Wednesday, 22 December 2010

Split-Share Corporations - Christmas Bargains Amongst Capital Shares?

A few weeks back we looked at Split Share Preferreds for potential good investments offering steady, safe, attractive dividend income. Today we examine the counterpart to those preferreds, the Capital shares issued by Split Share Corporations. Capital shares are completely different - their appeal is primarily for investors who seek capital appreciation, not income. Let's look at how they work, discuss their pros and cons and then compare some of them whose preferred shares we examined.

Key Features of Split Capital Shares:
  • Capital Shareholders are residual owners of the Split Share Corporation, taking lower priority after Preferred Share obligations are met.
  • Capital Shareholders are obliged to pay all the professional management and other fund costs (fund managers to run the portfolio, do all the accounting, meet legal and regulatory filing or tax requirements, decide and pay distributions, pay out retractions, decide on redemptions etc),
  • Since the Capital shares receive all the dividends coming from the common shares in the portfolio, they can benefit from any dividend increases of the holdings. In many Split Share portfolios, banks occupy a prominent place and until recent times, they have given off steady rounds of increases. A key question for the prospects of all Split Capital shares is whether the banks will resume dividend hikes with recovery from the credit crunch and recession. During the recent hard times, dividend cuts by the companies within portfolios have eaten into the cash flow received by the Split Corporations, which are still responsible to pay the unchanged preferred dividends. This has hurt the Capital shares.
  • Their use of leverage (borrowed money) increases volatility and risk of the returns. The aim is to boost returns but it can increase losses too. The leverage comes from the preferred shares. The "borrowing rate" is the fixed preferred dividend yield and the "amount borrowed" is the redemption value that will be paid back to preferred owners at the pre-set termination date of the Split Share Corporation. Unlike leveraged ETFs which are not suitable for long term investors due to their daily rebalancing, Capital Split shares with their infrequently re-balanced portfolios are much more suitable for the long term hold investor. The amount of leverage varies amongst the various Split Share Corporations but is always appreciably below 2x for the high quality issues we look at. However, even among the more conservatively managed Split Share Corporations which we have chosen to examine, the effect in the 2007-2008 crisis has in some cases been quite harsh. Note in the chart below from TMX Money of five-year prices for our Split Capital shares how the blue line of the S&P/TSX 60 Index decline through 2008, bad as it was, is dwarfed by the Splits' vertiginous falls. Several Split Capitals have never recovered up to the benchmark Index.
  • Lack of liquidity for Capital shares is typical, as very low trading volumes can make it difficult to sell or buy shares at a reasonable price. Our comparison table shows Split Capital trading volumes of a few thousand shares per day at most and large spreads between bid and ask market prices. The market price often diverges widely from fair value (Net Asset Value) unlike most ETFs, where mainstream fund market prices rarely exceed +/-1% of NAV. Poor liquidity also means that it may be difficult to carry out arbitrage to take advantage of retraction clauses by buying up shares trading well below NAV and then tendering them to the Split Corp to receive the NAV price.
  • Retraction rights form part of every Split Share. Details vary in small but crucial ways, which has a significant effect on the feasibility of arbitrage action to take advantage of apparent mis-pricing. Retraction rights allow the Capital shareholder to submit shares back to the Split Share Corporation for reimbursement at Net Asset Value (NAV) or some discount to NAV. In several Split Corporations, the investor wishing to retract must submit a combination of a Capital Share and a Preferred Share, termed a Unit. That means being required to buy one of each in the market. In a couple of cases - BBO and CFS - a pricing discount for Capital shares is partly or mostly offset by a premium on the Preferreds such that retraction offers less potential arbitrage profit.
  • Sector concentration or lack of diversification of holdings affects most Split Share Corporations, increasing risk. Big banks and insurance companies form the core of most Split Share portfolios and the woes of the financial sector in recent years have hit returns and capital values hard.
  • Capital shares have no direct ownership rights or voting rights to the shares in the portfolio. That is a weaker/riskier position than being a common shareholder in a normal corporation.
  • Some Split Corporations engage in covered option writing to generate more revenue and increase returns but that has a bit of added risk as well.
Comparison - Split Capital Shares with a Diversified Portfolio
(click on table image to enlarge)

