My last article was about standard vanilla Investment Trusts, their benefits over open ended funds and what to watch out for. This article adds another layer of complexity which I hope to shine a light through to show you a very interesting and potentially useful investment option for your portfolios. It is an area that is generally left to the professionals because it requires constant research.
It would appear that businesses can not resist creating spirals within their environment and assume that this is in some way a cushion for bad times. In reality it is the opposite and causes a complete collapse. For examples of this please see Japanese companies in the 1980’s, Lloyds of London in the LMX spiral in the 1990’s, the recent liquidity crisis where liabilities were packaged and then repackaged some more until no one knew their true exposure. There was another incident in the financial world and that was known as the Split’s debacle of 2001. Here split capital trusts invested in each other creating yet another spiral which proved to be the downfall of many when the markets fell. Since then many investors will not look at them at all, yet, there are now rules to limit incestuous activity and in fact very few continue this practice as it simply turns investors away. I think it is fair to say that very few market analysts even report on them and they hardly ever appear in statistical tables or graphs. I think this is denying investors knowledge and the potential to add a useful tool to their portfolios.
So what are Split Capital Trusts?
They are a type of Investment Trust and according to various sources, the first split capital trust was launched in 1965, called Dualvest. The idea came from the “father and son” arrangement. Through the creation of separate income and capital shares, the father could get the benefit of the income stream for the remainder of his life and his heir would receive all the long-term capital growth. It was in the wake of the 1965 Finance Act, when investors were being taxed very differently on their income and their capital. So as the name suggests the capital structure of the trust is split. It does not solely consist of Ordinary shares. Back when income tax rates were even more painful than todays some investors did not want any income while others still wanted that income stream and Splits, as they are commonly referred to, were born. There are generally two kinds and they generally have two classes of shares.
ZDP and Ordinary Income Shares
It is a well-known fact that banks are paid out first from a failed business or investment and that is still the case with Splits but then there are two classes of shares remaining so who is first? In this scenario it is the Zero Dividend Preference shares (ZDPs or simply Zeros) followed by the Ordinary Income shares, not to be confused with normal Ordinary shares although still abbreviated to Ords. Zeros are owned by those who do not wish for income. They accumulate a fixed and steady capital return over the life of the Split, which can be anything from 5 to 7 years. So these shares are less risky (but they do have some risk) than the Ords but they pay no income. The Ords are certainly higher risk as they are last in line to be paid out. Indeed there is the chance you receive nothing. But, and this is the key, you receive the income due from the investments, all the investments, that is you get the share the Zeros have declined. This means that the Ords do tend to yield above 5%. Indeed for the extra risk taken they should do!
In addition, the Ords are also entitled to all the capital gains above and beyond the fixed growth (seen as a charge) of the Zero. So in good times this is truly a double whammy of high income along with a reasonable capital gain, and can be made even better if bought at a discount.
So how risky are they?
Bank debt will increase the level of risk, so I tend to avoid geared splits, but the gearing is there for the Ordinary Income shares due to the capital structure. It is usually more than double your investment. However, the Zeros offer a much reduced level of risk and would be useful for those who are looking for defensive stocks. Now that the Splits do not invest in each other any slide is more contained and the Zeros should provide the redemption price on windup. The trust Capital Gearing holds quite a few Zeros as part of its defensive stance.
Income and Capital shares
Another older variation is to have Income and Capital shares. This is rather like the first example except in reverse. The Income shares have a fixed redemption price and a yield associated with them. The capital shares may have a small income but they are there to claim any assets over the redemption price of the Income shares rather like a high risk Zero because nothing is at a fixed rate.
Most Splits have a fixed life although some are undated. This has some advantages that are worth understanding. First, if successful in getting enough support through votes the trust will be able to Roll Over into another trust with a similar remit. Generally you can vote for cashing in your shares or rolling over. The value used to work out the shares in the new trust will be the NAV, less costs, and indeed this is also used for cashing in your shares. This means that any discount when purchased should all but disappear. Being such an under-reported market there are sometimes good bargains to be had. One must always remember that the Zeros are paid out first so it is still possible that in the last few months that NAV of the Ords could be reduced significantly if there is a fall in net assets or even if they remain level.
Because the net assets are returned, or rolled over, any revenue reserves will also have to be paid out. This used to be done on the final date of rolling over but this just attracted the wrong kind of shareholders in the last remaining months who then took the bonus payout dividend and voted for a cash exit, thus reducing the chances of the trust continuing or rolling over. Premier Energy & Water having recently started to pay out the surplus cash in advance of potentially winding up in December 2015. Although this is in the form of special dividends it is clearly not a one off and so the yield is now around 8%.
So, in order to work out which Splits to own, and which to avoid, and when to switch, there are a number of ratios one can look at. Websites like MorningStar and Trustnet produce them daily although you will realise that sometimes they are not always accurate when you have been doing this for a while! AIC also have some information too. First stage, you need a trust where the Zero is well covered, this means that the net assets at this moment can afford to pay out the Zeros entitlement should the worst happen. The larger the cover the better. This also means that the Ords will have some value.
The next figure you should use is the hurdle rate (growth rate) that the Zeros have to surmount to reach their redemption price using all the assets. This is the annual growth rate that must be achieved. If this is reasonable then another tick can be applied. Towards the end of the life of a Split this can be a negative figure if the Zero is very well covered. Also the Ords have a hurdle rate. The best one is if all the assets are grown what rate is required to keep the current price the same at windup. This should certainly be less than 5% but you can decide what you are comfortable with. This helps to remind us that the zeros are sucking away at the growth of the pot of assets and that the Ords will only grow if overall growth exceeds their demands. Of course, yield, discount, bank debt are standard ratios and should therefore be included. It also goes without saying that you should be happy with the fund manager’s philosophy and the sector/remit where the trust invests.
If you avoid ones with bank debt that removes some risk and headwind and I generally prefer the Ordinary Income stocks, in case you had not spotted this! Some fun can be had with some Capital shares and Zeros should offer some form of protection. So I would look at well covered Zeros and with hurdle rates for the Ords of less than 5%. If I can get them at a good discount then that helps. If you remember from the last article, a discount can increase your yield as well as your return. However, the most important thing to remember is that even if the market moves sideways, as it has done this year, the Ords could go backwards, and due to structural gearing this can be swift and painful. If you think a crash is coming you should look at the Zeros instead. Remember to keep reviewing the ratios on a regular basis, and even plot them.
To start the ball rolling try this link https://www.theaic.co.uk/guide-to-investment-companies/split-capital-investment-companies. As always, do your homework. The best of luck!
Sources: AIC (L. Flounders), Morningstar.