Anumber of readers have been contacting me asking how they can protect themselves f rom t he coming market crash, but before I delve into that, here’s an important point: Will our stock market crash – absolutely! When? No idea. It will happen again and nobody knows when, I do know that when it does happen, I will get out my shopping basket and start buying, remember the best buying opportunity in the last decade was during the darkest days of 2008/09 when everybody was talking about the end of the world.
But how do you protect a portfolio against a market downturn? The one route is through derivatives using short positions and the most common is probably longdated out-of-the-money put options on the Top40 Index as they’re really cheap, but only if the market loses 20% or 30% will their value rocket. These are almost like insurance in that they’re great if you need them, but otherwise just an ongoing expense.
So what of preference shares, as suggested by one reader? They offer both capital protection and income in the form of dividends and I really like this idea. Traditionally, any diverse portfolio would include debt instruments of some sort, and for the retail investor preference shares are the best and easiest form of debt.
So what are preference shares and how do they work? They are, as mentioned, debt and in this case issued by mostly larger listed companies. So let’s look at SBPP for our example. Issued by Standard Bank*, it sold almost 53m at R100, raising some R5.3bn of debt, debt that is now held by the owners of the SBPP preference shares. Importantly, these are non-redeemable, non-cumulative and non-participating shares. In other words they cannot be redeemed for cash, if a dividend is missed, the missed dividend does not accrue into the future and you do not get voting rights, and last, they cannot be converted into Standard Bank shares.
By owning one of these preference shares, you are entitled to a dividend payment ahead of ordinary shareholders and in the case of a liquidation of Standard Bank, you would be ahead of ordinary shareholders for any payout.
What is attractive is the rate that preference shares pay, typically linked to prime they pay around 60%-85% of the current prime rate as dividend. So taking an average of say 70% of prime, that equates to a current dividend payment of 5.95% (70% of the 8.5% prime rate). There is still dividend withholding tax of 15% making an effective after-ta x rate of 5.0575% – better than the vast majority of bank accounts. Of course that effective rate is higher or lower depending on what percentage of prime the preference share pays out and will move as prime changes.
The other benefit is that they have a notional underlying value, that is the amount of the debt they cover and as such you see very little price movement away from this underlying value. In the case of SBPP, the amount is R100 and the theoretical value of the preference share is R100 plus whatever dividend has accrued. The key point is that there should be very little capital appreciation or depreciation of a preference share due to the debt underpin. This would keep them largely unchanged in the event of a broad market sell-off.
This is, however, not a perfect science as liquidity plays an important part, and as I write this, SBPP is trading around 9500c, below its R100 notional value.
So not perfect, but a great way to protect a portfolio and earn some income.
Finally – there’s a preference share exchange-traded f und – PREFEX – issued by Grindrod Bank if you would prefer a basket.
Simon Brown is a Finweek contributor and heads justonelap.com, a free resource of financial information and investment education.
* The writer owns shares in Standard Bank.