If we're right then the City must be stupid

Share clubs
Every month David Stevenson recounts the fortunes of the Reservoir Dogs share club, a group of London investors who save money each month and pool funds to buy selected shares. The group has an adventurous strategy. This month: the group picks a third share and investigates more exotic investments.

Autumn is not a great time for any voluntary club or organisation. Just five of us attended the fourth meeting of the Reservoir Dogs Share Club. At least it made the business brisk and the first thing to report was our profit.

Yes, profit. We are 15 per cent up based on our two existing shares - Hong Kong and Shanghai Bank and Oxford Glyco Sciences.

HSBC's share price has looked distinctly unhealthy in recent weeks but the share price has rallied as investors have realised just how strong it is. But I'm still tempted to sell the shares and then buy again in a few weeks as the share price goes back down with a nervous stock market.

Limited attendance also helps decision-making.We wanted to pick a third share and in the end only one share really got any support: Acorn.

You may remember Acorn as those nice people who made great school computers that nobody now seems to buy. Its core market for computers is shrinking fast and it has decided to reorient. Acorn is big in interactive digital technology and has some excellent ideas. One in particular stands out: ARM. It is a micro-processor technology that leads the world. So impressed is mighty Intel with ARM that it has licensed its technology.

ARM makes good money, and Acorn owns just over a quarter of the company. Its share is valued as at least pounds 100m. Despite this, you cannot give away Acorn shares to people in the City. Why? Many don't like small companies, which Acorn definitely is, and no one in the City can understand all this digital technology baloney. Acorn doesn't make any profits, either.

Its shares have slumped to 64p, valuing Acorn and its ARM share at pounds 60m. Either the City knows something we don't or they're stupid. Call us fools but we reckon it is the latter.

We are now thinking about diversifying out of ordinary shares and may put some of our money into more unusual investments.We'll let you know what we decide to buy.

Exotic investments

By exotic we simply mean investments or instruments that are not ordinary shares. They are by their nature riskier, especially when the cold winds of recession blow. But the heightened risk factor can also provide rich pickings. There are four main categories we'll look at, starting with the least risky.

Convertible shares are issued by companies wanting to raise extra finance. They are similar to loans in that they usually guarantee to pay a fixed interest but they also carry with them the right to convert the investment into the ordinary shares of that company. Let's say UK Plc decides to issue convertible stock worth pounds 100, allowing you to buy 100 shares in, say, five years at pounds 1 a share. They also decide to pay you pounds 6 per annum for the privilege. Your yield or income is thus 6 per cent. The nice bonus is that not only do you get this steady income, you also get an option to buy the real shares at a fixed future date - and that option could be worth a lot if the ordinary shares have risen in value. The golden rule is simple: do not be attracted by the yield (frequently well above 6 per cent), invest in a company you have researched and believe in.

Warrants are similar in that they too give you the right to buy a company's ordinary shares at some fixed point in the future, only they don't pay any interest. Investment trusts particularly like warrants.

Split capital trusts. These are investment trusts with a fixed life. They will distribute profits at the end of the term according to different classes of shares issued by the trust.

Zeros (zero dividend preference shares) are nearly always first in the queue. They get a predetermined first cut of the profits after any debts have been repaid.

Capital shares, by contrast, will only receive a payout if the trust has done reasonably well. Talk to each of the trust managers first to get the exact details but basically if the stock market is on an upward curve, capital shares can skyrocket in value. If, on the other hand, shares look weak then zeros are a good bet.

Traded Options. An option is a contract giving you the right to buy or sell a fixed number of shares (normally 1,000 per contract) at a fixed price on a given date, normally later in the year.

A "call" option is an option to buy shares, a "put" gives you the right to sell shares. Assume UK Plc shares are trading at 100p. Let's say you buy an option to buy these shares in three months at 100p, and you are charged 10p for the privilege. In three months the shares of UK plc rise to 150p so you have made a profit of 150p less 100p and 10p for the option.

You can lose the entire investment in an option if the share goes the wrong way, but you will only lose what you paid for the option.

Read all about it

Thinking of setting up an investment club? The Proshare investment guide is the must-have book on the subject. Independent on Sunday readers can get hold of the guide for pounds 20 including postage (normal price pounds 25). Telephone 0171-394 5200.