Preferences shares: Picking out those diamonds

Schalk Louw, portfolio manager at PSG Wealth
Schalk Louw, portfolio manager at PSG Wealth

I find 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 money-market 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.

This article originally appeared in the 5 October edition of finweek. Buy and download the magazine here.     

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