Equity Securities: Common and Preferred Shares PDF

Equity Securities: Common and Preferred Shares 8 CHAPTER OVERVIEW In this chapter, you will learn the basic features of equity securities, a category that includes common and preferred shares. We explain t...

Equity Securities: Common and Preferred Shares 8 CHAPTER OVERVIEW In this chapter, you will learn the basic features of equity securities, a category that includes common and preferred shares. We explain the investment considerations of the two broad categories, and we compare the advantages and disadvantages of investing in either type. Finally, we describe the important role played by Canadian, U.S., and global stock market indexes. LEARNING OBJECTIVES CONTENT AREAS 1 | Discuss the features, benefits, and risks of Common Shares common share ownership. 2 | Describe the impact of stock splits and consolidations on shareholders. 3 | Describe the features, benefits, and risks of Preferred Shares preferred shares. 4 | Differentiate among the types of preferred shares. 5 | Summarize the important stock indexes and Stock Indexes and Averages averages. © CANADIAN SECURITIES INSTITUTE 8 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. arrears odd lot Canadian Depositary Receipts pari passu capital gains percentage changes CDR Ratio point changes consolidation rate-reset preferred shares cum dividend regular dividend cumulative responsible investment dividend record date restricted shares dividend reinvestment plan retraction dividends reverse stock split dollar cost averaging S&P/TSX 60 Index environmental, social, and governance S&P/TSX Composite Index ex-dividend S&P/TSX Venture Composite Index ex-dividend date soft retraction extra dividend standard trading unit fixed / floating preferred shares stock average fixed-rate perpetual preferred shares stock dividends fixed-reset preferred shares stock indexes float stock split floating-rate preferred shares street certificate hard retraction voting rights non-cumulative © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 3 INTRODUCTION Equity securities, particularly common shares, are an important part of most investors’ portfolios. History shows that the return on stocks exceeds the return on bonds over the long term. In addition, long-term common stock returns consistently outpace inflation and provide long-term protection from the loss of purchasing power. Common shares also provide a reliable measure of overall performance in the capital markets. At the close of trading each day, market participants want to know how the markets performed. To measure that performance, they look to the various stock market indexes that have developed over time. For the most part, these indexes track the performance of a basket of common shares that represents the most visible and easily accessible of investments. Common shares form the backbone of many investment portfolios and are a major component of pension funds, mutual funds, and hedge funds. Unlike many other types of investment, common share ownership provides a number of inherent rights, advantages, and disadvantages with which you should be familiar. Closely related, but with some key differences, are preferred shares. Preferred shares are a staple investment in the Canadian market largely because of the fixed-income stream that the investment generates. With an investment in common shares, what you see is mostly what you get: ownership position in a company. Preferred shares are different in that they have various structures and characteristics that are designed to appeal to different investors for different reasons. In fact, having read the previous chapter on fixed-income securities, you may notice that preferred shares are similar to bonds in many of their features. In this chapter, we discuss the benefits and risks of investing in both common shares and preferred shares. We also describe many different types of preferred shares and explain how and why investors use them. COMMON SHARES 1 | Discuss the features, benefits, and risks of common share ownership. 2 | Describe the impact of stock splits and consolidations on shareholders. Common shareholders can be an individual investor, a business, or an institutional investor. The shareholders have an ownership stake in the company and are considered the owners of the public company. If the venture prospers, the shareholders benefit from the growth in value of their original investment and from the flow of dividend income that may arise. However, if the business fails, the common shareholders may lose their entire investment. This possibility of total loss explains why common share capital is sometimes referred to as venture capital or risk capital. Common shares have the following characteristics: Position on asset Senior creditors (such as banks), bond and debenture holders, and preferred shareholders claims in case of all have prior claims over common shareholders on the company’s assets in case of bankruptcy bankruptcy. Common shares, therefore, have a relatively weak position on asset claims. Dividends Unlike the payment of interest on outstanding debt, common share dividends are payable at the discretion of the board of directors. In other words, there is no guarantee of dividend income. Evidence of ownership Shares are most often registered in street certificate form, which means that they are registered in the name of the securities firm, rather than the beneficial owner. This aspect increases the negotiability of the shares by making them more readily transferable to a new owner. © CANADIAN SECURITIES INSTITUTE 8 4 CANADIAN SECURITIES COURSE      VOLUME 1 Clearing and CDS Clearing and Depository Services Inc. (CDS) offers computer-based systems to settlement replace certificates as evidence of ownership in securities transactions. This system almost eliminates the need to handle securities physically. Trading units Stocks trade in uniform lot sizes on stock exchanges. A standard trading unit is a unit whose size has uniformly been decided upon by the exchanges. The usual unit of trading for most stocks is 100 shares. A group of shares traded in less than a standard trading unit is called an odd lot. BENEFITS AND RISKS OF COMMON SHARE OWNERSHIP The right to