by WWM | Nov 8, 2017 | Equities
Most readers have traded common shares of individual companies.
The main method is to buy and sell shares on the open market through a brokerage account.
However, you can invest in public companies using other means. Many investors acquire common shares through public offerings, direct stock purchase plans, dividend reinvestment plans, employee stock purchase plans, and warrants. Often, these methods can be excellent ways to save costs, while building your investment portfolio.
Public Offerings
Investors may acquire shares through a “Direct Public Offering” or “public offering”.
Companies that go public for the first time have an “Initial Public Offering” (IPO) for its shares.
Existing public companies may have “Subsequent Public Offerings” or “Follow-On Public Offerings” when issuing additional shares to the public. You may also see other derivations of these terms.
In my experience, public offerings have mixed results for small investors.
Stock offerings have a maximum number of shares issued. If the offering is popular, there is a good chance that it will be fully or over-subscribed (more investors want shares than are being offered).
In the investing realm, large investors (mutual funds, pensions, wealthy individuals, etc.) are usually accommodated to a greater extent than small. For popular offerings, you may not be able to get any or all of the shares you desire.
If there is greater demand than supply, investors that cannot purchase all their shares in an IPO may do so on the open market once the shares begin trading.
Use caution if you follow this strategy. As with everything, when there is excess demand, prices rise. The greater the excess, the higher the price shoots until equilibrium is reached.
For very popular issues, the share price may rise simply on the excess demand and not on the company’s fundamentals. When this occurs, it is common to see the share price increase rapidly above the issue price in the initial few days of trading. It is also typical in these circumstances to look at the share price a year later and see that it has fallen significantly to reflect reality, rather than hysteria.
For example, The Blackstone Group (symbol: BX) issued an IPO in June of 2007 at $31 per share. Shares traded between $34.25 and $38.00 and closed at $35.06 on June 22, the initial day of trading. If you had been part of the IPO at $31, you could have earned between 10.5% and 22.5% (before transaction costs) in one day. A very nice return.
However, if you were one of the investors who had scrambled to buy this stock in the open market on June 22, your returns might have been a little different. One week later, at the end of June, your shares were only worth $29.27. At the end of July 2007, $24.01. The end of August 2007, $23.13. And so on.
After an initial frenzy, the shares settled back to where the fundamentals indicated they should trade. As for fundamentals, we shall look at this topic when reviewing how to analyze stock.
Over time, Blackstone shares have had ups and downs. As low as $4.51 in January 2009. As high as $43.80 in April 2015. In December 2016, Blackstone traded just under $30.00. Had you bought in the IPO or on the initial trading date, you would hold an unrealized capital loss after all this time. Not as nice as flipping the IPO immediately.
Yes, there are many examples where the IPO kept going up in price. This further complicates the issue of small investors buying IPOs once they begin to trade.
When investors bought Blackstone on the initial trading day, every one of them believed they were buying the next Alphabet Inc. Better known as Google (symbol: GOOGL). Google issued its IPO in 2004 at $85 and closed its opening day at $100. Over the next 52 weeks, Google never traded below $100. It traded at $280 a year later, and sat in December 2016 at $808. That also does not factor in the 2014 stock split which brought shareholders substantially more value.
But it does not work out this way very often.
When buying an IPO or shares in the open market, do not pay for the excess demand. Always buy based on facts, not hype. You may miss out on a few Googles, but you will also avoid purchasing the many Blackstones.
As an aside, Blackstone is a decent company. A reason I chose it here. Easy to take a fly by night company selling vapour-ware and see why it fell from favour. But plenty of real and profitable companies whose shares still suffer from IPO over-enthusiasm. Every stock looks very promising at IPO time. Be careful.
Open Market Purchases
Most investors buy and sell shares on the “open market”. Also known as the “secondary market” or “aftermarket”.
The open market may be a formal stock exchange (e.g., New York Stock Exchange [NYSE]) or “over the counter” (OTC).
