Ch 10: Equity and property markets

Question 1

Define the term ordinary share

Answer 1

Ordinary shares are shares in the ownership of a company.

Ordinary shareholders have the right to receive all distributable profits of the company after debtholders and preference share holders have been paid. They also have the right to attend and vote at general meetings of the company.

Question 2

List 11 investment and risk characteristics of ordinary shares

Answer 2

1) Income = dividends = share in company’s profits
2) Capital gain may arise on sale of share.
3) Default risk depends on security of issuing company.
4) Security of capital depends on NAV, level of gearing and risk profile of issuing company.
5) Higher long-term expected return than government bonds
6) Expected to provide a real return in the long term
7) Term: no fixed redemption date, generally considered to be long term
8) Potential for volatile markets (and dividends)
9) Dealing costs higher than for conventional bonds.
10) Marketability depends on the issuing company and whether listed or not - generally worse than for gov bonds
11) Tax treatment depends on territory

Question 3

Describe the cashflows on an ordinary share from the perspective of the investor

Answer 3

1) Share purchase:
An initial lump sum negative cashflow equal to the price paid for the share plus dealing expenses.

2) Dividend payments
- A regular series of positive cashflows representing a share in the company’s profits
- The timing of these payments are generally known
- The amount is unknown and variable
- Over time, profits, and hence dividends, are expected to increase broadly in line with growth in GDP
- The company may choose not to distribute all of its profits but to retain some for new projects, expansions or to subsidize dividends in less profitable years.

Final payment:
- There is no redemption payment, dividends can be assumed to continue indefinitely
- However, there will be a final positive cashflow, which is unknown in amount and timing if:
1) The investor sells the share or the company buys it back
2) The company winds up and there is residual funds to distribute

Question 4

What are the advantages of listed shares over unlisted shares to investors

Answer 4

1) Greater marketability
2) Greater divisibility
3) More information is available, due to disclosure requirements.
4) Greater security, from stock exchange regulations
5) Easier to value

Question 5

It is practical for analysts to specialise in one area of industry because…

Answer 5

• Factors affecting one company within an industry are likely to be relevant to other companies in the same industry.
• Information for companies in the same industry will come from a common source and be presented similarly.
• No one analyst can expect to be an expert inn all areas, so specialisation is appropriate.
• The grouping of equities according to some common factor gives structure to the decision-making process. Assists in portfolio classification and management.

Question 6

What are 4 practical reasons for analysing shares by industry?

Answer 6

1) Most companies within an industry are affected by similar factors.
2) The information about these companies tends to come from a common source and is presented in a similar way.
3) No-once can be an expert in all areas
4) It adds structure to the decision-making process.

Question 7

List 3 reasons for the correlation of investment performance in the same industry

Answer 7

1) Resources
Companies in the same sector will use similar resources and will therefore have similar input costs.

2) Markets
Companies in the same sector supply the same markets, and will therefore be similarly affected by changes in demand.

3) Structure
Companies in the same sector often have similar financial structures and will therefore be similarly affected by changes in interest rates.

Question 8

Why are market movements the biggest influence on a share’s price

Answer 8

1) Most companies are affected by macro-economic factors and the political climate in similar ways.
2) Most companies’ costs are affected by similar factors (e.g. tax, labor markets, cost of borrowing, fuel costs)
3) Many investors are interested in equities as a whole rather than in specific shares, because:
- The equity market appears attractive compared to another market.
- Investors have real liabilities
- Regulation and tax breaks tend to favor equities
4) Many investors invest passively rather than actively seeking out specific shares, because:
- They believe the costs of active management are not sufficiently compensated for by the extra return.
- They lack the expertise

Question 9

Investment and risk characteristics of equities

Answer 9

• Security and returns depends on profitability of company
• Provide a long-term real yield as companies grow in line with inflation, dividends tend to grow in line with GDP
• Higher expected returns than government bonds, over the long-term
• Income and capital values can be volatile
• Equities can generally be held in perpetuity
• Dealing expenses are linked to marketability
• Marketability depends on the size of the company

Question 10

Quoted shares

Answer 10

Listed on a stock exchange and make up the majority of available equity investment

Question 11

Investment characteristics of quoted shares

Answer 11

• More marketable
• Mare secure
• Easier to value
  than non-quoted shares

Question 12

Preference share

Answer 12

A particular class of share that generally ranks ahead of ordinary shares.
Normally entitled to a specific rate of dividend, and, unlike ordinary shareholders, not to residual profits.

Question 13

Typical features of preference shares

Answer 13

• Dividend on a preference share is usually a fixed percentage of the par value and is always paid before any distribution to ordinary shareholders.
• Dividend on preference shares is normally treated in the same way as ordinary shares for tax purposes.
• Dividend rate is quoted net of tax
• Dividends don’t have to be paid if profits are insufficient
• Mostly no final redemption date
• No voting rights

Question 14

Cumulative property of preference shares

Answer 14

If a dividend is unpaid, the arrears must be paid off before any payment is made to ordinary shareholders

Question 15

Payout ratio

Answer 15

Dividends per share/Earnings per share

Question 16

Reasons for buying back shares

Answer 16

• Excess cash that cannot be used profitably and is returned to shareholders.
• Excess cash may only earn deposit rate of interest, thus improves earnings per share of remaining shares.
• May be more tax-efficient than dividends.
• Company may wish to change capital structure from equity financing to debt financing.

Question 17

SYSTEM T

Answer 17

Security
Yield
Spread
Term
Expenses and exchange rate
marketability

Tax

Question 18

Direct property investment

Answer 18

Involves the purchase and management of tangible assets.
Are large and indivisible.