buy or sell common shares in the open market at any time is an attractive feature; either process is a relatively simple matter with few legal formalities. When a company first sells its shares to investors, the proceeds from the sale go to the company. When these outstanding shares are subsequently sold by their holders, the selling price is paid to the seller of the shares, not to the company. Shares may therefore be transferred from one owner to another without affecting the operations of the company or its finances. From the company’s point of view, the effect of a sale is simply that a new name appears on its list of shareholders. Common share ownership holds the following benefits: Potential for capital appreciation The right to receive any common share dividends paid by the company Voting privileges, including the right to elect directors, approve financial statements and auditor’s reports, and vote on important issues Favourable tax treatment in Canada of dividend income and capital gains Marketability—the shareholdings of most public companies can easily be increased, decreased, or sold The right to receive copies of the annual and quarterly reports, as well as other mandatory information pertaining to the company’s affairs The right to examine certain company documents, including its by-laws and its register of shareholders, at specified times The right to question management at shareholders’ meetings Limited liability Along with these benefits and the potential for large capital appreciation, investors should be aware of the following risks of investing in common shares: The issuer has no obligation to pay dividends. Common shareholders generally have very little influence over the day-to-day operations of the company. Common share prices can be volatile, and price changes can lead to investors losing money. In terms of claims to assets, common shareholders fall behind creditors, bondholders, and preferred shareholders in the case of bankruptcy or dissolution. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 5 CAPITAL APPRECIATION Capital appreciation is any increase in the value of a company’s assets, including the value of its common shares. The prospect of capital appreciation is the main attraction of common shares for many investors. A company’s net earnings may be kept as retained earnings and reinvested in the business or distributed to shareholders, in whole or in part, as dividends. When earnings are retained, the value of the company’s common shares may increase. The size of shareholder’s equity increases accordingly, which makes the stock more attractive to investors. Higher demand for a company’s stock, and a corresponding increase in the company’s value, can also result from increasing profits and dividend payments. However, not all common shares fulfill investor expectations. Even when a company increases shareholder equity, earns profits, and increases dividend payments, its shares may not necessarily increase in value every year. Many other factors can affect a company’s stock price. Therefore, careful analysis is required to ensure a profitable investment, particularly one that suits your investment horizon (e.g., are you investing for the short term or long term?). We will discuss stock price analysis in detail in Volume II of this course. DIVIDENDS Dividend policy is determined by a company’s board of directors, who are guided primarily by the company’s size, goals, and financial position, and by the industry in which it participates. For example, a large, established company such as a bank may pay out a substantial percentage of its earnings as dividends to shareholders, whereas a growing tech company may need to keep a higher proportion of earnings within the business to fund research and development. Most companies retain some portion of earnings each year to maintain operations and finance growth. In the long run, this policy works to the benefit of shareholders if it results in increased earnings. Dividends are sometimes reduced or halted, particularly in poor economic times. Although such interruptions may be temporary, they should be recognized as one of the risks of common share investment. REGULAR AND EXTRA DIVIDENDS Companies paying common share dividends might designate a specified amount to be paid each year as a regular dividend. The term regular indicates to investors that, barring a major collapse in earnings, those payments will be maintained. Some companies may pay an extra dividend on the common shares, usually at the end of the company’s fiscal year. The extra payment is a bonus paid in addition to the regular dividend. The term extra indicates that investors should not assume that the payment will be repeated the following year. DECLARING AND CLAIMING DIVIDENDS Companies may pay dividends once, twice, or four times a year. Unlike interest on debt, however, dividends on common shares are not a contractual obligation. The board of directors decides whether to pay a dividend and—if it is to be paid—the amount and payment date. An announcement is then made in advance of the payment date. If the shares are registered in the name of the owner, dividend payment cheques are mailed directly to the owner. For shares registered in street certificate form, dividend payments are made to the securities firm whose name appears on the certificate. The dividends are then credited to the accounts of the firm’s clients who own the shares. EX-DIVIDEND AND CUM DIVIDEND Many companies announce the declaration of a dividend through various channels, including print media, press releases, and their company websites. A typical newspaper dividend announcement is shown in Figure 8.1. © CANADIAN SECURITIES INSTITUTE 8 6 CANADIAN SECURITIES COURSE      VOLUME 1 Figure 8.1 | Notice of Dividend NOTICE OF DIVIDEND The Board of Directors of ABC Inc. voted to pay on July 2, 20XX to shareholders of record at the close of business on June 13, 20XX a dividend of $0.75 per each share of common stock. The transfer books will not be closed. Payment will be made in Canadian funds. Adele Aziki, Company Secretary When a stock is actively traded, the record of shareholders is continually changing. For convenience, the issuing company names a date known as