Preference Shares Explained

Preference shares (also commonly known as preferred stocks) are those shares that enable shareholders to receive the dividends announced by a company before receiving to the equity shareholders.

The yield of preference shares are good, which makes this type of  shares very attractive to those who are seeking to generate a stable income from their portfolio over the long term without taking on too much risk.

Quick Overview of Preference Shares

✔️What are company shares?
✔️What are ordinary shares?
✔️What are preference shares?
The Companies Act and preference shares
Why do companies issue preference shares?
Features of preference shares
Classes of preference shares
Preference shares trading

What are company shares?

A company share represents one unit of ownership in a company, allowing particular rights for the owner of the share.

Basically, company shares are categorized into two classes, namely ordinary shares, also called common shares and preference shares.

What are ordinary shares?

An ordinary share entitles the shareholder to partial ownership of a company with other shareholders and to certain rights, such as voting rights.

What are preference shares?

Preference shares, as with ordinary shares, grant the shareholder partial ownership of a company and certain preferential rights over ordinary shareholders.

Preference shares are also called preferred stock.

The Companies Act and preference shares

The Companies Act (Act 71 of 2008) regulates the authorization and issue of the various classes of shares by a company, including preference shares.

With regard to shares in general, and preference shares in particular, the following regulations* in the Companies Act are, inter alia, noteworthy:

• Chapter 2, Part D, Section 35 (1)

A share issued by a company is moveable property, transferable in any manner provided for or recognised by this Act or other legislation.

• Chapter 2, Part D, Section 35 (3)

A company may not issue shares to itself.

• Chapter 2, Part D, Section 35 (4)

An authorised share of a company has no rights associated with it until it has been issued.

• Chapter 2, Part D, Section 36 (1)

A company’s Memorandum of Incorporation –

• must set out the classes of shares, and the number of shares of each class, that the company is authorised to issue;
• must set out, with respect to each class of shares –
• (i) distinguishing designation for that class; and
• (ii) the preferences, rights, limitations, and other terms associated with that class, subject to paragraph (d);
• may set out a class of shares –
• (ii) for which the board of the company must determine the associated preferences, rights, limitations, or other terms, and
• (iii) which must not be issued until the board of the company has determined the associated preferences, rights, limitations, or other terms, as contemplated in subparagraph (ii).
• Chapter 2, Part D, Section 36 (2)

The authorization and classification of shares, the numbers of authorized shares of each class, and the preferences, rights, limitations and other terms associated with each class of shares, as set out in a company’s Memorandum of Incorporation, may be changed only by –

• an amendment of the Memorandum of Incorporation by special resolution of the shareholders; or
• the board of the company, in the manner contemplated in subsection (3), except to the extent that the Memorandum of Incorporation provides otherwise.
• Chapter 2, Part D, Section 36 (3)

Except to the extent that a company’s Memorandum of Incorporation provides otherwise, the company’s board may –

• increase or decrease the number of authorized shares of any class of shares;
• reclassify any classified shares that have been authorized but not issued.

* Accentuations by the article writer.

Why do companies issue preference shares?

When a company needs more money to, inter alia, expand its operations or start new projects, there are a variety of options the board of the company can utilize to obtain the money. Such as:

• Issue more ordinary shares, that could dilute the value of the shares already issued.
• Borrow money from lending institutions to finance projects. This option means more interest to be paid and it could jeopardize the company’s leverage position.
• Issue bonds, which is also a way to borrow money.
• Issue preference shares, which actually is a combination of the two options above.

Features of preference shares

The types of shares issued by a company are distinguished from each other based on the benefits, rights, and features associated with them.

Preference shares are hybrid securities that include features of debt (fixed dividends) and equity (capital appreciation), meaning it is a debt instrument and a type of share combined.

As a debt instrument, preference shares include the following features:

• Preference shares enable companies to raise money at a moderate interest rate, implying that a company’s cost of money is less than when the money is raised from outsiders. Typically, the interest rate attached to preference shares is linked to the prime interest rate.
• Eventually, preference shareholders have to be paid back their initial investment (capital amount) after a certain period of time.
• Holders of preference shares receive fixed returns in the form of guaranteed preference share dividends.
• Preference shares carry a higher risk than other types of debt instruments because interest payments to lending institutions have the preference above dividend payments to the shareholders.
• Preference shareholders are second in line to receive capital repayments after lenders and bondholders when a company goes bankrupt and is wound up. However, preference shareholders will be paid ahead of ordinary shareholders.

Preference shares comprise the following features as an equity instrument:

• Preference shares behave like ordinary shares in that their prices can rise and fall over time as they are traded.
• Preference shareholders are not granted voting rights at annual general meetings (AGMs) of a company. Therefore, a preference shareholder cannot influence a company’s policies or the decisions of the board of a company. They also have no say in the selection of the board of directors.
• If the company is profitable, preference shareholders will receive a specified percentage dividend.
• Usually, the dividend rate on preference shares is fixed. Hence, the dividend is more regular and steadier than dividends with regard to ordinary shares.
• Regarding dividends, preference shareholders enjoy preference over all holders of ordinary shares.
• Preference shares carry a lower risk than ordinary shares.

