The split per­son­al­i­ties of split shares

The Globe and Mail (BC Edition) - - REPORT ON BUSINESS - JOHN HEINZL E-mail your ques­tions to [email protected]­and­

What is your opin­ion of split shares?

Many in­vestors don’t re­al­ize that there are ac­tu­ally two kinds of split shares – pre­ferred shares and cap­i­tal (or class A) shares. Split share cor­po­ra­tions is­sue both types of shares to the pub­lic and use the cash to in­vest in a bas­ket of div­i­dend-pay­ing com­pa­nies.

Even though split pre­ferred and split cap­i­tal shares are ex­posed to the same un­der­ly­ing port­fo­lio of stocks, they be­have in dif­fer­ent ways and have dra­mat­i­cally dif­fer­ent risk pro­files. –

“I only real­ized how they worked when it was too late … I lost a sig­nif­i­cant amount of money in the process,” said one reader who in­vested in split cap­i­tal shares only to watch their prices tum­ble when the stock mar­ket hit a rough patch this fall.

The best de­fence is to ed­u­cate your­self, so let’s look at each type of split share in turn.

Split pre­ferred shares are ac­tu­ally quite con­ser­va­tive; they typ­i­cally pay a fixed monthly dis­tri­bu­tion that is funded by the div­i­dends from the un­der­ly­ing port­fo­lio. The pre­ferreds get first claim to these div­i­dends and also to the cap­i­tal of the un­der­ly­ing port­fo­lio, up to a cer­tain level (equiv­a­lent to the is­sue price of the pre­ferred shares).

The trade-off for pro­vid­ing greater safety is that split pre­ferreds of­fer lit­tle up­side po­ten­tial. This makes them ap­pro­pri­ate for in­vestors seek­ing steady in­come and sta­bil­ity.

Split cap­i­tal shares, on the other hand, are much more volatile. In ex­change for giv­ing up the un­der­ly­ing div­i­dends to the pre­ferred shares, the cap­i­tal shares are en­ti­tled to all of the value in the port­fo­lio above the fixed amount al­lo­cated to the pre­ferreds. Many cap­i­tal shares also pay div­i­dends, which are usu­ally fi­nanced by sell­ing op­tions and earn­ing pre­mium in­come on the un­der­ly­ing stocks.

Es­sen­tially, the cap­i­tal shares are a lever­aged play on the un­der­ly­ing port­fo­lio. If the stocks in the port­fo­lio rise, the cap­i­tal units will ex­pe­ri­ence an even big­ger gain. But if the port­fo­lio stocks fall, the cap­i­tal shares will suf­fer an even big­ger loss. The div­i­dends from cap­i­tal shares can also dry up if the mar­ket turns neg­a­tive.

Let’s look at an ex­am­ple. Cana­dian Life Com­pa­nies Split Corp. in­vests in a port­fo­lio of four div­i­dend-pay­ing Cana­dian life in­sur­ance com­pa­nies: Man­ulife Fi­nan­cial Corp., Sun Life Fi­nan­cial Inc., Great-West Lifeco Inc., and In­dus­trial Al­liance In­sur­ance and Fi­nan­cial Ser­vices Inc.

The pre­ferred shares of Cana­dian Life Com­pa­nies Split trade un­der the sym­bol LFE.PR.B and the class A or cap­i­tal shares trade un­der LFE. (The split cor­po­ra­tion is man­aged by Quadravest Cap­i­tal Man­age­ment Inc., which also has about a dozen other “en­hanced yield” prod­ucts.)

The pre­ferreds have pro­vided steady re­turns, trad­ing be­tween $10 and $10.50 for most of the past five years and never miss­ing a monthly div­i­dend pay­ment. They cur­rently yield about 6.25 per cent, based on trail­ing 12month div­i­dend of 62.5 cents a share.

The cap­i­tal shares have been far more er­ratic. In Jan­uary of this year, for in­stance, LFE traded be­tween $6 and $7. But as life in­sur­ance stocks strug­gled, the class A shares have sub­se­quently lost more than half of their value. LFE closed Fri­day at $2.56.

LFE’s div­i­dend his­tory is also spotty. Over the past five years the class A shares have de­clared a div­i­dend in just 16 of 60 months – or about 27 per cent of the time. No div­i­dends have been paid since Fe­bru­ary. When the to­tal net as­set value of the split share cor­po­ra­tion falls be­low $15 – it was about $13.42 as of Nov. 30 – div­i­dends on the class A shares are sus­pended.

Un­der the right con­di­tions, the lever­aged na­ture of split cap­i­tal shares can work in an in­vestor’s favour. From the start of 2016 to the end of 2017, for ex­am­ple, LFE posted a to­tal re­turn (as­sum­ing all div­i­dends had been rein­vested) of about 96 per cent – nearly triple the to­tal re­turn of the S&P/TSX Com­pos­ite In­dex over the same two-year pe­riod.

But while split cap­i­tal shares can pro­duce mar­ket-beat­ing re­turns at cer­tain times, they can also de­liver gut-wrench­ing losses. And the div­i­dends aren’t as re­li­able. For most peo­ple, pre­ferred split shares are go­ing to pro­vide a much more com­fort­able ride.

I al­ways re­mind peo­ple to do their own due dili­gence be­fore in­vest­ing in any se­cu­rity. With split shares, it’s crit­i­cal that you read and un­der­stand the prospec­tus, ask a lot of ques­tions and study the track records of var­i­ous se­cu­ri­ties be­fore you even con­sider in­vest­ing a penny in these com­plex prod­ucts. For my money, a di­ver­si­fied port­fo­lio of high-qual­ity, div­i­dend-grow­ing com­mon shares is still the best way to go.

For some ex­am­ples, see my model Yield Hog Div­i­dend Growth Port­fo­lio at­i­dend­port­fo­lio.

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