Ch 10: Equity and property markets Flashcards
Define the term ordinary share
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.
List 11 investment and risk characteristics of ordinary shares
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
Describe the cashflows on an ordinary share from the perspective of the investor
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
What are the advantages of listed shares over unlisted shares to investors
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
It is practical for analysts to specialise in one area of industry because…
- 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.
What are 4 practical reasons for analysing shares by industry?
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.
List 3 reasons for the correlation of investment performance in the same industry
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.
Why are market movements the biggest influence on a share’s price
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
Investment and risk characteristics of equities
- 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
Quoted shares
Listed on a stock exchange and make up the majority of available equity investment
Investment characteristics of quoted shares
- More marketable
- Mare secure
- Easier to value
than non-quoted shares
Preference share
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.
Typical features of preference shares
- 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
Cumulative property of preference shares
If a dividend is unpaid, the arrears must be paid off before any payment is made to ordinary shareholders
Payout ratio
Dividends per share/Earnings per share
Reasons for buying back shares
- 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.
SYSTEM T
Security
Yield
Spread
Term
Expenses and exchange rate
marketability
Tax
Direct property investment
Involves the purchase and management of tangible assets.
Are large and indivisible.
List 14 investment and risk characteristics of direct property
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)
Investment and risk characteristics of property to be considered
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
What ti consider when comparing direct to indirect property investments
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
On what factors would a prime property score highly?
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
Property as a hedge
Property is a real asset and would be expected to provide a hedge against unanticipated inflation
Define freehold ownership of a property and outline the rights and restrictions of the freeholder
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
Easements (property)
Specific rights acquired by someone other than a londowner or tenant
Unencumbered freehold property
No existing tenant, i.e. freeholder may choose to:
- Add value by re-developing and/or refurbishing
- Set up a lease and receive rents
Indirect property investment
Investments via shares in property companies or units in a pooled property fund
Give 3 examples of indirect property investment
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
Marketability of property
- Very unmarketable
- It can take a long time to buy or sell and dealing costs are high
3 characteristics that make property unmarketable
- 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.
Security of property income
- 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
What is obsolescence (direct property)
- 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
Spread (direct property)
Capital values of buildings can be volatile over the longer term, although infrequent valuations and stable valuation methods reduce short term volatility
Yield (property)
Less marketable and less secure than index-linked government bonds.
Investors thus require a higher return from property.
Expenses (Direct property)
Property management costs are high and includes regular maintenance and insurance.
5 Disadvantages of direct property holdings
- Size
- Lack of diversification
- Lack of marketability
- Valuations difficult and costly
- Expertise needed
Advantages of direct property investment
- 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
Advantages of indirect property investment
- 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)
Financial gearing w.r.t. property investment
Commercial property investments often provide secure income streams, making property investment/development companies ideal vehicles for financial gearing
Discount to net asset value w.r.t. property investment
- Property shares usually stand at a discount to NAV
- Property assets may be purchased cheaply
Why are shares grouped by industry sectors?
- Practical for analysts to specialise in one area.
- Share prices for companies in the same sector tend to be correlated
Shares of companies in the same sector are correlated because…(3)
- 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
Investment and risk characteristics of equities
- 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
