The advantages of being a 'preferred' investor

PF University Today, I am going to teach you about four types of preference shares (and mention warrants) that a company can issue. Remember, preference shares are less risky than ordinary shares, but won't give you the same returns.

Last week we looked at ordinary shares as the most common way to invest in a company. Today, I am going to teach you about four types of preference shares (and mention warrants) that a company can issue. Remember, preference shares are less risky than ordinary shares, but won't give you the same returns - thought they may give you a better night's sleep. Preference shares offer specified payments on particular dates. Issuers prefer these instruments because the payment remains constant, and the investor may select them over bonds due to certain tax advantages. And remember: the dividends paid to investors take "preference" over dividends paid to ordinary shareholders.

Preferred shares can be either cumulative, where unpaid dividends will accrue until preferred shareholders have received full payment, or they can be non-cumulative, where preferred shareholders can impose significant restrictions on the company if a dividend is missed. Most preference shares are cumulative. Of course, one drawback of preference shares, when compared to ordinary shares, is that if the company starts to generate large profits, the ordinary shareholders will often see their dividends rise, whereas the preference shareholders still receive a fixed dividend. To counter this, an instrument called "participating preference shares" offers the opportunity to participate in higher distributions.

On the other hand, redeemable preference shares enable the company to buy back the shares at an agreed price in the future in order to remove any obligation the company may have to the shareholder. Convertible preference shares can be converted into the company's ordinary shares at a pre-specified price on a predetermined date. If they are not converted, they simply continue to entitle the shareholder to the same fixed rate of dividend until the stated redemption date. Please note that with convertible preference shares, investors can ultimately share in the fortunes of the company while enjoying a fixed rate of income in the meantime.

So, having learnt about ordinary and preference shares, how do we know which one to invest in? The answer lies in whether the conversion into the ordinary shares is at a premium or discount. Let me illustrate. ABC issues 7 per cent convertible preference shares at 110p (currently priced at 125p) that can be converted into the company's ordinary shares at the rate of five preference shares for one ordinary share. The ordinary shares are trading at 600p. Which would make the better investment? By using a fixed formula, we can calculate the premium or discount. So, applying the formula, we arrive at a premium of 4.2 per cent: [(5 x 125/600) - 1] x 100 = 4.2 per cent] making the ordinary cheaper than the convertible preference.

Nevertheless, you do get a fixed rate of dividend on the preference shares, which may be attractive enough compared to that being paid on the ordinary shares to justify this premium. Finally, I want to briefly mention warrants. These are issued by a company and offer the holder the opportunity to buy its ordinary shares at the "exercise price" at or during a specified period in the future. They are usually issued on a standalone basis to existing ordinary shareholders, or can accompany loan stock issues (such as convertible bonds) as an incentive to reduce the coupon rate. But they do not entitle the investor to dividends. Another type of warrant is a covered warrant. These are warrants issued by firms (usually investment banks), rather than the company.

Like options, which I shall deal with later, warrants (including covered warrants) are highly geared investments, and can be volatile. A modest outlay can result in a large gain, but you can lose everything, since their value is driven by the length of time for which they are valid, and the value of the underlying asset. In other words, they are not for the faint-hearted. John McGaw is a financial adviser based in Dubai. Contact him at [e-mail]