Preference Shares and Share Splits

Q. What are Preference Shares?

Recently I've heard of banks issuing preference shares - how are these different to ordinary shares and am I better or worse with preference shares (when compared to ordinary shares?)

A: Unlike ordinary shares, preference shares have a 'face value' - e.g. £100, and a fixed dividend, e.g. £10 (usually quoted as a percentage - 10%). Preference dividends are fixed, so they do not participate in increases (or decreases) in profits as ordinary shareholders do.

In this case, the shares are similar to a loan - there are, however, some key differences:
  1. The preference shareholders come later in the queue if the company goes bust and the creditors get the proceeds of liquidation. Normally, loans (bonds) to banks rank equal to, or higher, than depositors*. However, preference shares come after loans, but before ordinary shareholders. However, in the event that the bank doesn't have enough cash to pay its depositors, then the preference shares are worthless.
  2. Unlike a loan repayment, the dividends on the preference shares may be defaulted on without penalty - however, there is a provision that the arrears (and accrued interest) must be repaid as soon as practicable, and no dividend may be paid to ordinary shareholders until preferred dividends are fully up to date.
  3. Unlike a loan, preferred shares are perpetual - there is no fixed repayment date. However, there is usually a provision for repayment. e.g. if the preference shares are more than 5 years old, the company may buy them back at a 10% premium to face value. The presence of the preference shares is highly damaging to ordinary shareholders because of the high, fixed, dividend that must be paid in preference to ordinary shareholders, as a result there is motivation for the company to buy back and cancel the preference shares as soon as it can do so.

So, preference shares have a lower risk than ordinary shares, produce a good income, but have less scope for capital growth (because of the fixed dividend).

* - this has been the traditional capital structure of banks. The ordinary bond holders, depositors, staff, etc...come first. Then subordinated bond holders, then preferred shareholders, and finally ordinary shareholders. Each step takes a higher risk, in return for a potentially higher gain. Bonds pay low rates of interest, subordinated bonds pay more.

Q. So are Preference Shares like Loans taken at LIBOR?

A: No, not really - LIBOR is the rate for short-term loans - up to 1 year max. Preference shares represent a dose of cash that doesn't have to be paid back as long as the company survives. The other issue is the a loan at LIBOR must have all its payments made on time, and repaid in full on the due date. If the loan isn't paid, then the lawyers start getting limbered up, creditors start filing for involuntary bankruptcy, and things generally get unpleasant. Whereas with preference shares, dividends may be missed if cash-flow doesn't permit their payment.

Finally, preference shares come late in the queue if the company does default on their debt - making severe loss likely.

In view of the indefinite duration of this 'loan' and the high risk associated if the company does go bust, the risks to the buyer of these shares is hugely higher, and so a higher rate is required. Look at some of the recent capital raising by the banks - the new shares (ordinary shares, so even higher risks) were sold or placed a huge discount - basically giving anyone buying them an instant profit (or it would have done, had the share prices not collapsed in the interim).

12% isn't unreasonable for a preference share dividend - especially given the tight credit now. Warren Buffet has for instance loaded up on new preferred stock in Goldman Sachs and General Electric. In both cases, he's getting 10%. In the case of GS, there's the option for GS to buy the shares back after 3 years for a 10% premium - if they take that option at the first opportunity, that's a return of 13.3%.

From the bank's point of view, this is very important. These shares are to raise capital - in other words, liquid assets which won't disappear unless deliberately used. Loans at LIBOR don't provide that, they provide cash, which is liquid, but it will be called away - and it may not be available in the future (as a number of banks have found to their cost). Capital, therefore, provides a buffer to cover temporary shortfalls in funding, and sudden demands for cash. It isn't a substitute for the money markets (which is where a number of banks go to get funding for business operations) but complementary - in particular, the presence of the capital provides a big cushion against default of shorter term loans or, indeed, bank runs.

A well capitalised bank is therefore more stable and more trustworthy. It won't fix a broken business model (e.g. borrow short, lend long), but it's one component that helps build trust. The government's plan is that if you can force all banks to have a huge capital cushion, then you can improve trust enough that interbank lending becomes possible, and depositors won't be so keen to run the banks.

It's a risky move. It may work, but the rot runs deep, and the sheer quantity of poor quality assets is vast, and the total amount of capital is relatively trifling in comparison.

Q.:  What is a Share Split?

A: A share split increases the number of shares available for trading in a public company. The company's market capitalizationi is not changed since the share price is adjusted according to the terms of the split. Nor do shareholders suffer any decrease in the value of their holdings or any dilution, although they have no option but to accept a split if one happens.

For example, if a shareholder owns 10,000 shares of UK plc at £10 on the record date of the split, then that stake in the company is worth £100,000. A two-for-one split - which could also be described as a one-for-one 'bonus issue' - would mean the investor owns 20,000 shares priced at 500p. Splits can take place on any basis, although the most common is two-for-one. Stock splits are useful to enhance the a company's shares' liquidity.

A share consolidation is the opposite of a stock split, which explains why they are sometimes known as reverse splits. The number of shares available to trade in a public company is reduced and the share price is adjusted upwards accordingly. As in the case of stock splits, the value of a company, and shareholders' stakes in it, are in no way affected. Consolidations can be associated with a company whose share price is low because it is in distress.

A consolidation can also lower the bid-offer spread and reduce volatility in a share price, boosting liquidity in a stock. This may be the case with a penny share as the spreads may be too high if the share price is too low (as everyone assumes it has been higher in the past).

However, in practice I can say that very few consolidations work - I have seen so many share consolidations over the last 20 years fail miserably. They only work if the company has seriously good prospects - which have to start happening within days/weeks of the consolidation - and if this is the case why really bother consolidating?

 ...Continues here - Yield, Ex-Dividend and Record Date

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