THE PROS AND CONS OF PREF­ER­ENCE SHARES

Pref­er­ence shares could be a good in­vest­ment, if you choose them very care­fully.

Finweek English Edition - - Front Page - By Schalk Louw

ifind the story of di­a­monds fas­ci­nat­ing. It takes be­tween 1bn and 3bn years for this jewel to form out of car­bon, deep within our earth and only ex­tractable at high cost. If the ideal con­di­tions are not met in the for­ma­tion process, you can end up with graphite, and while this min­eral is still very use­ful, it isn’t quite as mag­nif­i­cent as a di­a­mond.

This past year both am­a­teur in­vestors and ex­perts alike have in­creas­ingly been ex­press­ing con­cern re­gard­ing the val­u­a­tions of world mar­kets and also how few “di­a­monds” can be found among growth shares. Pref­er­ence shares have def­i­nitely lost their shine over the years, but they can still be good in­vest­ments if you are able to tell the di­a­monds and the graphite apart.

One of the main rea­sons why pref­er­ence shares have lost their ap­peal is prob­a­bly due to the an­nounce­ment made in 2015 that, ac­cord­ing to Basel III, they are no longer seen as Tier 1 cap­i­tal, which forced cer­tain changes in or­der to make them more cap­i­tal suf­fi­cient. The big­gest con­se­quence was that banks were forced to buy back their own shares, which made pref­er­ence shares less liq­uid, and they couldn’t trade in large vol­umes like or­di­nary shares.

The av­er­age rand trad­ing value for South African pref­er­ence shares over the past 60 days amounted to only R1.5m per day, which can cause prob­lems when an in­vestor would like to get rid of a large share­hold­ing quickly. This also means that an in­vestor should have a longer in­vest­ment hori­zon.

But what makes pref­er­ence shares dif­fer­ent? These in­stru­ments are a cross be­tween an in­ter­est-bear­ing and an eq­uity in­vest­ment. Their re­turns are usu­ally tar­geted rel­a­tive to a fixed per­cent­age of a vari­able such as a prime in­ter­est rate, but are only paid out if the com­pany ac­tu­ally de­clares a div­i­dend. It is there­fore not guar­an­teed. Pref­er­ence shares trump or­di­nary shares in rank­ing or­der of profit dis­tri­bu­tion, but they don’t come with the vot­ing rights that ac­com­pany or­di­nary shares.

It’s im­por­tant to note that the com­pany is un­der no obli­ga­tion to pay out div­i­dends. For this rea­son, it is es­pe­cially im­por­tant to only con­sider pref­er­ence shares from trust­wor­thy com­pa­nies with a con­stant and pos­i­tive div­i­dend his­tory. It’s also im­por­tant to note that pref­er­ence shares may ex­pe­ri­ence great price fluc­tu­a­tions, al­though much less so than with or­di­nary shares. Pref­er­ence shares should there­fore not be seen as an al­ter­na­tive to a typ­i­cal in­ter­est-bear­ing in­vest­ment.

South Africa’s four largest banks (Absa, FirstRand, Ned­bank and Stan­dard Bank) have at least one listed pref­er­ence share on the JSE, which is linked to the cur­rent prime rate. All of these banks have a fan­tas­tic div­i­dend his­tory; div­i­dends are paid bian­nu­ally and, un­like in­ter­est, are taxed at only 20% (div­i­dend tax) for in­di­vid­u­als.

If you had an av­er­age in­vest­ment in all four of these banks’ pref­er­ence shares, the fact that prices have dropped con­sid­er­ably rel­a­tive to All Bond (Albi) rates be­comes clear. In fact, the drop has been so much that in­vestors now re­ceive a pre-taxed rate of nearly 1.1 times more than Albi rates. Sure, fac­tors like tax leg­is­la­tion and ris­ing in­ter­est rates may have been good rea­sons for the de­cline of pref­er­ence share prices, but 1.1 times rel­a­tive to bond rates may be a bit much. Over the last decade, these four pref­er­ence shares de­liv­ered an av­er­age of 0.97 times higher re­turns when com­pared to the Albi, so it does ap­pear as though pref­er­ence shares are well-priced at the mo­ment.

Based on in­come, these four banks are cur­rently trad­ing at an ex­pected av­er­age re­turn (should the prime rate re­main un­changed) of 10% over the next 12 months. In other words, af­ter div­i­dend tax has been taken into ac­count, the ex­pected in­come of 8% should re­flect bet­ter than cur­rent mon­ey­mar­ket rates (be­fore taxes). As men­tioned be­fore, liq­uid­ity re­mains a huge risk, with the past 60 days’ av­er­age daily rand trad­ing value on these four shares to­talling only R3.2m per share. It’s also im­por­tant to con­sider the pos­si­ble price volatil­ity. Al­though the an­nual volatil­ity of 8% (since 31 Au­gust 2008) may be lower when com­pared to the FTSE/JSE All Share In­dex’s 15% over the same pe­riod, it’s still a bit higher than the 7.2% an­nual volatil­ity of the Albi.

For those who have a need for a bit more risk and less liq­uid­ity, In­vestec (INPR) and PSG pref­er­ence shares may also be con­sid­ered. Both of these pref­er­ence shares have traded at an av­er­age of R4m (R2m each) in value per day over the past 60 trad­ing days and you can now buy these shares at an ex­pected div­i­dend rate of 11.2% (be­fore div­i­dend tax).

Al­though pref­er­ence shares shouldn’t nec­es­sar­ily re­place an as­set class like or­di­nary shares or money mar­ket in my port­fo­lio, I do be­lieve that there are good in­vest­ment op­por­tu­ni­ties if you go about them se­lec­tively. Al­ways keep in mind the lim­ited liq­uid­ity and price fluc­tu­a­tions, and rather add pref­er­ence shares se­lec­tively as a small ad­di­tion to your to­tal port­fo­lio, so that you don’t end up with graphite in­stead of di­a­monds. ■ ed­i­to­rial@fin­week.co.za

Schalk Louw is a port­fo­lio man­ager at PSG Wealth.

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