you have the spare capacity.

The Rights and Issues Trust can theoretically be liquidated at any time, but the directors have indicated it is not their present intention to do so until July 2011.

Why would you invest in Rights and Issues Trust?

UK investors who want to put money into small cap companies have a problem that their US counterparts don’t face; unlike in the States, there are currently no index trackers for the UK small cap or AIM indices.

This means that UK investors who want to put money into small caps must either buy individual small cap shares or else put their money into a fund or investment trust.

Collective vehicles are less risky then holding individual shares, and obviously they involve less work then picking and following dozens of small caps. With both trusts and funds you also have the chance to benefit (or more likely lose) from the manager’s skill in picking specific shares.

I prefer investment trusts to funds, due to their lower charges, ability to use gearing, far lower marketing cost wastage, and the potential to benefit from narrowing discounts (though that and gearing are big risk factors, too).

And here’s where the pretty unique Rights and Issues Trust comes in.

Hunting for small cap value

The directors of the Rights and Issues Trust are long-term value investors.

To simplify, this means they tend to invest in traditional companies with solid balance sheets, decent dividend yields, and trading at a discount to their embedded value. Also, they tend to buy and hold shares for long periods – another valuable trait both in reducing costs and in capturing the gains from good picks.

Rights and Issues would invest in a small profitable manufacturer on a lowly rating, for example, over a biotech start-up with lots of promise but no profits.

This is important because small cap value has been shown to be the most historically rewarding of equity classes. (See this excellent article on Moneychimp for more).

Of course, ‘value’ is all in the eye of the beholder, but I like the Rights and Issues Trust directors’ definition.

Here’s the trust’s largest holdings as of its recent final results:

Rights and Issues Trust: Major investments

• RPS Group
• Hill & Smith Holdings
• Thorpe F.W.
• Celsis Int’l
• Intelek
• Colefax Group
• Scapa Group
• Aggreko
• Eleco Holdings
• VP
• Spirax Sarco Eng
• Treatt
• Brammer
• Domino Printing Sciences
• RPC Group
• BSS Group
• Low & Bonar
• Logica CMG
• Dawson Holdings
• White Young Green

In an ideal world where I’d already made my millions and wrote Monevator from a tropical beach, I’d now break down each of those holdings for you, explaining what each company does and giving a few of its fundamental numbers.

As it is, I can only tell you that most of these companies look cheaply rated to me, and a number are trading well in excess of what their gloomy ratings would suggest.

Many have come up in my own filters when I’ve trawled the market for value shares, too.

There are good reasons for small cap shares being low-rated, however. Most are much more exposed to the UK economy, and to Sterling, than say FTSE 100 companies. This means they are bearing the brunt of the recession (although some will be benefiting from the weaker currency).

Traditionally, large companies do better doing downturns, too, whereas small caps tend to outperform in the latter stages of the economic and market cycle.

Finally, there are also concerns arising from the banking crisis. Small companies who need financing have been particularly vulnerable in the past 18 months, although this hasn’t actually affected many of the companies Rights and Issues invests in, as far as I can tell.

What about sheer fear?

A ‘better’ reason for the downgrading from our point of view is the risk aversion that is now rampant in the markets.

At a time when Wall Street names are going bust, banks won’t lend, global growth has imploded, unemployment is soaring and Britain is borrowing so much money that the markets recently rejected an issuance of new UK government bonds, most investors don’t want to hold small caps.

I’d suggest however this has little to do with a five-year outlook, and everything to do with fear.

If you’re going to buy shares for the long-term and ride out the volatility of the bear market, now might just be a great opportunity to buy small cap shares for a song.

The big caveat to that position is you might have said the same thing about the Rights and Issues Trust six months ago but its shares have fallen and kept on falling, as I know to my cost.

Past performance and recent plunges

Over the longer-term, Rights and Issues Trust has an excellent record.

From 1985 to its peak value in 2006, the Net Asset Value (NAV) of the Capital shares increased 25-fold from 139p per share in 1985 to £36.70 in 2006.

The NAV of the Income shares increased 17-fold, too, while the total dividend each Income share delivered increased from 4p in 1985 to 46p in 2007.

In contrast, the FTSE All Share went up around five-fold over the period.

No wonder the directors gained a reputation for stock picking! A 25x increase in a little over a couple of decades is an almost Warren Buffett-like performance, equating to an average annual gain of nearly 17% per year.

But it was not to last. In the last couple of years Net Asset Values have plunged.

According to Rights and Issues’ most recent Final Results, as of 31st December 2008 the NAV of the Capital shares was just £16.43. The dividend on the Income shares has fallen by a quarter to 33p per share.

