How to Use Preference Shares to Become an Absolutist Investor

Do you want to care about what the ASX200 is doing on a daily basis when you’re in retirement? We’ll rephrase the question in case you have a morbid sense of humour and enjoy Schadenfreude (you find pleasure in someone else’s misfortune). Do you want your retirement lifestyle to be reliant on what the ASX200 is doing on a daily basis?

Our guess is no.

If you don’t need convincing, you can skip a couple of paragraphs to find out what one alternative is. Although if you do have a morbid sense of humour and enjoy Schadenfreude, read on.

Now is not the time to presume and rely on capital gains as your strategy for retirement. In fact, it’s not the time to presume your assets will even hold their prices. There’s a good chance that selling out of assets will quite simply fail as a way to fund your retirement. Your cash could come up several years short. You need a different strategy.

Of course, if you want to dabble in the market with some of what Australian Small-Cap Investigator Kris Sayce calls your ‘play money’, go for it. But Kris would never council you to go to ‘punters paradise’ with the savings you need to live well. Yet that’s just what most Australians seem to be doing. They’ve placed their savings into investments that rely on capital gains – something that is hard to come by in an over-indebted economy.

We won’t go into the demographic issue much today. The irony of everyone relying on selling thus far unrealised capital gains to fund their retirement seems lost. How will prices be supported if young people aren’t foolish enough to buy the assets being sold en masse by their parents? Unless they are forced to by politicians…

So why did we mention the level of debt in our prediction of poor capital gains over the next few years? We quoted an American report on the topic yesterday. But that was far from the only analysis along these lines. As Australian economist and financial crisis predictor Steve Keen explained to an Irish panel of journalists, debt is a good thing if it finances investments. Because those investments pay a return that covers the debt.

But if debt is used to finance price speculation, that gives you a positive feedback loop. Higher prices encourage more debt funded speculation, which pumps up prices. Rinse, lather repeat. Once debt levels can’t be supported by income, the whole thing collapses. Especially asset prices.

If you think Julia Gillard, Tony Abbott and Reserve Bank Governor Glenn Stevens will save us, you should know government intervention just prolongs the unavoidable collapse. Their policies turn the crisis into a long downward spiral instead of the fire sale it should be for the prudent people who sat out the madness of debt fuelled speculation. The Japanese stock market and the US housing market, which is taking another turn for the worse, are perfect examples of this drawn out pain.

Japanese NIKKEI – 20 Years of Decline

Japanese NIKKEI - 20 Years of Decline

Source: Yahoo Finance

S&P/Case-Shiller Home Price Indices

If you’re waiting for a time to buy into the asset classes set to fall, you might have to wait a heck of a long time if governments keep trying to save us. The Japanese ‘lost decade’ has lasted twenty years. Considering how bailouts are the flavour of the day all around the world, it’s safe to assume this will happen in Australia.

Of course, market professionals will tell you now is the time to buy. When blood is in the streets, or so the saying goes. You’ve probably read about the Australians picking up American property at bargain prices. We wrote about why that advice is probably wrong when it comes to the stock market yesterday too. US property is probably the ‘least bad’ investment, which requires and assumes capital gains to pay off.

And that’s just the kind of thinking that’s a big no-no.

Economists and finance professionals are obsessed with analysing things in relative terms. ‘I outperformed the index by 5%,’ your super fund manager might have told you victoriously in 2008 when the ASX200 fell 40%. ‘We’re not the Gold Coast,’ Brisbane realtors will tell you after prices there crashed. ‘We’re not Queensland,’ their Victorian colleagues will tell you. ‘We’re not as bad as Greece,’ the Spaniards say. ‘We’re not as bad as Spain,’ the Italians say. ‘We’re not as bad as [insert political party].’

That’s a fat lot of good, isn’t it?

‘Everything is not relative,’ John Mauldin writes in his new book set to hit the virtual shelves soon. He’s published the promising first chapter. And this part stuck out like a Spanish bond yield:

‘In secular bull markets, an investor should search for assets that offer relative returns – stocks and funds that will perform better than the market averages. If you beat the market, you’re doing well. Even though there will be losing years, the strategy of staying invested in quality stocks during a secular bull market will be a long-term winner.

‘In a secular bear market, however, that strategy is a prescription for disaster. If the market goes down 20 percent, and you just go down 15 percent, you’d be doing relatively well, and Wall Street would call you a winner. Your broker would expect a pat on the back. But you are still down 15 percent.

‘In markets like those we face today, the essence of Bull’s Eye Investing is to focus on absolute returns.’

Amen. Now we don’t know if John Mauldin has figured out a way to generate those absolute returns. Especially when you factor in concerns over inflation. We’ll have to buy the book. (That marketing strategy worked well, didn’t it?) But there is a very valuable message in John’s opening chapter.