Classes of preference shares

There are various classes of preference shares, including cumulative, non-cumulative, redeemable, participating, and convertible preference shares.

Cumulative preference shares

With this class of share, when a company is not able to pay guaranteed dividends due to insufficient profits in a particular financial year, the dividend is accumulated and carried forward to successive years. The ‘outstanding’ dividends will be paid when financial results have improved to allow the distribution of dividends.

Preference shares are cumulative by default unless explicitly stated differently.

Non-cumulative preference shares

Contrary to cumulative preference shares, the unpaid dividends of non-cumulative preference shares of a particular financial year are not carried over to the following year. Hence, holders of this type of share forfeit the right to the particular financial year’s dividend.

Redeemable preference shares

Redeemable preference shares are issued with the provision that the company that issued the shares has the option to redeem the shares at some date in the future. Put differently, the board of directors is allowed to buy the shares back and withdraw them from circulation to the public.

The shares can be redeemed either at a fixed rate on a specific date or over a specified time period.

Upon redemption, the company will be obliged to pay all the accrued distributions to the holder of the preference shares as well as all other amounts owed to the particular shareholder. The company is required to follow section 46 of the Companies Act which regulates as follows: ‘A company must not make any proposed distribution unless the distribution is pursuant to an existing legal obligation of the company, or a court order; or the board of the company, by resolution, has authorised the distribution.’

Companies can use the redeemable option of this type of preference shares to their advantage. For example, if redeemable shares are issued with a guaranteed 7% dividend but interest rates dip to 4.5%, then the board of directors can buy back any outstanding shares at the market price, then reissue those preference shares with a lower dividend rate. Hence reducing the cost of capital.

Therefore, redeemable preference shares can be a disadvantage to shareholders.

Participating preference shares

Holders of participating preference shares are entitled to the surplus assets and profits of a company after all the shareholders have been paid what is owed to them while non-participating shareholders are only entitled to their fixed dividends.

Convertible preference shares

Convertible preference shares have the option available to be converted into ordinary shares at the request of the company on specified terms. However, upon conversion, a preference shareholder will lose its preferential rights, obtaining the same rights as an ordinary shareholder.

Preference shares trading

Preference shares are an appropriate option for risk-averse equity investors. They are used by professional and private investors who prefer a medium risk and return.

Typically, preference shares are less volatile than ordinary shares, providing a steadier income flow of dividends. In addition, they provide investors with more options than ordinary shares, for example, the advantages pertaining to convertible and cumulative preference shares.

Professional investors recommend that an investment portfolio should include around 10% – 15% of preference shares. A further recommendation is that an investor should keep preference shares for around 5 years – the longer they are kept, the more income they will generate.

The Johannesburg Stock Exchange (JSE)

In South Africa, preference shares are traded on the Johannesburg Stock Exchange (JSE). They are listed on the JSE in the same way ordinary shares are.

To trade preference shares on the JSE an investor is required to open a brokerage account with a JSE equity member, also referred to as an accredited stockbroker.

Preference shares do not trade as much as the ordinary shares of the Top 40 companies on the JSE. However, investors find preference shares appealing because they provide a safe and steady income.

In addition, they offer significant returns. For instance, in 2019, the preference shares of 8 companies outperformed the Satrix 40 ETF, an investment that tracks the 40 companies listed on the JSE by market capitalization, as shown in the table below. Returns include dividends, except for the Invicta Preference Share.

Source: FSP Invest

Exchange Traded Funds (ETFs)

Certain exchange traded funds (ETFs) also offer opportunities for preference shares trading.

The JSE defines an ETF as ‘a listed investment product, which tracks the performance of a particular index (e.g. FTSE/JSE Top 40 Index) or “basket” of shares, bonds, money market instruments or a single commodity. These are known as underlying securities or assets.’ (Accentuation by article writer.)

An ETF is traded on an exchange just like an ordinary share. The price of an ETF is determined by supply and demand. An ETF is also an ideal investment for a novice investor.

Some benefits of ETFs:

• Diversification – ETFs enable investors to invest in a number of asset classes through a single listed investment product.
• Regulation – ETFs are well regulated by both the JSE and the Financial Sector Conduct Authority (FSCA), adding protection against unfair treatment.
• Entitled to dividends – Investing in an ETF does not give direct ownership of the underlying securities, such as preference shares, of the index being tracked. However, the good news is that the owner of an ETF is still entitled to receive dividends should the securities (preference shares) in the tracking index pay dividends.

The CoreShares PrefTrax ETF tracks the FTSE/JSE preference share index.

EasyEquities explains that the FTSE/JSE preference share index ‘measures the performance of nonconvertible, floating rate perpetual preference shares (these are the most standard form of preference share which cannot be converted to ordinary equity or recalled by the company).’

Banks represent 89.4% of the preference equity fund. The top three banks are:

• Standard Bank – 18.7%.
• FirstRand – 15.9%.
• Investec – 15.8%.

Note: This article does not intend to provide investment or trading advice. Its aim is solely informative.

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