OTC shares trade via a dealer network and not on a formal exchange. OTC stocks may also be called “unlisted” shares.
To purchase shares on the open market, you require a brokerage account. Further, you need to ensure that the brokerage house where you have your account is entitled to trade shares on the markets you desire.
For example, I use one on-line broker that allows me access to all major Canadian and US stock exchanges. But they do not have access to exchanges outside North America. I must use another broker to trade equities in Europe and Asia.
I believe most investors should trade via low-cost, on-line accounts. I see little value, for most investors, in using premium, full-service brokers. Your bank likely offers relatively easy to use on-line brokerage accounts.
Online brokers tend to offer adequate products and services to meet most investors’ needs. It is not difficult to trade on your own via your own bank. Just be wary if they try to “help” you purchase their own in-house products.
Direct Stock Purchase Plan (DSPP)
DSPPs allow individuals to purchase shares directly from a company (or transfer agent).
The benefit of DSPPs is that investors can acquire shares without paying a commission on the transaction. In today’s low cost on-line broker world this is less important, but every penny saved is useful in compounding returns for future growth.
A potential downside of DSPPs is that usually there is a minimum purchase amount. This may be higher on the initial purchase and then lower for subsequent acquisitions.
Employee Stock Purchase Plan (ESPP)
If you work for a public company, you may encounter an ESPP.
ESPPs allow eligible employees to acquire company shares with no transaction costs. Even better, the shares are normally offered at a discounted price to market value. This can be a very nice perk for staff.
The discounted share price incentivizes employees to invest in their company versus other investment options.
In return, the company has shareholder employees with a vested interest in the firm’s performance. As such, staff will work harder to ensure that the company does well financially and that its share price increases. Well, that is the idea.
Some ESPPs have restrictions on selling shares (e.g., an initial period of time where shares cannot be sold), but often there are no restrictions on trading. Also, depending on the discount value, there may be tax implications at purchase.
Dividend Reinvestment Plan (DRIP)
DRIPs are also helpful in avoiding commissions. One of my favourite investing recommendations.
DRIPs allow investors to reinvest any cash dividends, they are eligible to receive, into additional shares of the company. Often this results in the purchase of fractional shares based on the dividend amount.
DRIPs are nice as they help investors (hopefully) compound investment returns by adding to their existing shares in the company. The additional shares, in turn, result in their own future stock dividends, and so on throughout the future.
DRIPs are an easy way to invest. Without thinking or acting, you automatically acquire additional shares of the company.
One problem with DRIPs is that, in most countries, you are taxed on the dividend as if you received the cash.
For example, you are entitled to receive a dividend of $1000 that is reinvested in additional shares of the company. You receive shares and not cash. However the tax man usually still wants his share of your earnings. If you have a 30% marginal tax rate, you must find $300 to pay for tax on income you did not actually receive.
Another thing to watch with DRIPs (and other investing methods that make automatic purchases) is the lack of thinking required. When using DRIPs you need to still assess the investment potential of the dividend.
Perhaps you are entitled to a $5000 dividend from Omega corporation. You have the option of a cash dividend or stock dividend. Omega shares are expected to return 10% over the next year and carry a risk of 5%.
If you take the DRIP, you may earn 10% on your shares (and the stock that you received in lieu of a cash dividend). But perhaps you analyzed other investments and found Alpha company with the same 5% risk, but an expected return of 20%. If you received a cash dividend from Omega, you could have bought Alpha shares instead.
DRIP programs can be useful, but do not fall into the trap of blindly reinvesting in underperforming shares. Always look at where your income is being invested. Ensure it is the best investment for you, not simply the most convenient.
Note that with Omega, you could sell shares equal to the stock dividend and then use the proceeds to buy Alpha shares. But then you will incur transaction costs and possibly capital gains tax payable.
Warrants
Warrants are issued by companies, usually as a sweetener to an offering.
Warrants give holders the right to purchase shares from the company at a certain price for a specified period of time.
Warrants are much like call options. Both can be traded separately in the secondary market.
