Pref­er­ence shares

Finweek English Edition - - INVESTMENT -

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.

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