Philip Arthur Fisher (Photo credit: Wikipedia)Financial IQ Philippines Quick Hit(s):This article is written by a good friend of mine. It provides detailed information regarding preferred shares and how it differs from common shares.
Question: My broker recently asked me if I wanted to subscribe to the preferred shares of San Miguel. I was told that the preferred shares would pay me a guaranteed return of 8 percent a year. It is my first time to invest in preferred stocks and I am a little confused on the mechanics. Can you advise me?—Elisa Sagre by email
Answer: Preferred stocks are similar to common stocks in the sense that they also give you partial ownership in a company, except that you enjoy certain advantages over the common stockholders when it comes to receiving dividends. When you buy preferred stocks, you are guaranteed dividends on a regular basis, say quarterly or semi-annually. If the company fails to pay dividends on time, for example, the dividends will simply accumulate and you will still receive them all once the company is ready to pay.
This differs from common stocks where the amount of dividends and frequency of payment depend largely on the company’s board of directors. The company may or may not pay any dividends at all. In the event that the listed company goes bankrupt and liquidates all its assets to pay its creditors and suppliers, any excess cash will not be returned to common stockholders until all preferred shareholders are fully paid.
This sounds like a good deal, isn’t it? Well, buying preferred stocks is like investing in bonds. The dividends are like the interest income you receive regularly, except that in bonds, payment of interest income on time is assured. Companies who borrow money by issuing bonds are obligated to pay interest regardless of their financial situation. Payment of dividends for preferred shares, although the amount is guaranteed, may be suspended if the company has cash-flow problems.
Companies can also buy back preferred shares from you at the original offer price after certain number of years similar to the maturity period of bonds when you get back your principal. However, in preferred shares, there is no assurance that they will be redeemed on time. If the company is encountering financial problems, they may defer the redemption and make you wait indefinitely.
Preferred shares give companies the flexibility to delay payments of interest and principal when they experience financial distress. If these were bonds and they were unable to pay on time, they would be considered in default and this would seriously affect their credit rating. Companies who have already put in huge debt in their balance sheets normally use preferred shares to raise funds to avoid getting a credit risk downgrade.
Before you buy preferred stocks, make sure that the company is financially capable of paying its dividends on time. You can do this by reviewing its financial performance and track record of management.
Based on this, ask yourself, what is the probability that it will fulfill its promise to pay dividends consistently? Can the company generate enough cash flow to cover the projected dividends aside from the existing interest expenses that it is contractually obligated to pay?
Preferred stocks are also traded on the stock market but the price is not as volatile as that of common stocks because the valuation of preferred shares is not directly driven by earnings but rather by interest rate. Similar to bonds, because dividends are fixed and paid at regular intervals, the market value of preferred shares is easily affected by movements in interest rates.
If the interest rate goes up, the price of preferred shares would need to fall in order to match a better yield to investors. The opposite happens, on the other hand, when interest rate goes down.
Consider the recent offering of preferred shares of San Miguel, which are offered at P75 each. Each share has a fixed rate of 8 percent, which pays P6 or P75 x 8 percent per share annually.
To value the share price of the preferred share, simply divide the P6 annual dividend by the current interest rate, say 5 percent, and this will give you a projected market value of P120. If the interest rate goes up to 10 percent, the projected market value of preferred shares will fall to P60. Bear in mind that we are assuming your opportunity cost to place your money elsewhere is only 5 percent.
San Miguel offers three types of preferred shares. The first subseries called 2-A offers fixed rate of 7.5 percent with redemption period of five years, meaning the company has the option to buy back the shares after five years. The second subseries called 2-B has a longer redemption period of seven years but offer a higher rate of 7.625 percent and the third one at 10 years with an interest rate of 8 percent a year. Which one should you choose?
If you are risk-averse and want to play safe, you can choose the shortest redemption period of five years but at a lower rate of 7.5 percent a year. Why? Five years is a foreseeable future and with the track record of the company, you can safely assume that dividends will be paid faithfully as promised. The risk of delay increases as the holding period increases. What if the economy goes into recession due to a global economic crisis in few years? What if the new investments will not turn out to be profitable as initially expected? Will San Miguel still have the same management team in 10 years?
Preferred shares are a good investment if you are looking for regular income and stability. This is very ideal for people who want to try the stock market but do not want to lose their money. With the declining interest rate environment, preferred shares offer a safe haven for fixed income because they offer a higher yield and at the same potential appreciation especially if interest rates continue to fall.
It will be wise to allocate a portion of your stock investments in preferred shares to balance the overall risk of your portfolio.
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