Also, options and warrants fluctuate in price based on the value of the underlying shares relative to the exercise price of the warrant/option and the time remaining until expiration.
However, options are not issued by companies. They are exchange traded instruments created by other investors.
As well, most options expire in under one year, whereas warrants may not expire for years.
I include warrants in this section as warrants are often exercised and company shares received by the warrant holder.
I do not include options here as almost all common share option contracts are closed out for financial consideration (assuming they are “in the money”) prior to expiration. There is no actual exchange of shares between the counterparties.
We will look at options, in brief, in the future.
by WWM | Nov 1, 2017 | Equities
Many investors go their entire lives without purchasing individual bonds, preferred shares, or even cash equivalents. Instead, they utilize funds for these asset classes, if investing at all.
Most investors though, do buy and sell common shares of individual companies.
I am not sure buying individual stocks is the best investment strategy, but almost all of you will trade specific stocks during your life. So we will spend some time reviewing common stock.
Today a look at key characteristics of common shares.
Ownership in the Company
As we discussed in my last post, investing in common shares means owning a (very small) piece of a company.
Ownership is important as it allows the investor to benefit from growth in the company.
Participation in Corporate Success
As a common shareholder of a public company, you may directly and indirectly share in the profits of the company.
Dividends
Dividends the company declares and pay come from its accumulated earnings. If the company does well, you can directly benefit by receiving dividends. Normally, there is no right to a dividend for common shareholders (unlike preferred shareholders). But if the company deems it prudent, excess earnings are often paid out to common shareholders.
We will look at dividends a little more later, as they are integral to some investors’ strategies.
Capital Gains
You may indirectly share in the company’s success by the value of your stock increasing.
A change in the share value has many causes. Earnings – current, but more importantly the expected future earnings – is a major determinant of share price. If the earnings outlook appears rosy relative to competitors, other companies, other asset classes, etc., the share price should increase.
We will review the factors that impact share valuations later.
Limited Liability
A corporation is an individual legal entity, separate from its shareholders.
Think of companies the same as you would a person. A corporation, as represented by its officers and Board of Directors, may enter into business contracts, buy or sell assets, borrow or issue debt, develop new products, and so on.
The corporation itself is responsible for its actions. And, in today’s business world, the company’s officers, Board of Directors, key insiders, or substantial shareholders, may also be found liable for the company’s actions in a court of law.
But as a general, minority investor, you will not assume legal responsibility for the company’s actions.
This is “limited liability”. Your liability, or potential loss, is limited to the amount you invested in the company’s shares.
For example, you invested $10,000 in common shares of ToxicWasteco, a public company on the New York Stock Exchange. The company was extremely profitable and your shares grew to a value of $50,000.
Then ToxicWasteco was discovered to have deliberately discarded radioactive refuse in landfills that were later used for housing communities. The company declares bankruptcy after losing a class action lawsuit. In addition, three senior executives that approved the plan to use landfills were each sentenced to 10 years in jail and fined $1 million.
The company’s officers were found liable for their actions on behalf of the company.
However, as a mere investor, you did not play a part in ToxicWasteco’s operational decisions. Your liability is limited to the $10,000 in initial capital invested in the company. And yes, to you, the loss will feel like the unrealized $50,000.
Voting Rights
While common shareholders do not have a direct say in the company’s operations, they do have some influence through their voting rights. Technically, yes. Practically, you have zero influence.
Most common share issues (and possibly other classes of shares if they include voting right features) give shareholders the right to vote at Annual General Meetings (AGM) and on other occasions where votes are required.
Note that some common shares may only have partial or no voting rights. These shares are called “restricted shares” (not to be confused with “restricted stock” that cannot be traded by shareholders for a given period).
There may also be “subordinate voting shares” which rank behind another class of voting shares. Usually the ranking is based on the number of voting rights per share.
For example, ABCco requires 10 Class B shares to equal 1 vote as opposed to 1 Class A share equalling 1 vote. That makes Class B shares subordinate to Class A in terms of voting rights.
