Chapter 10: Equity and property markets Flashcards
(15 cards)
What are ordinary shares?
Ordinary shares are securities held by the owners of an organisation.
Ordinary shareholders have the right to receive all distributable profits of a company after debtholders and preference shareholders have been paid. They also have the right to attend and vote at general meetings of the company.
Describe the cashflows on an ordinary share from the perspective of the investor
Share purchase:
* An initial lump sum negative cashflow equal to the price paid for the share plus dealing expenses.
Dividend payments:
* A regular series of positive cashflows representing a share in the company’s profits
* The timing of these payments is 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 subsidise dividends in poorer years
* The proportion of profits that a company decides to distribute as dividends is determined by the payout ratio, dividend per share / earnings per share.
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 the investor sells the share, or the compnay buys it back, or the company winds up and there is residual funds to distribute.
Suggest reasons why a company might want to buy back some of its shares
- The company may have excess cash that it cannot use profitably, so it decides to return it to shareholders
- The excess cash may only have been earning a deposit rate of interest, less than the return earned on the company’s other assets. Disposing of the cash should therefore improve the earnings per share for the remaining shares.
- It could be a tax-efficient means of returning capital to shareholders if the tax treatment of capital gains is more favourable than that of dividends.
- The company may wish to change its capital structure from equity financing to debt financing.
List the investment and risk characteristics of ordinary shares
- Security: The security will depend on the company issuing the shares. Dividend income depends on the stability of profits and payout ratio. Security of capital depends on NAV, level of gearing and the risk profile of the company.
- Yield: Higher expected long-term returns than government bonds. Expected to provide a real return over the long term.
- Spread: Potential for volatile markets (and dividends). Price is based on the assessment of the present value of future dividends.
- Term: No fixed redemption date, generally considered to be long-term and can be held into perpetuity.
- Expenses: Dealing costs are higher than for conventional government bonds, but this depends on the relative marketability of the stocks being compared.
- Exchange rate: There will be currency risk for an investor investing in equities denominated in one currency, but who has liabilities in another.
- Marketability: Marketability depends on the issuing company and whether it is listed or not - generally worse than for government bonds.
- Tax: Tax treatment depends on the territory, but are usually taxed on income and capital gains.
What are the advantages of listed shares over unlisted shares to the investor?
- Greater marketability
- Greater divisibility
- More information is available due to disclosure requirements
- Greater security, from stock exchange regulations.
- Easier to value.
It is practical for analysts to specialise in one area of industry because
- The factors affecting one company within an industry are likely to be relevant to other companies in the same industry
- Much of the information for companies in the same industry will come from a common source and will be presented in a similar way
- No single analyst can expect to be an expert in all areas, so specialisation is appropriate
- The grouping of equities according to a common factor gives structure to the decision-making process. It assists in portfolio classification and management
List 3 reasons for the correlation of investment performance within the same industry
- Resources - companies in the same sector will use similar resources, and wil therefore have similar input costs
- Markets - companies in the same sector supply to the same markets, and will therefore be similarly affected by changes in demand.
- Structure - companies in the same sector often have similar financial structures and will therefore be similarly affected by changes in interest rates.
Identify the practical difficulties that may arise with industry groupings
- Companies that operate throughout several sectors - i.e. conglomerate companies.
- The heterogeneity of companies within particular sectors
What is “prime” property?
Property that is most attractive to investors is called “prime”.
Prime property would score highly on all of the following factors:
* location
* age and condition
* quality of tenant
* the number of comparable properties available to determine the rent at rent review and for valuation purposes
* lease structure
* size
Describe the cashflow pattern of direct property from the perspective of the investor
Purchase of property:
* There will be an initial large negative cashflow when the property is bought, equal to the value of the property bought.
* If renovation is necessary another negative initial cashflow will occur
Rent income:
* Regular rent income will be received if the property is occupied by a tenant.
* These values are usually known both in amount and timing.
* The rent paid might be reviewed regularly to adjust for inflation, or it may remain fixed for many years.
* Regular negative cashflows might also occur due to maintenance.
* These maintenance costs are unknown both in amount and timing
Sell property:
* A large final positive cashflow will be received if the property is sold, equal to the value of the property at that time.
List the investment and risk characteristics of direct property
- Security: The security of income depends very much on the quality of the tenant. There is also a risk of “voids” - periods when the property is not let. Other risks include obsolescence - when a building becomes out of date and is no longer of use to potential tenants - and government intervention - such as rent and planning controls which limit the supply of property.
- Yield: Investors would expect to require a higher return from property due to lower marketability and security compared to index-linked government bonds. Property is also expected to provide a hedge against inflation.
- Spread: Capital values can be volatile over the long term, although infrequent valuations and stable valuation methods reduce short-term volatility.
- Term: Usually long term investments
- Expenses: Property management costs are high, although the tenant is often responsible for building maintenance and insurance.
- Marketability: Very unmarketable, as it can take a long time to buy or sell and dealing costs are high. This is because of the large unit size, uniqueness and valuation variations
- Tax: Tax treatment depends on the territory, but usually subject to income tax for rent and capital gains tax when selling.
What are the disadvantages of direct property holdings?
- Size - too big for most investors to afford
- Diversification - many properties are needed for diversification, but the size makes this impractical
- Lack of marketability - the time taken, and the costs associated, with buying and selling make properties unmarketable.
- Valuation - property values are never known until sale, and estimates of value can be expensive.
- Expertise needed - much of the profit to be made through property investment comes through detailed local knowledge. Many investors will not have the specialist expertise.
These disadvantages can be avoided by investing in indirect property arrangement. Discuss the different arrangements available
- Pooled property funds: These include open-ended unitised funds and losed-ended investment trusts. These vehicles normally have constitutions that specify the types of property that they can invest in, limits on liquidity, management charges that can be deducted from the fund etc.
- Property company shares: Exposure to real property can also be gained by investing in the shares of a property company. These can be property developers or property investors.
- Listed JSE REITs: Real Estate Investment Trusts (REITs) are companies that manage, operate and own a real estate portfolio consisting of income-producing property. These REITs operate in a strong legislative environment.
What is net asset value per share?
NAV per share is the value of the company’s assets divided by the number of shares.
Net assets in this definition means assets net of liabilities. We also net off intangible assets. This is because net asset value per share represents a company’s wind-up value per share. Upon wind-up, intangible assets such as goodwill are unlikely to have a significant value.
What does the discount to NAV reflect?
- Any differences between the way in which investors value shares and the way they value property.
- Risk of loss on forced sale - cashflow requirements result in property companies being more likely to be forced sellers of properties than institutions undertaking direct property investment on their own account.
A smaller discount, or possibly even a premium, to NAV is possible where:
* the market has a positive view of developments giving the potential for capital gains
* the valuations underlying the NAV are conservative
* the property company has a good management track record.