Question 19

List 14 investment and risk characteristics of direct property

Answer 19

1) Risk of voids and tenant default
2) Risk of political interference
3) Risk of obsolescence and need for refurbishment
4) Real return, broad hedge for inflation
5) Higher expected return than for government bonds
6) Income forms a ‘stepped’ pattern over time
7) Running (rental) yields varies by the type of property.
8) Volatile capital values in long term, stable capital values in short term
9) Subjective infrequent valuations, lack of information
10) High dealing and management costs
11) Very unmarketable
12) Larger unit sizes, indivisibility
13) Uniqueness
14) Characteristics can be changed by owner (e.g. redevelopment)

Question 20

Investment and risk characteristics of property to be considered

Answer 20

MUST PROVIDE FIVE

M - marketability
U - uniqueness
S - size
T - type of property (determines running yield)

P - political risk
R - real long-term returns
O - Obsolescence
V - valuation
I - indivisibility
D - diversification
E - high management and dealing Expenses

F - forced sales
I - stepped Income stream
V - volatility
E - Expertise

Question 21

What ti consider when comparing direct to indirect property investments

Answer 21

CEDE MEET VVFG

C - control
E - expenses
D - diversification
E - expertise

M - marketability
E - exposures to other sectors
E - equity correlation
T - taxation

Volatility
Valuation
Gearing
Forced sales

Question 22

On what factors would a prime property score highly?

Answer 22

1) Location
2) Size
3) Tenant quality
4) Age, condition and flexibility of use
5) Lease structure
6) Comparable properties for rent reviews and valuations

Question 23

Property as a hedge

Answer 23

Property is a real asset and would be expected to provide a hedge against unanticipated inflation

Question 24

Define freehold ownership of a property and outline the rights and restrictions of the freeholder

Answer 24

Freehold ownership is ownership in perpetuity.

Rights are:
1) To occupy the building or to let it out
2) To refurbish the property

Restrictions include:
1) Covenants
2) Easements such as right of way
3) Planning and building regulations
4) Statutory requirements not to cause a nuisance to others

Question 25

Easements (property)

Answer 25

Specific rights acquired by someone other than a londowner or tenant

Question 26

Unencumbered freehold property

Answer 26

No existing tenant, i.e. freeholder may choose to:
- Add value by re-developing and/or refurbishing
- Set up a lease and receive rents

Question 27

Indirect property investment

Answer 27

Investments via shares in property companies or units in a pooled property fund

Question 28

Give 3 examples of indirect property investment

Answer 28

1) Open ended schemes, such as property unit trusts
2) Closed ended schemes, such as property investment trust companies
3) Shares in property (development/investment) companies

Question 29

Marketability of property

Answer 29

• Very unmarketable
• It can take a long time to buy or sell and dealing costs are high

Question 30

3 characteristics that make property unmarketable

Answer 30

• Unit size
  Large and indivisible (in general)
• Uniqueness
  Each property is unique
  Makes it harder to value, reducing marketability.
• Valuation
  Requires professional judgement.
  No central market with quoted prices.
  There may be significant variations in valuations carried out by different valuers or by the same valuer on different bases.
  Lack of information due to infrequent sales.

Question 31

Security of property income

Answer 31

• Depends on the quality of the tenant
• Rent payable as a company is a prior charge on its profits, but costs of recovery from tenants in arrears can be high.
• There is a risk of “voids,” which are periods when the property is not let

Question 32

What is obsolescence (direct property)

Answer 32

• Slowdown in the relative rate of growth in value between old and new buildings.
• Need for modernisation: large expenditure

Susceptible to government intervention such as rent and planning controls

Question 33

Spread (direct property)

Answer 33

Capital values of buildings can be volatile over the longer term, although infrequent valuations and stable valuation methods reduce short term volatility

Question 34

Yield (property)

Answer 34

Less marketable and less secure than index-linked government bonds.

Investors thus require a higher return from property.

Question 35

Expenses (Direct property)

Answer 35

Property management costs are high and includes regular maintenance and insurance.

Question 36

5 Disadvantages of direct property holdings

Answer 36

• Size
• Lack of diversification
• Lack of marketability
• Valuations difficult and costly
• Expertise needed

Question 37

Advantages of direct property investment

Answer 37

• Less volatile than property shares
• Control over property portfolio management
• Loss on forced sale unlikely
• Inflation linked returns, and the property asset itself should also grow in value over time

Question 38

Advantages of indirect property investment

Answer 38

• Diversification within the property market (property companies offer greater spread of risk)
• Market prices/performance measurement
• Marketability, property shares are more marketable than direct investments
• Management expertise not needed (company can afford expertise)
• Advantage of size (large companies may invest in large properties, too big for direct investors)

Question 39

Financial gearing w.r.t. property investment

Answer 39

Commercial property investments often provide secure income streams, making property investment/development companies ideal vehicles for financial gearing

Question 40

Discount to net asset value w.r.t. property investment

Answer 40

• Property shares usually stand at a discount to NAV
• Property assets may be purchased cheaply

Question 41

Why are shares grouped by industry sectors?

Answer 41

• Practical for analysts to specialise in one area.
• Share prices for companies in the same sector tend to be correlated

Question 42

Shares of companies in the same sector are correlated because…(3)

Answer 42

• Use the same resources and thus have similar input costs
• Supply to the same market, similarly affected by demand
• Similar financial structures, i.e. influenced by changes in interest rates

Question 43

Investment and risk characteristics of equities

Answer 43

• Security depends on profitability of the company
• Provide a long term real yield as companies grow in line with inflation, dividends tend to grow in line with GDP
• Higher expected returns than gov bonds over the long term
• Income and capital values can be volatile
• Equities can generally be held in perpetuity
• Dealing expenses are linked to marketability
• Higher dealing costs than gov bonds
• Less marketable than gov bonds
• Marketability depends on the size of the company