Chapter 10 - Equity & Property Markets

Question 1

Ordinary Share

Answer 1

share in the ownership of a company

Question 2

Investment and risk characteristics of equities

Answer 2

• 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
  (the hedge is a loose one, there is no guarantee of inflation protection)
• Higher expected returns than government bonds over the long term
  (lower running yield than gvmt bonds, as much of the return is expected to be made from future dividend growth. Main sources of return = capital growth + dividends)
• 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 3

Quoted shares

Answer 3

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

Question 4

Investment characteristics of quoted shares

Answer 4

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

Question 5

Why are shares grouped by industry sectors

Answer 5

• practical for analysts to specialise in one area
• share prices of companies in the same sector tend to be correlated

PROBLEMS WITH GROUPINGS:

• Conglomorates that operate over several sectors
• heterogeneity can occur within sector due to niches within market

Question 6

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

Answer 6

• 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 specialization is appropriate.
• The grouping of equities according to some common factor gives structure to the decision-making process. Assists in portfolio classification & management

Question 7

Shares of companies in the same sector are correlated because… (3)

Answer 7

• Use the same resources, have similar input costs
• supply to the same market, similarly affected by demand
• Similar financial structures, ie influenced by changes in interest rates.

Question 8

Preference share

Answer 8

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

Question 9

Typical features of preference shares

Answer 9

• 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 10

Cumulative property of preference shares

Answer 10

If a dividend is unpaid, the arrears must be paid off before any payment is made to ordinary shareholders.

Question 11

Payout Ratio

Answer 11

Dividends per share/Earnings per share

Question 12

Reasons for buying back shares

Answer 12

• 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
  – in inflationary environment, debt financing is more attractive than equity financing, since dividends are expected to keep up with inflation (as opposed to loans and bonds which costs are (mostly) fixed).

Question 13

SYSTEM T

Answer 13

SYSTEM T

Question 14

Property

Answer 14

A legal title to the use of land and buildings.

Question 15

Direct property investment

Answer 15

Involves the purchase and management of tangible assets.

- Are large and indivisible.

Question 16

Indirect property investment

Answer 16

Investment via shares in property companies or units in a pooled property fund.

Question 17

Prime property

Answer 17

Property most attractive to investors. Score highly on:
S - Size
T - Tenant quality
A - Age & condition
L - Location
L - Lease structure

C - Comparability

Question 18

Property as a hedge

Answer 18

Property is a real asset and would be expected to provide a hedge against unanticipated inflation.

Question 19

Marketability of property

Answer 19

Very unmarketable

It can take a long time to buy or sell and dealing costs are high.

Question 20

3 Characteristics that make property unmarketable

Answer 20

• Unit size
• Uniqueness
• Valuation

Question 21

Unit size (Direct Property)

Answer 21

Unit size of most property investment is large and in general, single properties are indivisible.

Question 22

Uniqueness (Direct Property)

Answer 22

Each property is unique.

Makes it harder to value, reduces marketability.

Question 23

Valuation (Direct Property)

Answer 23

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 24

Security of property income

Answer 24

• Depends on the quality of the tenant.
• Rent payable by 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” - periods when the property is not let.

Question 25

Obsolescence (Property)

Answer 25

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

Question 26

Spread (Direct Property)

Answer 26

Capital values of buildings can be volatile over the longer term, although infrequent valuations and stable valuation methods reduce short-term volatility.

Land is indestructible, therefore a good location will always have value.

Question 27

Yield (Property)

Answer 27

Property is less marketable & less secure than index-linked government bonds.
Investors thus require a higher return from property.

Question 28

Expenses (Direct Property)

Answer 28

Property management cost are high even if the tenant is responsible for building maintenance and insurance.

Question 29

Freehold ownership (Property)

Answer 29

Ownership in perpetuity.
Freeholder has the right to occupy the building, let it out, and refurbish the property or develop it.
There may be restrictions, ex covenants, easements such as rights of way, planning and building regulations & statutory requirements not to cause a nuisance to others.

Question 30

Easements (Property)

Answer 30

specific rights acquired by someone other than a landowner or tenant.

Question 31

Unencumbered freehold (Property)

Answer 31

No existing tenant, ie freeholder may choose to:

• add value by re-developing and/or refurbishing
• set up a lease and receive rents

Question 32

Leased freehold (Property)

Answer 32

Already has a tenant, so that the investor will receive the rents due under the terms of the existing lease, plus reversion of the unencumbered freehold at end of lease.

Question 33

5 Disadvantages of direct property holdings

Answer 33

• Size
• Diversification
• Lack of marketability
• Valuation
• Expertise needed

VELDS

Question 34

Advantages of direct property investment (vs property share / indirect property investment)

Answer 34

• Diversification of overall portfolio (property shares are subject to movements in equity market)
• Volatility (less volatile than property shares)
• Control over property portfolio management
• Loss on forced sale unlikely
• Exposure can be managed (property company may invest in buildings under construction, multiple risks associated)

Question 35

Advantages of indirect property investment

Answer 35

• Diversification within the property market (property companies offer greater spread of risk)
• Market prices / performance measurement - no visible market price for real property.
• Marketability - property shares are more marketable than direct investments.
• Management expertise (company can afford expertise)
• Advantage of size (large companies may invest in large properties, too big for direct investors)

Question 36

Financial Gearing w.r.t. property investment

Answer 36

Commercial property investments often provide secure income streams, making property investment / development companies ideal vehicles for financial gearing.

Question 37

Discount to net asset value (NAV) w.r.t. property investment

Answer 37

property shares usually stand at a discount to NAV.

Property assets may be purchased cheaply

Question 38

Investment and risk characteristics of property to be considered:

Answer 38

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 39

What to consider when comparing direct to indirect property investments:

Answer 39

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

Question 40

ADD & Supplement especially “Indirect Property Investment”

Answer 40

YES!