Ups and Downs of Doing Stock Splits

03/03/2011 4:00 am EST


John Heinzl

Reporter and Columnist,

What are split shares exactly, and are they a good investment?-G.M.

This is a great question. Actually, it's two questions. So today we'll explore the basics of how split shares work, then we'll address who—if anyone—should buy them.

Because split shares can get a bit tricky, we've invited one of Canada's leading preferred-share experts, James Hymas of Hymas Investment Management in Toronto, to share his expertise.

How Are Split Shares Created?
A split-share corporation is established to invest in a portfolio of dividend-paying common shares. The underlying shares can be from a single company, from several companies in the same industry, or from different industries altogether.

To finance the purchase of these common shares, the split-share corporation raises money by selling two kinds of shares to the public: preferred shares and capital shares. These two classes of split shares, which are issued initially as a unit but then trade separately, differ dramatically in their structure and performance.

Preferred Vs. Capital Shares
The preferred shares are geared to income-oriented investors, and have first dibs on the dividends spun off by the underlying portfolio. The preferreds also get first claim on the capital of the portfolio, up to a certain amount (equivalent to the issue price of the preferred shares).

Because of these built-in protections, the preferreds typically provide a high level of safety, but minimal upside potential.

The capital units are for risk-takers only. In exchange for giving up most or all of the underlying dividends, these units are entitled to all of the value in the underlying portfolio over and above what the preferreds are entitled to.

The capital shares are essentially a leveraged play on the underlying portfolio-and as we all know, leverage cuts both ways. If the underlying portfolio rises, the capital units will experience an even bigger gain. If the portfolio falls, however, the capital shares will suffer an even bigger loss.

While some capital shares also dangle the prospect of double-digit dividends before investors, these dividends are often unsustainable because the underlying portfolio isn't throwing off enough income to cover them, so portfolio shares must be sold to generate the cash. When the underlying portfolio is volatile, the capital dividends often stop altogether.

For those reasons, Hymas says the capital shares are only appropriate for "suckers."

"They're for people who like to pay high fees, and they're for people who like to take a lot of risk, and they're for people who can't read a prospectus properly," he says.

Why Preferreds Are Preferable
Split preferred shares, in contrast, are "relatively safe," Hymas says. He can recall only two instances of split preferreds that defaulted on their dividends. (One invested in telecom stocks that crashed during the tech meltdown, and the other invested in US financial companies during the credit crisis.)

In a very small minority of cases, split preferreds suffer a capital loss on maturity, but there is usually a large enough buffer in the capital of the underlying portfolio that the loss is minimal.

Another attribute that makes split preferreds attractive is their finite lifespan. The vast majority of split-share corporations are wound up after a predetermined time period, usually five to seven years from the issue date.

Because of this relatively short maturity, when interest rates change, split preferreds are not as volatile as longer-term fixed-income investments.

What's more, split preferreds often have higher yields than traditional preferred shares of similar credit quality. This is partly because most split-share issues are too small to be included in preferred-share indexes, which reduces demand.

In addition, because split shares are asset-backed securities, some investors are leery of them, which also tends to keep prices lower-and yields higher-than they otherwise would be.

One drawback of split preferreds is that they are thinly traded. Investors should therefore use limit orders and exercise patience when buying them, Hymas says.

He has bought several split preferreds both personally and for his Malachite Aggressive Preferred Fund. The fund's current split-preferred holdings include: BAM Split Corp. (Toronto: BNA.PR.C-yield to maturity 6.11%), which holds Brookfield Asset Management shares; and Canadian Life Companies Split Corp. (Toronto: LFE.PR.A-yield to maturity 4.58%), which invests in a basket of life insurers.

In the February edition of his PrefLetter, Hymas also recommends Dividend Growth Split Corp. (Toronto: DGS.PR.A-yield to maturity 4.31%), which holds a portfolio of 20 large-cap dividend stocks; and Financial 15 Split Corp. (FFN.PR.A­-yield to maturity 4.81%), which holds a portfolio of Canadian and US financial-services companies.

"The preferreds are the easy half to sell. They could sell as many as they would like," Hymas says. "Capital units are relatively difficult to sell and are the limiting factor in how much of these things come out."

You can read more about the risks and benefits of split shares on his Web site.

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