Shareholders vote to elect the directors of the company. The directors are charged with overseeing the company’s actions on behalf of all shareholders.
Shareholders may also vote on material transactions that affect the company. These include: purchase or sale of significant assets or business operations; corporate acquisitions, mergers, consolidations, or liquidations; approval of the appointment of auditors; approval of dividend declarations by the Board of Directors.
It may seem impressive, but in actuality shareholder votes amount to no power. The vast majority of outstanding shares are held by large institutions (e.g. pensions, mutual funds, etc.) and corporate insiders. This ensures their priorities override those of minority shareholders.
For example, you own 100 common shares of Microsoft worth USD 7500. Windows 10 is installed on your computer and it has some very annoying features. You plan to speak up at the next AGM and would like a vote to force Microsoft to fix the bugs in their operating system. With your 100 shares, you receive 100 votes. That should make an impact.
Unfortunately, Microsoft has approximately 7.6 billion shares outstanding versus your 100. Of those 7.6 billion shares, corporate insiders own 2% and institutions and mutual funds hold another 75%. Bill Gates himself controls about 167 million shares. Unless Mr. Gates agrees with you on Windows 10, there is no chance that your proposal will get a vote.
While having a vote sounds good, unless you are an institutional investor or insider, it has no relevance.
And yes, these corporate insiders and institutions essentially alone choose the Board of Directors. Which may explain why the Directors often seem to act contrary to the best interests of minority shareholders. Or perhaps it is a coincidence.
Determining Your Rights
Those are the key characteristics of common shares.
If you wish to determine the rights of common shares that you own, or intend to purchase, the details will be disclosed in the company’s and/or share issue’s documentation.
The key documents are usually the Memorandum and Articles of Association (Mem and Arts). But share details should also be disclosed in annual reports, prospectuses, and corporate filings with regulators and stock exchanges.
by WWM | Oct 25, 2017 | Equities
Equity is the final major investment category, along with cash equivalents and fixed income.
Today we will review the concept of equity, in general, and in relation to companies.
Equity in General
Equity is anything that represents an ownership interest.
If you own a home (or possibly even a vehicle), you likely borrowed money from a bank (or similar) upon purchase. But you also contributed a portion of the cash yourself. This percentage is your equity interest in the house (or car). Over time, as you pay off the debt, your level of equity increases proportionately in the asset.
Your equity at any point in time equals the current market value of the asset less any outstanding debt and accumulated interest owing on the asset.
Equity and Margin Accounts
Some readers may have, now or in the future, brokerage accounts that allow margin trading.
A margin account allows investors to leverage by borrowing funds from the brokerage house using their investment portfolio as collateral. The amount that may be borrowed is dictated by the type of assets and market value of the investments within the account.
The equity portion is the value of the total investment portfolio minus the amount that has been borrowed.
While this may seem the same as a mortgage or a car loan, it is not. Asset values within a portfolio fluctuate daily. If prices fall, even in the very short term, you may be required to make additional contributions to the account (margin calls) to cover shortfalls. If you cannot, your assets will be sold to meet your minimum margin levels.
For most investors, margin accounts are a risky proposition. Take care if you ever decide to set up a margin account.
Debt is Not Equity
Creditors, like a bank that loans you money, are not equity holders in your home or vehicle.
Creditors may have a lien, or claim, to your overall assets (general) or specific assets (mortgage), but they do not have any right to participate in your affairs (unless incorporated into the the debt agreement or via court order).
The debt holder is simply entitled to the principal outstanding and all agreed upon interest payments.
Owning an equity interest gives the holder the right to participate in the company’s performance. As results may vary over time and circumstances, equity is riskier than debt.
The debt holder is only concerned about seeing the debt serviced in a timely manner. The equity holder wants to see an appreciation in the asset value or other performance factor that increases the value of the equity interest.
Corporate Equity
Within a company, equity refers to the funds contributed by all shareholders. While there may be a variety of share classes issued, the main form is common stock. And, as we saw previously, some companies issue preferred shares.
