Ch 10: Equity and property markets

Question 1

Define the term ordinary share

Answer 1

Ordinary shares are securities held by the owners of an organization

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

Question 2

List eleven 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 the risk profile of the issuing company
5. Higher long-term expected return than government bonds
6. Expected to provide a real return over the long term
7. Potential for volatile markets (and dividends)
8. Term: no fixed redemption date, generally considered to be long-term
9. Dealing costs higher than for conventional government bonds
10. Marketability depends on the issuing company and whether listed or not – generally worse than for government bonds
11. Tax treatment depends on the territory

Question 3

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

Answer 3

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, and 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 poorer 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 the investor

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

What are four practical reasons for analyzing shares by industry?

Answer 5

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-one can be an expert in all areas
4. It adds structure to the decision-making process

Question 6

List three reasons for the correlation of investment performance within the same industry

Answer 6

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 7

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

Answer 7

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, eg tax, labor markets, cost of borrowing and fuel
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 in instruments covering a broad range of equities rather then actively seeking out specific shares, because:
   - They believe the costs of active management are not compensated for by sufficient extra return
   - They lack the expertise

Question 8

List 14 investment and risk characteristics of direct property

Answer 8

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’ patter 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 costs and management costs
11. Very unmarketable
12. Large unit size, indivisibility
13. Uniqueness
14. Characteristics can be changed by owner, eg redevelopment

Question 9

On what factors would a prime property score highly?

Answer 9

CALL ST

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

Question 10

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

Answer 10

Freehold ownership is ownership in perpetuity.

Rights are:

1. To occupy the building or let it out
2. To refurbish the property of develop it

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 11

Give three examples of indirect property investment

Answer 11

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 12

Outline the advantages of investment in direct property compared with investment in property company shares

Answer 12

1. Control
2. Diversification away from the stock exchange
3. Forced selling and the associated loss is less of an issue
4. Management fees to property share company advisors avoided
5. Not exposed to high risk types of property
6. Not exposed to extra volatility caused by gearing or the discount to NAV changing
7. Tax advantages (possibly)
8. Utility value
9. Volatility of prices lower in the short term as valuations are infrequent

Question 13

Outline the advantages of investment in property company shares compared with investment in direct property

Answer 13

1. Access to larger / more unusual properties
2. Discount to NAV may exist – property shares may represent a ‘cheap’ way of buying property assets
3. Diversification within the property market
4. Divisibility
5. Economies of scale in the case of large property share companies
6. Expected return may be higher due to the extra volatility associated with gearing and the possibility of any discount to NAV narrowing
7. Expenses associated with direct property investment avoided
8. Expertise of property company managers
9. Marketability better
10. Quoted prices making valuations easier
11. Tax advantages (possibly)

Question 14

Define a lease and outline how a leasehold property differs form a freehold property from an investment perspective

Answer 14

A lease is an agreement between two parties which allows one of the parties (the leaseholder) the use of a specified portion of a building owned by the other party for a specified period in return for some payment.

Leasehold differs from freehold as, typically, leasehold:

• Has a fixed term
• Involves a capital loss to the leaseholder at the end of the lease
• Has a higher initial rental yield

Question 15

Investment and risk characteristics of equities

Answer 15

• 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 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 16

Quoted shares

Answer 16

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

Question 17

Investment characteristics of quoted shares

Answer 17

• more marketable
• more secure
• easier to value than non-quoted shares.

Question 18

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

Answer 18

• 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 in 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 & management

Question 19

Preference share

Answer 19

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

Question 20

Typical features of preference shares

Answer 20

• 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
• Generally cumulative
• Mostly no final redemption date
• Normally don’t carry voting rights

Question 21

Payout Ratio

Answer 21

Dividends per share/Earnings per share

Question 22

Reasons for buying back shares

Answer 22

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

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

Valuation (Direct Property)

Answer 24

Matter of 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 25

Investment and risk characteristics of property to be considered:

Answer 25

M-Marketability
U- Uniqueness
S- Size
T- Type of Property (determines the running yield)

P- Political Risk
R- Real long term RETURNS (property is a real asset)
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 available

Question 26

What to consider when comparing direct to indirect property investments:

Answer 26

C- Control
E- Expenses
D- Diversification
E- Expertise

M- Marketability
E- Exposure to other sectors
E- Equity correlation for instance
T- Taxation

Volatility
Valuation
Gearing
Forced Sales