Preferring Preferreds
By Malaya Laraya
The last five years has seen a small revolution in the local equity market. Specifically, more and more of the country’s biggest firms have taken to issuing preferred shares to the general public. So, what exactly are preferred shares and who are they suitable for?
In a nutshell, preferred shares can be thought of as a hybrid between a bond and a common share. This is because preferred shares signify a commitment by the issuer to give a regular return (like a bond) while at the same time allowing the share to trade freely on the stock market (like a common share). Furthermore, many preferred shares have a fixed life (like a bond) while at the same time requiring only a small amount of capital to purchase (like a share). Consequently, preferred shares have the potential to offer the best of both worlds to people who are uncertain as to whether to purchase bonds or common shares.
To illustrate this, let’s take a look at two of the preferred share offerings in the Philippine Stock Exchange.
AYALA CORPORATION PREFERRED CLASS “B” (ACPR): Listed in 2006, ACPR was offered at P100 per share with a return of 9.4578% per year. You could have bought a minimum of 500 shares at that time so that would have meant an initial investment of P50,000. Think about that. If you had P50,000 in 2006 and were unsure as to what to do with it, you probably would have kept it in a savings account. Hence, you would probably have been making less than 2% per year on your money. Specifically, a P50,000 placement in 2006 at 2% per annum would have grossed you P5,204 by the end of 2010. Comparatively, ACPR’s cash dividends during the same period totalled P24,609.39. And that’s assuming that you weren’t putting the annual dividend into a savings account. If you placed the annual dividend into a 2% savings account as well; then from 2006 till end of 2010 you would have earned over P25,000 – nearly five times more than if you kept it in a savings account.
PETRON CORPORATION PREFERRED SHARES (PPREF): Listed just this past March, PPREF was also offered at P100 per share. However, PPREF’s return is somewhat higher at 9.5281% per annum. With most savings rates now hovering at about 1% per annum, the difference in returns between PPREF shares and savings accounts will only increase. To better illustrate this, let’s say that you placed P50,000 into PPREF shares and P50,000 in a savings account. In one year, you will probably gross about P500 in your savings account. PPREF on the other hand, will return about P4,764. That’s over nine times more. Of course, that amount is fully dependent on Petron actually paying the dividend – and that brings us to the risks that people must be willing to accept when buying preferred shares.
As mentioned in the beginning, preferred shares are very much like bonds so, like bonds, one of their biggest risks is the risk of default. Unfortunately, when the issuer decides they are unwilling or unable to pay the stated dividend; the investor has very few legal remedies. However, this risk is somewhat mitigated by the fact that common shareholders (which usually includes most of a company’s senior management and the board of directors) will not be eligible for cash dividends until all outstanding cash dividends owed to preferred shareholders have been settled. Furthermore, a company that misses a cash dividend payment will take a pretty severe public relations and credit ratings hit which will make it very difficult to raise funds in the future.
Another significant risk investors in preferred shares will have to accept is liquidity risk. This is because history has shown that, on certain days, there are no willing buyers. This means that, should a holder of a preferred share be looking to sell his holdings, there may be no one willing to buy – unless the shares are offered at a steep discount.
So, with all of that said, who should be looking at preferred shares? Well, if you have at least P50,000 that you are looking to grow over time and you are willing to accept the risks stated above, then I believe you should seriously consider this instrument. Preferred shares are also good for people who would like to dabble in the stock market but are uncomfortable with the sudden price movements that accompany most common shares. Lastly, preferred shares are good for people who are looking for a fixed annual return and the possibility of capital gains. This is because, like a common share, preferred share prices do move and they can potentially deliver solid capital returns.
In ACPR’s case, it reached a high of P112 per share so if you were able to sell at that point; not only would you have gotten all the dividends that had been paid out until then but you would also have received a good 12% return on your capital.
Now, just about the only thing left is to disclose is where to get these things. The best place to get them would be from the underwriters during the initial offering. This is because if you get them from underwriters, you don’t have to pay the broker’s fees and government taxes that you would otherwise have to pay if you bought it in the open market. These fees and taxes can be as high as 2.2% of the purchase price so even if you buy it at the original offer price, these additional costs can eat up a significant part of the cash dividends. So if you want to be informed about the latest company that will offer preferred shares, make sure to visit the PSE’s website at www.pse.com.ph on a regular basis as all information regarding forthcoming offerings will definitely be posted there.