Equity includes more than just the capital contributed by shareholders. It also includes the company’s retained earnings.
Retained earnings are a company’s accumulated earnings over its life less dividends that have been paid to shareholders.
Combined, retained earnings plus contributed share capital, equal a company’s shareholder equity on its balance sheet.
Companies issue shares to raise capital. The proceeds are used to finance current operations, pay down pre-existing long term debt, or allow for expansion of the company.
Authorized Versus Outstanding Capital
Each class of stock has a maximum number of shares that may be issued. This maximum is known as the company’s “authorized capital” and is stated in the corporation’s “articles of incorporation”.
The number of shares actually issued to date is known as the “outstanding shares”. It is also referred to as the “float”.
For example, ABC has an authorized limit of 10 million, Class A common shares, according to its articles of incorporation. As at December 31, 2016, ABC has 1 million, Class A common shares outstanding.
The number of outstanding shares includes any “restricted stock” that may exist. Restricted shares are those that have restrictions on their ability to trade.
Perhaps corporate insiders (e.g. officers of the company) own shares that cannot be sold for a 5 year period from issue. Often this is used as an incentive for senior employees to stay tied to a company for long periods. Also, by having a vested interest in the long term growth of the shares, the employees personal objectives are in line with other shareholders.
Shares that have been repurchased by a company through open market transactions or “share buy-back programs” are not considered outstanding stock.
Note that if there are no repurchased shares in existence, or those that previously were purchased by the company have been retired, the outstanding shares may be referred to as “issued and outstanding”.
Knowing the number of shares outstanding is important when analyzing a company’s value. This may include “earnings per share” (EPS) or “market capitalization” calculations.
Knowing the number of shares authorized is also important. It allows you to assess the potential dilution effect on existing shareholders if new shares are issued.
Next we will take a deeper look at common shares.
by WWM | Oct 19, 2017 | Fixed Income
In many ways, preferred shares act like fixed income. As with bonds, preferred shares may incorporate many different features, creating different types of shares.
Most of these are almost identical to the bond variants we looked at here and here. In fact, for any not listed below, you can look back at the bond features posts for further preferred share possible combinations.
Straight Preferred
These are your plain, vanilla preferred shares. The pay a fixed dividend rate and trade in the open market on a yield basis as if they were a bond.
For example, XYZ company issues 5.5% Cumulative Series H Preferred Shares at $25 per share. If comparative interest rates increase, the share price will fall to provide investors with the market yield. If general interest rates decrease, the share price will rise to again reflect the market returns.
Variable Rate Preferred
Also called “floating preferred”. These preferred shares are exactly the same as variable rate bonds. They pay a dividend that fluctuates with changes in interest rates.
For example, on January 1, 2017, ABC company issues Cumulative Series R Preferred Shares. These shares pay an annual fixed dividend of $2.00 per share until December 31, 2019. Beginning January 1, 2020, the dividend rate will float at a rate of 70% the average US prime rate of interest.
As with bonds of the same name, corporations normally include interest rates maximums and minimums to protect both themselves and shareholders from significant increases or decreases in interest rates.
Convertible Preferred
Like convertible bonds, the investor has the option to convert the preferred stock into another class of shares at a fixed priced within a specified date or period. Normally the option is to convert into the company’s common shares.
Because of the embedded option, a convertible preferred share will be priced somewhat higher than an equivalent straight preferred share. The premium paid by investors is the value of the embedded option.
The market value of straight preferred shares fluctuates based on general interest rate levels relative to the dividend paid. Convertibles though, are also affected by the market value of the shares that the preferreds may be converted into.
For example, each Convertco Cumulative Series B Preferred Share is convertible into 1.2 common shares of Convertco. On July 5, Convertco common shares traded at $20.50. At this price, the preferred shares would be worth $24.60 simply on the conversion factor alone ($20.50 * 1.2).