This isn’t the time to keep up with the Jones’ investment portfolio. Just like it wasn’t a good idea to keep up with the Jones’ debt financed lifestyle. Because they’re set to struggle. You want to be in a different game altogether. The absolutist investor game – where any gain is as valuable, where avoiding a loss is even more valuable, and where everyone else’s return doesn’t matter to you.

What kinds of investments serve that purpose?

Yesterday we mentioned dividend paying shares and a strategy to get the most out of them. Today, we have a similar idea – preference shares. Specifically, step up preference shares. These are practically made for absolutist investors faced with the scenario we wrote about yesterday – when you’re not sure if it’s time to buy.

Now they can seem a little complicated at first, so bear with us.

Step up preference shares work like this, according to the ASX website:

‘These securities normally pay a floating rate coupon and have a call date after a set period. If these securities are not called at the first call date then the coupon ‘steps-up’; to a higher rate to compensate investors for non-redemption. They are typically perpetual in nature.’

Here’s a scenario to explain how this works and where this type of investment comes into its own:

You buy a step up preference share of company XYZ for $100 at an interest rate of the Bank Bill Swap Rate (BBSW) + 3%. (The BBSW is the rate at which banks lend to each other for 3 months and is the common benchmark for many interest rate linked securities.) Today that would be a 7% dividend. (Preference shares have both debt and equity characteristics, so the terminology of interest rates and dividends is a little confusing.)

Over the next few years, the Australian economy struggles. A funding crisis develops in the Australian financial industry, driving up the BBSW because of perceived risk. That increases your dividend yield, because it is tied to the BBSW. But at the same time, the Reserve Bank of Australia lowers interest rates, which does indirectly affect the BBSW. For the sake of simplicity, let’s say the two moves in rates cancel each other out. The BBSW stays put. You are still earning 7%. Meanwhile, the ASX200 has halved.

A few years pass and the so-called ‘increased margin date’ comes to pass. This is where the ‘step up’ feature of a step up preference share comes into play. The company must, by a certain date, redeem the shares either by buying them back for cash at their par value ($100) or converting them into ordinary XYZ shares at a discounted price of 2.5% off the market price. If they don’t do either, the dividend calculation is ‘stepped up’ by a further 1%. So you would be receiving BBSW + 4%, an 8% dividend yield if the BBSW stayed flat.

The idea here is that you are generating cash at a good rate in times where capital gains are hard to come by, or riskier than they are worth. You are extremely likely to get your capital back from a preference share, so that isn’t really at risk compared to ordinary shares. Assuming you don’t sell out in the meantime, that is. Although, theoretically, the shares shouldn’t fluctuate as much as ordinary shares anyway.

Here’s why times like these add to the lure of step up preference shares.

If the company has enough cash lying around to buy back the shares on the increased margin date, it’s time to invest in another company anyway – one that is generating a return on its investment and wants your cash to do so. This would be the end of the story. You earned interest while others suffered capital losses. Now you’re ready to invest again at lower prices, or you could spend the money on the ‘superyacht’ you bought with proceeds from small-cap shares.

But if the company is struggling because of the difficult economic conditions, it will either convert the preference shares into ordinary shares, or pay out the increased 4% margin above the BBSW. Both of those results are advantageous to the holder, because you are either generating an even higher return on your investment in tough times, or are investing in a company right when you should – when it’s struggling. And at a discount to the market price.

We’ll be keeping an eye out for step up preference share offers. Please see a broker or financial advisor to determine whether preference shares are a suitable investment for you before investing in them.

In the meantime, here’s the key message: It will be important for you not to lose money on your investments. So don’t risk too much of it on capital gains.

That doesn’t mean you can’t have fun speculating. Another one of our fellow editors Murray Dawes, specialises in just that, but with a twist. This is a chart of how your starting capital would have grown with and without leverage if you had followed his recommendations:

Slipstream Trader Cumulative P+L

Source: Slipstream Trader

The reason this chart is important is because your capital would not have experienced a significant fall at any point. Unless you’ve experienced active trading first hand, you don’t understand just how impressive that is. Although it is an integral part of Murray’s strategy. Not to lose money is the first rule of many other famous investors too. But they won’t share their trades with you. Murray will.

He has also revealed the second integral part of his strategy here. Fans of Schadenfreude will enjoy the video immensely.


Nick Hubble
for Markets and Money

From the Archives…

A Sub-prime Crisis State of Mind
2012-04-20 – Bill Bonner

How The Belief in Australian Property Will Go With the Generational Wind
2012-04-19 – Greg Canavan

Chinese Communism and the Human Cost of the Cultural Revolution
2012-04-18 – Dan Denning

Lifting the Curtain on the Chinese Communist Party
2012-04-17 – Dan Denning

How Empires Really Work
2012-04-16 – Paul Craig Roberts

Nick Hubble
Nick Hubble is a feature editor of Markets and Money and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about Markets and Money, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails.

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