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Jargon Buster: Preference shares

Sep 03 2008 13:01 Marc Ashton

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Johannesburg - In recent years, many listed companies have elected to develop a preference share offering and list this on the JSE.

Standard Bank, Investec, Nampak, Beige Holdings and Nedbank offer such shares, to name but a few.

Typically, a preference share is issued as a way for the business to raise money without diluting existing shareholder value.

This is done by offering an alternative class of share, separate to the existing shares in issue.

Holders of preference shares will receive priority in terms of being paid dividends from the business.

Preference shares rarely carry voting rights (real ownership in the business), so they could be perceived as being less "valuable" than ordinary shares.

As a result, shareholders need incentives to buy them.

This is done by offering investors a greater dividend yield than they would receive if investing directly in the underlying business, typically at a fixed percentage which will be much higher than the ordinary share.

For instance, using current market data Standard Bank (JSE ticker: SBK) ordinary shares yield around 4.42% dividend. Standard Bank preference shares (JSE ticker: SBPP) would yield about 11% dividend.

There are four main classes of preference share in the South African market: cumulative, non-cumulative, participating and convertible preference shares.

Here's what they mean.

Cumulative preference shares guarantee that dividends will be paid. Should a company fail to make a dividend payment when it is expected, these 'missed' dividends will accumulate until the next period when they will be due for payment.

Dividends in non-cumulative preference shares do not accrue if payments are missed.

Participating preference shares give the shareholder the right to participate in higher dividends than the company initially declares.

In other words, the dividends of the share are based on a pre-determined percentage or level.

Should certain events in the ordinary share happen, such as liquidation or above normal dividend distribution, this will trigger a higher level of distribution in the preference share.

Convertible preference shares allow the holder to convert these shares into ordinary voting shares at a future date.

A final characteristic of preference shares is that they will often be classified as 'redeemable' or 'non-redeemable'.

If a company offers 'redeemable' preference shares, it means that they will consider buying the shares back at a future date. In contrast, non-redeemable shares will not be considered for repurchase.

Preference shares may also make a combination of the above characteristics. SBPP (see above), for instance, is classified as a non-redeemable, non-cumulative, non-participating preference.

Why preference shares?

Investors who are interested in a high level of dividend yield may consider preference shares a good way to invest.

The price for preference shares is also not directly linked to the underlying performance of the business.

While operational performance may influence the share to some degree, the demand for preference shares increases or decreases in line with three main factors:

  • Dividend cycle;
  • Interest rates;
  • Tax.

Dividend cycle: Much of the value in preference shares is built up as the company comes nearer to paying its dividend.

Once the business goes 'ex' dividend, the price drops as it no longer carries that value.

Interest rates: Demand for preference shares is partially driven by interest cycles.

Investors need to weigh up whether they will generate superior returns in interest-bearing accounts (for example, money-market accounts) or through preference shares.

When interest-bearing instruments are in greater demand, investors will move away from preference shares.

Tax: Preference shares are non-taxable according to South African legislation.

This makes them attractive to shareholders. However if the tax legislation should change, demand for preference shares will decline.

- Fin24.com

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