  • Brompton Equity Split Class A (TSX symbol: BE) - This is an actively managed fund with mainly Canadian and some US stocks whose managers have picked right recently with a one-year price advance of 11.4%, beating the S&P TSX 60 Index return of 10.5%, while also providing an extremely high 9.7% distribution yield. This yield has evidently been achieved by distributing its unrealized capital gains through Return of Capital, against which no tax is payable. Meanwhile its market price still trades at a 5.6% discount to NAV. There appears to be a trading opportunity with BE since the fund termination date is less than six months away and NAV will be paid out to shareholders then. However, BE's leverage is relatively high 1.87 so buying a share could still produce a loss - remember, leverage amplifies losses as well as gains - if the stock market heads downwards before May. The chart below from TMX Money of the one-year price performance of our Split Capital shares illustrates this well. Note how much more the black line of BE dipped during the summer compared to the blue line of the TSX index
  • Sixty Split Corp (SXT) - This fund's policy is to passively mimic the S&P TSX Index, except that it adds a modest amount (1.17) of leverage. As result, its price is less volatile than BE's and the chart reflects this - see how much the brown line of SXT stays much closer to the blue line of the TSX Index. SXT has a small discount to NAV of 3.0% but its termination date is upcoming soon in March. However, it pays no distribution while the TSX Index pays about 2.5%. Its one-year return of 17.2% has outstripped the TSX Index's 13% total return (price increase plus dividend).
  • Big Bank Big Oil Split Corp (BBO) - This is the least diversified of our Split Corp line-up with only bank and energy company holdings. The result of sector concentration shows up in poor one-year price returns - a 2.2% loss - compared to the 10.5% price gain of the TSX. The loss is offset by a hefty 8% distribution yield. For the future, BBO will be continually hampered by the highest total costs in our set of funds, a total of 7.25%. Even the 6.1% discount of market price to NAV doesn't help much since termination is six years away.
  • Canadian Financials and Utilities Split Corp Class A (CFS) - This is an unusual fund in that it currently uses no leverage at all. Due to its forced de-leveraging formula to protect the highest Pfd-1 rating on preferred shares, in the 2008 crisis the Capital Class A shares got hammered and CFS reduced its leverage to zero. The distribution on Class A shares was eliminated and there still is none. There will likely not be any distributions either before the fund termination in 2012 since the NAV would have to rise over $7.37 from its current $5.54 and there is a low chance (i.e. of another 33% rise in the stock market before 2012) of that. Nowadays, the return of CFS' NAV will track very closely that of the TSX 60 Index. CFS has little investment attraction until we notice that its market price is a whopping 17.5% below NAV. With only two years to go to wind-up and the payout of NAV on a Class A share, if the market merely remains flat, there is a possible gain. Even in a flat market, one must deduct about 2.6% annual loss (5.2% for two years) from operations since common dividends received from the fund portfolio and interest on cash deposits only cover about half the 5.2% total expenses of CFS. As investors, we must ask ourselves whether it is worth tieing up money for two years to get a possible 12% or so gain (17.5% - 5.2%). If markets go up or dividends rise, such an investment in CFS will do better as NAV rises. If markets go down again, we would do worse as further NAV capital losses would be reinforced by more portfolio selling to protect the preferred payouts.
  • NewGrowth Corp (NEW.A) - This is a middle of the road fund with moderate leverage (1.62), a reasonable size (15-20) and variety (utilities, telecomms and banks) of holdings in its portfolio and distribution yield (2.4%) similar to that of the TSX 60 Index. Its recent market price is a large 10.1% discount to NAV and its annual retraction clause is the best possible for a Capital share investor. The clause requires only submission of a Capital share to receive its NAV and it is the preferred issue/redemption price that is used, so we do not need to worry about the preferred share market price. That may well be worth the wait till the June retraction date to get a potential trading profit if the market price does not recover to NAV and the overall market does not fall.
Bottom Line: BE, CFS and NEW.A all offer possible trading profits over the next 3 to 36 months if the market and especially financials go up or stay at least flat. For the longer term, a similar replacement for the soon-to-expire SXT will be attractive to those who seek amplified returns of leverage and who think the market's direction is upward, or at least not due for a 2008-equivalent crash downwards.

Whether these shares are on your last minute Christmas shopping bargain list or not, best wishes to all readers for an enjoyable holiday with family and friends!!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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