Preference shares

There was some discussion on preference shares on my favorite financial blog. Here are my thoughts regarding this topic.

Someone wrote: I read in Benjamin Graham's The Intelligent Investor that the best time to buy them is during market turmoil when prices are depressed. )

Yes, I remembered that Benjamin Graham did mention that preference shares are to be bought on a depressed basis. Preference shares have certain characteristics that make it even more necessary to buy them on a depressed price than common shares.

When bought at or above par value (SGD100 in Singapore's context), preference shares do not take part in the profitable growth of the company. The company can announce 50%-100% profit growth, but the price of the preference shares will move up only a little. If you bought the common shares, it is possible to earn capital appreciation of more than 20% with this kind of performance. To appreciate this point, compare the price charts of UOB shares and UOB 5.05% NCPS from Mar 2008 onwards.

However, if you bought on a depressed price well below par value, the preference shares do participate in the growth of the company until the price reaches par value (but rise slowly after this point). When you buy preference shares on a depressed price, you enjoy both higher dividend yield and capital appreciation if the company recovers.

The best reason for not buying preference shares at non-depressed levels (above par) is that they decline more in adversity but do not rise much in prosperity. The dividends from preference shares are discretionary, not obligatory as in the case for bonds. Discretionary expenses are usually the first to be cut when a company is struggling. Hence, when the company starts announcing poor financial results, the fear of dividend cuts can drive the price down significantly. In any case, it is most likely to fall below par value.

Look at the price chart of the bank preference shares in 2008 and early 2009 to appreciate this point. In investing, if the downside exceeds the upside, you don't invest.

Also, when the banks redeem the preference shares, they will redeem it at par. So, if you bought the preference shares above par, you suffer a guaranteed loss in principal upon redemption. The dividends can cover this loss provided you have at least held the preferences shares for some time and the bank did not redeem the shares. Please at least check the date from which the bank has the option for redemption. I would not buy a preference share above par near the redemption date.

Now that most preference shares are trading above par, I personally will not buy them. Unfortunately, I was not smart enough to buy them in 2008 and early 2009 on a depressed basis. So much for talk only.