Why 2018’s secret investment winner, could win in 2019

PUBLISHED: Tue, 12 Feb 2019 17:58:18 GMT

By Samantha Steyn, Chief Investment Officer, Cannon Asset Managers

2018 was a bruising year for investors, as traditional asset classes delivered returns that can at best be described as unsatisfactory. Yet, amidst the gloom, an often-forgotten asset class shone through, achieving a solid return of 15%: preference shares.

Source: Cannon Asset Managers (2019)

Little-known by most investors, preference shares – like ordinary shares – offer investors the potential for capital growth as their price rises over time.

However, as the name suggests, preference shareholders are given preference over other shareholders in pay-outs, which means that they also offer investors the benefit of a stable income stream in the form of attractive dividend payments.

As the value of dividends is driven by interest rates, preference shares are the only asset class, other than cash, that benefit from rising interest rates. The advantage of this for investors has become particularly clear in recent years where equity markets have underperformed

Additionally, the income stream from preference shares’ dividend payments is taxed according to dividend withholding tax (DWT), which is currently 20%. Compared to the after-tax yields of bonds, property or cash investments, which are taxed according to investors’ marginal tax rates, this means that preference shares also offer investors relatively attractive tax benefits.

The yield is especially attractive for corporates, which are exempt from DWT. This makes preference shares a great investment option for businesses.

Table 1: Performance over three years

FTSE/JSE All Share Index 2.6% 21.0% -8.5%
FTSE JSE Preference Share Index 18.8% -3.3% 15.0%
Property 10.2% 17.2% -25.3%
Bonds 15.4% 10.2% 7.7%

Source: Cannon Asset Managers (2019)

Diversification benefits

Numerous factors have led to preference shares being overlooked or falling out of favour as an investment class in recent years.

First, the preference share universe is relatively small compared to other major asset classes, and the market for preference shares is comparatively illiquid. The preference share market has also been tainted in the recent past by the African Bank and Steinhoff investment scandals, where preference shareholders experienced material capital losses, suspension of trading and suspended dividend payments.

This has meant that the asset class is now very well priced, offering private and institutional investors an appealing option for introducing additional diversification into their portfolios, especially amidst market volatility.

Asset allocation and effective diversification are the most powerful ingredients when it comes to investing, playing a key role in ensuring healthy returns through market cycles. Preference shares’ traditionally low correlation with other asset classes means that they offer investors excellent diversification benefits, particularly when paired with asset classes such as bonds or property.

Healthy growth potential

Furthermore, new banking regulations have changed the way in which preference shares are treated. Under Basel III regulations, the asset class no longer counts towards banks’ Tier 1 capital. Consequently, preference shares have become an inefficient and expensive form of capital for banks.

This means that investors should also potentially see positive price growth moving forward.

Capitec has already begun repurchasing its issuance, and we expect that other banks will follow. We’ve also seen an increase in corporates repurchasing their preference shares of late, particularly as many have been sitting with surplus cash. For example, Brait and Imperial recently repurchased their respective preference shares at attractive premiums to market prices.

If this continues, we may see premiums rise further, as there may be a strong pull to par. In this case, there would be a potential capital gain in the region of as much as 20%.

Attractive income stream
The benefits of preference shares dividend yields should not be underestimated, especially in difficult investment environments.

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