This would be the minimum value based on potential conversion. Because of the attached dividend, the preferred shares would actually be worth more.
As you pay a premium for the shares, you should believe in the underlying growth potential of the common shares. If not, then stick with straight preferreds and receive a higher yield on the dividend receipts.
Participating Preferred
Convertible preferreds provide the potential to capitalize on the growth of the issuing company. If the company grows and its common shares increase in value, you can convert your preferred shares to common shares (assuming that is the correct class) and benefit from the upside potential.
And, as we saw above, if the common shares have already increased in value, there will be a relative price increase to the preferreds as well, based on the conversion factor.
Participating preferreds also allow investors to benefit from the company’s success. In this case, it allows the preferred shareholders a right to a certain level of the company’s net earnings above the specified dividend rate.
This participation in the company’s net earnings comes in the form of a supplemental dividend, in addition to the normal payment. Often this is tied to the payment of dividends to common shareholders.
For example, Profitcorp has enjoyed a record year of earnings and cash flow. They are easily able to pay the dividends to holders of Profitcorp’s 10%, $25 Par Value, Cumulative Participating First Preferred Shares. With excess cash, Profitcorp decides to pay a $2.00 dividend to its common shareholders as well.
Under the terms of Profitcorp’s First Preferred Shares, any dividends paid to common shareholders must also be paid to holders of the First Preferred Shares at a rate of 50%.
In addition to the normal dividend of $2.50 (10% of 25 par value) received by the preferred shareholders during the year, they would also receive an incremental dividend of $1.00 (50% of $1 common share dividend).
As to the amount of extra dividends or the conditions for eligibility, one needs to review the relevant share documents.
Redeemable Preferred
Another one that we saw with bonds. Here the company holds an embedded call option on the shares. This allows the company to redeem some or all of the shares within a specified period of time.
If the company redeems the shares on a gradual basis, they usually utilize a “sinking” or “purchase” fund to do so.
As the company holds the option, they must pay for their privilege. As a result, the company will pay investors a premium for this option.
For example, in 2010, Callco issued 8% Cumulative Redeemable Series F Preferred Shares with a par value of $25. The shares were redeemable by Callco at $28 until December 31, 2015, $26.50 until December 31, 2020, and at par thereafter.
As you can see, if you owned shares that were redeemed in 2014, you would receive a $3 premium on each share ($28-25). But with the passage of time, the premium falls to $1.50 from 2016 through 2020, and then is zero after 2020.
Many companies issue redeemable shares. In part, because preferred shares often do not have a maturity date like bonds.
If a company wants to retire its debt, it can simply wait to maturity and then repay the principal. Of course, companies can utilize callable or redeemable bonds as well.
Minus any features, preferred shares cannot be cancelled except through repurchases on the open market. This can be expensive and may not result in being able to purchase and retire as many shares as the company desires.
Retractable Preferred
These give the shareholder the option to sell the shares back to the company at a specified price within a specified period.
As the option to sell now lies with the shareholder, there is a premium paid by the shareholder for this right.
Typically, if the retractable preferreds are not converted within a maximum time frame, they convert back to straight preferred shares.
That should provide a sense of what preferred shares are.
It should also illustrate why many consider them to be more debt than equity.
Next up, we will look at individual investments most of you own. Common shares or equity.
by WWM | Oct 11, 2017 | Fixed Income
Today we will look at preferred shares.
Although a form of equity, I generally consider preferred shares as fixed income. The characteristics of preferreds make them more like debt than equity. For asset allocation purposes, I normally include preferred shares with fixed income.
So what exactly is this hybrid asset that lies somewhere between debt and equity?
Ownership in the Company
Preferred stock is a means of ownership in a corporation. As part of a company’s ownership structure, preferred shares are part of shareholder equity on the balance sheet.
This differs from debt instruments which are merely loans to the issuer by the debt holder. As loans, debt is a liability of the issuer. Bond holders may have claims to specific assets upon default, but they are not owners of the issuing entity.
