Investment laboratory

Bearbull belatedly took a detailed look at RECI early this month and came away with a holding in the ordinary shares for the Bearbull Income Portfolio. The timing was fortunate. I bought 14,000 shares at 109.5p on 4 January, since when the London market's bullish canter has taken the price to 118p. Even at that level, the ordinaries are interesting, as are the other two classes of shares that RECI offers - preference shares and shares in its so-called 'cell' company, European Residual Income Investments (ERII).

Take the cell shares first. Back in 2008 - when it was still Queen's Walk Investment - RECI had lost its way as it focused on asset-backed securities whose value was plummeting. Undeterred, its managers saw an opportunity in mortgage-backed securities - property loans bundled together - whose value had also crumbled. So it restructured in order to raise new capital and ring-fence two separate activities within one corporate vehicle. Into the cell company went the residual asset-backed securities and RECI shareholders got cell shares on a one-for-one basis.

The cell shares are RECI's high-risk proposition for four reasons. First, the ultimate value of the cell's asset-backed securities remains in doubt. Second, if need be, the 'core' company, RECI, can make a claim on the cell's assets when the RECI preference shares mature in September 2017. Third, the cell's ability to pay dividends is restricted by the ratio of total company assets (RECI plus the cell) to the preference capital liability (about £45m). The cell was able to declare a dividend in November but, taken together, these three factors make uncertain the timing and the amount of cash that the cell shares can throw off. Fourth, the cell shares, which are listed on London's specialist fund market, trade close to book value anyway. At €0.58, their aggregate value is €23.2m compared with €24.1m book value of the cell at the end of September although the company points out that its latest fact sheet puts its book value now at €33.5m. Sure, book value is based on 'fair value' of its investments, which should be well below their redemption value. Even so, the cell's shares are only for risk-tolerant investors who can stick to a stop-loss plan.

The contrast with the RECI preference shares could hardly be sharper. These are the low-risk option, which carry a running yield of 7.7 per cent but, crucially, a redemption yield of 7.0 per cent. Their coupon costs about £3.8m a year; with the RECI core generating interest income of £11m or so per annum, that payout is under little threat. Pop them into an individual savings account, and they become a sensible four-and-a-half-year bond.

However, the prefs put some strain on RECI's ordinary shares, so maybe they are the better investment, especially as they start with a small yield advantage - 7.0 per cent compared with a current annualised yield of 6.3 per cent on the ordinaries. That depends on the pace at which the ordinary share dividends grow and the ease with the company can meet its liability to pay off the prefs in 2017.

RECI's managers aim to pay ordinary dividends equal to 6 per cent of the net asset value of the core company's portfolio. So the pace of dividend growth largely depends on the rate at which the portfolio's value rises. The signs are encouraging as receding fears about the euro's future combined with investors' search for yield drive up values of RECI's mortgage-backed securities. This trend will eventually be curtailed because the prices that RECI is paying for new bonds are also rising. At the end of September, its portfolio of 124 bonds had an average purchase price of 68 per cent of 'par' (ie, targeted redemption value). But, during the six months to that date, on average RECI paid 78 per cent of par for new investments.

Yet dividends on RECI ordinaries only need grow by 10 per cent to top that of the prefs, which seems feasible. Nor does it seem likely that the value of the ordinary shares will be hit by RECI's £45m liability on the prefs. That's because even at 118p, the ordinary shares trade 14 per cent below their latest pro-rata net asset value of 138p - and, just to spell it out, that figure is calculated after the preference liability is deducted. Not just that, but quite likely there is hidden value in RECI's bond portfolio. In September, RECI's managers reckoned the bond portfolio had a 'fair' value (ie, a best guess of market value) of £80m, but that was almost 34 per cent below redemption value. Obviously not all bonds will be redeemed painlessly, but such a discount seems to leave a wide margin for error.

Granted, it would be nice to know the managers' plans for the company when the preference shares are redeemed. They could use that as a prompt to liquidate the whole vehicle and maybe some activist investors should sniff around. All of which could add spice to the investment I've just made.