In response, the Capital and Income shares have fallen 67% and 69% respectively over the past 12 months:

For anyone holding the shares with the expectation to sell in the near-term, the performance has been little short of catastrophic.

As the chairman himself says in the recent final results:

The bare statistic of a 32.8% fall in the FTSE All Share index does not describe the full agony of this past year. The performance of the FTSE Small Cap and the FTSE Fledgling indices which plunged by 45.8% and 42.3% respectively brings out the full extent of the tragedy. […]

Your Trust has suffered the full force of the current economic hurricane. The net asset value of the capital shares declined from 3342.1p to 1643.3p and that of the income shares from 851.4p to 459.0p. The falls of 50.8% and 46.1% go beyond disappointment.

Discounts and spreads increase the pain

Rights and issues traded at a premium in early 2007. This means the shares sold for more than the underlying investments were worth, as investors effectively gambled that the stockpicking abilities of the managers would continue to deliver superior investment returns to make up for the premium.

Buying investment trusts at a premium is always risky and generally something to avoid. Sure enough, the situation has been utterly reversed at Rights and Issues, with the shares now trading at a discount of around 30%.

For new investors, this means you’re effectively getting the opportunity to buy Rights and Issues underlying investments for nearly a third off.

Less rosy for new buyers though is the hideous spread between the buying and selling price of Rights and Issues Trust.

At the moment, the Income shares can be bought for around 250p, but you’ll be quoted 180p if you want to immediately sell them. In other words, you will theoretically face an instant near-25% paper loss when you buy the shares, although you may find in practice you’re offered more than that standing quote if you do go to sell.

For this reason it only makes sense to buy Rights and Issues shares for the very long-term (and some would argue even then it’s senseless, given that ridiculous spread, though I’d hope it will narrow in better times).

I bought RIghts and Issues Income shares to diversify my portfolio and for the dividend income. I hold them in an ISA, and don’t really expect to sell them in the foreseeable future.

Is now a good time to buy Rights and Issues shares?

In the short-term, who knows? Seriously!

The G20 summit is taking place in London as I type. Written at the top of the various leaders’ notes, hopefully in a bold font, will be “Agenda: Stop the world going to economic hell in a hand basket”.

In such a scenario, almost nothing can be ruled out. Perhaps we’ll all be communist by 2011, when the trust will potentially be wound up, and all small caps will have become machines of the state.

More likely we face another year or two of at best stop-start growth, household retrenchment, and economic shocks.

The chairman of Rights and Issues certainly isn’t pulling punches.

For a start, the dividend has been cut:

Your Board has reviewed its medium term forecasts and decided that it would be prudent to rebase the level of the ordinary dividends for the income and capital classes.

Your Directors have therefore reduced the level of the dividend to 33.0p per income share and 1.65p per capital share. This new level should be sustainable but given the current level of uncertainty this cannot be guaranteed. Additionally, the supplementary capital dividend of 68.6829p per capital share was paid on 2nd January 2009 and, barring unforeseen circumstances, will be maintained at 68.6829p per capital payable on 2nd January 2010.

And things could get worse:

The outlook is far from good. The UK economy is likely to fall by over 3% in 2009 with only Japan registering a worse economic performance. The capital goods cycle is now in a profound downswing. Cross border banking relationships are not functioning starving the UK banking sector of funds to lend on. Still even in these most difficult of times some companies will produce reasonable profitability.

Personally, I think the 14% yield is a decent offer on a risk/return basis.

Even if we see a further 50% reduction in the dividend, you’d still be looking at an income way ahead of cash and government bonds, with the prospect of a big recovery if/when we get out of this mess.

I like the directors’ track record and their plain-speaking style, and even more I like the simple and transparent remuneration – there are no share options or strange incentive bonuses.

Directors salaries are very reasonable. The Total Expense Ratio (aka the fees!) for the year ending 31st December 2008 was, according to the Final Results, just 0.96%. That’s comparable with a specialist index tracker.

In my view the 30% discount might just offer a once-in-a-generation opportunity for someone wanting to buy into UK small caps.

Accordingly, I’ve this week topped up a holding first acquired (woefully early!) back in September 2008, paying £2.46 per share.

Perhaps illogically given how cheaply UK small caps now appear to be trading, I’m still wary of over-investing in smaller companies right now though.

My position in Rights and Issues Trust (which may change at any time from posting!) is therefore currently worth less than 1% of my portfolio, with my total small cap exposure in all shares and funds amounting to around 5%.

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