As preferred shares are equity in the company, there is no natural maturity date as with most debt. Although, as we will see later, a maturity feature may be added to the shares.
Preferred Status
As the name suggests, preferred shares have a priority to the company’s assets and earnings over common shares. However, usually debt issues have priority than preferred shares.
A higher claim on assets is important if the company breaks up, intentionally or not. If this occurs, preferred shareholders will be paid the par value of their shares before common shareholders.
The prioritized claim to earnings is crucial for dividend receipts. Dividends payments require adequate cash flow and earnings to ensure an uninterrupted stream to shareholders.
Dividends Not Capital Appreciation
Dividends are the main reason investors purchase straight preferred shares. Like bond coupons, preferred shares normally have a fixed dividend that is paid out quarterly (bonds usually pay semi-annually).
While many investors in common shares do enjoy dividends, the main motivation is the potential for capital gains. Again, this aligns preferred shares more in the debt than equity investment realm.
That said, there may indeed be capital gains (or losses) on preferred shares if sold.
As with bonds, the market value of preferred shares move in opposite directions to changes in interest rates. As general rates increase, preferreds with fixed rate dividends will fall in price. If rates decrease, the price of the shares will rise to reflect the lower yield in the marketplace.
Depending on the specific preferred share issue, there may or may not be participation in the company’s performance. If not, the shares will react in price as if they were bonds. If there is participation, the share price will reflect that.
Dividends Not Interest Income
Bonds pay investors interest on debt. Preferred and common shares pay dividends from accumulated retained earnings.
In many jurisdictions, including Canada, eligible dividends may be taxed at a preferential rate versus interest income. If so, then on an after-tax basis you will net more cash from a dividend than interest income at the same gross amount.
If you earn 8% interest and 8% in eligible dividend income, you will be better off owning the preferred (or common) shares than the bonds. The exact advantage will be based on the preferential tax treatment and your own tax status.
Tax treatment on interest, dividends, and capital gains varies significantly between tax jurisdictions. Taxation is a major investment consideration. Investors should gain, at least, a basic understanding of the differences.
Not All Dividends Are Taxed the Same
As well, not all income in a specific class may be treated the same for tax purposes.
In Canada, for example and writing in generalities, an eligible Canadian public corporation’s dividends may allow for a gross up and tax credit. Canadian private corporation dividends may or may not be eligible depending on the company’s tax situation. Foreign corporations generally are not eligible for the tax credit. You need to understand the different types of dividend income received, as that will impact your after-tax returns.
If you own shares or funds listed on foreign exchanges, withholding taxes may be deducted before paying out your dividends. Often you can “recover” via tax treaties, but be aware of this on foreign sourced income.
Dividends Must Be Declared
Interest on bonds is based on the loan terms. Interest is paid out of cash flow. If the company is unable to make an interest payment, that money accumulates and is paid as soon as possible.
Dividends are paid out of retained earnings and must be declared by the company. Preferred share dividends are paid out prior to any dividend payments to common shareholders. Understand the conditions for when dividends may or may not be declared. If you invest to earn dividends, you will want to receive them.
For “cumulative preferred shares”, any unpaid dividends accrue over time and must be paid in full before any other dividends are paid. Again, this is much like bond issues. If investors do not get paid, the interest or dividends owing cumulate and are back-paid. It is much better to invest in preferred shares that are cumulative in nature.
No Voting Rights
Like bonds, preferred shares typically carry no voting rights within the company. Voting normally resides solely with common shareholders.
However, if dividend payments have been missed by the company for a period, often the preferred shareholders are granted voting rights on a contingent basis (usually while the dividends are in arrears). Bondholders, too, may have some say in company operations while interest payments are in arrears.
While the above is generally true, like bonds, there are many permutations of preferred shares.
Also, companies may issue various classes of preferred shares with different features. These classes may rank equal in their rights or some classes may be subordinate in their claim to assets and earnings.
As was the case in our bond review, knowing the details for each issue is important.
Next up, we will review common preferred share features. Many are identical to bond features.