When even the market darlings continue to disappoint | Fin24
 
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When even the market darlings continue to disappoint

Oct 29 2018 12:49
Simon Brown

Simon Brown, founder and director of JustOneLap.com.

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Trying to find something that is going up in our current market is proving almost impossible. 

It feels like there is nowhere to hide. And no matter what valuations you buy at, the price just continues lower. 

Even the market darlings of the last few years are out of favour. 

But there is still money to be made. We just need to look in different corners.

The corner I am talking of here is preference shares. These are debt instruments issued by listed companies, and are a loan to the company at the time of listing. 

They then pay regular dividends that are linked to the prime interest rate. 

Being dividends, they attract dividend withholding tax of 20%. What we are seeing is some great yields from the non-financial preference shares, with some over 10%. 

This is potentially a great place to hide while our market decides what it wants to do.

What is also important is that while a preference share will be issued at an underlying value (most often R100), it trades free without a market maker. 

You can therefore buy it at a discount to its actual value, enhancing the yield. 

Liquidity is often a problem with these second-tier preference shares, and getting in or out can often result in slippage and less-than-ideal prices.

Back in July, I recommended the PrefTrax exchange-traded fund (ETF) from CoreShares that was yielding 12% at the time. 

That yield has dropped to around 11.5% as the price of the ETF has risen.

While 11.5% is attractive for a little more risk, we can get even higher yields on individual preference shares – the extra risk being because these are not in a basket, and therefore single-company risk exists.

In the case of the ETF, it will trade at the fair value relative to the basket of preference shares, but the underlying preference shares may not. 

Typically, they trade below their fair value, offering a higher yield. The CoreShares ETF will have a market, making it easier to get in and out.

The recent announcement from Invicta that they have reached an agreement with the South African Revenue Service (Sars) removes this overhanging uncertainty and their preference share (JSE code: IVTP) offers a yield of just over 13% at R82.50c. 

But, as I write on p.12, more allegations have been levelled against the company and while a preference share is ring-fenced, investors may rather want to look to some of the second tier financial preference shares. 

Another is the Grindrod preference share (JSE code: GNDP) offering a 12.3% yield at R72.00c.

In a flying local market none of these yields would be great, but considering the Top40 has returned 9% over the last three years and 27% over the last five – some certainty of return is attractive.

There are, of course, risks. Firstly, periods in which markets give low returns are as a rule followed by higher returns, and if markets start running, these yields may be modest. 

That said, some certainty of return, especially if income is required, is worth this risk.

Another risk is the underlying company going bust. If this happens, preference shares do have priority over normal shares, but you are holding debt of a bankrupt company so that hardly matters. 

You also have the risk of the dividend payments being linked to the local prime rate. 

So lower interest rates will reduce the yield. The inverse of course is that higher rates increase the dividend.

I have already mentioned the risk of liquidity. If you are buying in size you may have to push the price higher, reducing your rate. 

Then exiting may also not be easy and may require pushing the price lower, potentially resulting in a capital loss offsetting part of the yield.

But considering the current state of the market, these risks may be worth considering in order to lock in some decent returns.

This article originally appeared in the 25 October edition of finweek.
 Buy and download the magazine here or subscribe to our newsletter here.

investment  |  risk  |  markets
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