the dividend record date, and all shareholders recorded as of this date are entitled to the declared dividend. The dividend record date is usually two to four weeks in advance of the payment date. The purpose of the interval (between June 13 and July 2 in Figure 8.1) is to give the company time to prepare the dividend cheques for mailing to recorded shareholders. Investors who buy shares during this interval are not entitled to the declared dividend. Those shares are referred to as ex-dividend (without dividend) shares. To determine whether the seller or the buyer is entitled to a dividend when a sale takes place around the time of the dividend payment, the stock exchange names an ex-dividend date. Before this date, shares are sold cum dividend (with dividend); that is, the buyer receives the dividend. On and after this date, they sell ex-dividend; that is, the seller retains the dividend. The first ex-dividend date is the same day as the dividend record date. Because common and preferred share trades settle on the first business day after a trade, an investor who buys shares on the record date would not have the trade settle until the business day after the record date. The buyer would therefore not be a shareholder of record and thus would not receive the dividend. The last day a stock trades cum dividend is the business day before the dividend record date. Using the dates shown in Figure 8.1, and assuming that none of the weekdays are holidays, the shares would trade as shown in Table 8.1. Note that weekends are not counted when determining the settlement date of a stock transaction. Table 8.1 | Trading Ex-dividend and Cum Dividend Date Traded Date Settled Ex-dividend or Cum Dividend Wednesday, June 8 Thursday, June 9 Cum Dividend Thursday, June 9 Friday, June 10 Cum dividend Friday, June 10 Monday, June 13 Cum dividend Monday, June 13 Tuesday, June 14 Ex-dividend Tuesday, June 14 Wednesday, June 15 Ex-dividend © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 7 DID YOU KNOW? The major Canadian stock exchanges publish dividend announcements in their daily news releases. DIVIDEND REINVESTMENT PLANS Some major companies give their preferred and common shareholders the option of participating in an automatic dividend reinvestment plan. In such a plan, the company diverts the shareholders’ dividends to the purchase of additional shares of the company. Reinvested dividends are taxable to the shareholder as ordinary cash dividends, even though the dividends are not received as cash. Share purchases, in most dividend reinvestment plans, are made on the open market under the direction of a trustee. Participating shareholders are periodically sent a statement showing the number of shares bought under the plan (including fractional shares in some cases) and the price at which they were bought. The provision in some plans for crediting participating shareholders with applicable fractions of shares is unique. Normally, fractions of shares cannot be purchased in the market by a shareholder. Under a reinvestment plan, the company uses authorized dividends to purchase additional shares in bulk. For this reason, it pays a lower commission than would an individual shareholder buying the same small number of shares. The commission is particularly high for individuals when odd lots are involved. In effect, a dividend reinvestment plan is an automatic savings plan that allows investors to reinvest small amounts of cash. Participating shareholders acquire a regular, gradually increasing share position in the company at a reduced average cost per unit. This process is known as dollar cost averaging. STOCK DIVIDENDS Some dividends are in the form of additional stock rather than cash. These so-called stock dividends are typically paid by rapidly growing companies that must retain a high proportion of earnings to finance future growth. Shareholders receiving stock dividends can sell them if they require the cash. Stock dividends are recorded on a company’s statement of retained earnings in the same fashion as cash dividends. Because stock dividends are treated as regular cash dividends for tax purposes, many investors, given the option, elect to receive dividends in cash. VOTING PRIVILEGES Voting rights are an important feature of common shares. Usually, each common shareholder has one vote for each share owned. Through the right to vote at the annual meeting and at special or general meetings, shareholders exercise their rights as owners to control the destiny of the corporation. However, many companies have two or even three different types of shares, often designated as Class A, B, or C. Not all classes have voting rights and may differ in other respects, such as dividend entitlement. Therefore, it is important to know their respective features. RESTRICTED SHARES Restricted shares (or special shares) give the shareholder the right to participate to an unlimited degree in the earnings of a company and in its assets on liquidation, but they do not carry full voting rights. There are three categories of restricted shares: Non-voting shares carry no right to vote, except in certain limited circumstances. Subordinate voting shares carry a right to vote if another class of shares is outstanding and those shares carry a greater voting right on a per-share basis. © CANADIAN SECURITIES INSTITUTE 8 8 CANADIAN SECURITIES COURSE      VOLUME 1 Restricted voting shares carry a right to vote, subject to a limit or restriction on the number or percentage of shares that may be voted by a person, company, or group. In recent years, the number of companies issuing restricted shares has increased substantially. Some investors have become concerned and have resisted efforts by companies to reorganize and create restricted shares. DID YOU KNOW? Canadian securities regulators have introduced policies regarding restricted shares. For example, Ontario sets out the details of these rules in the Ontario Securities Commission Rule 56-501. As an investment advisor, you should be able to identify restricted shares and understand their implications. You should also communicate the differences in the voting rights of such shares to your clients to provide proper advice. STOCK EXCHANGE REGULATIONS OF RESTRICTED SHARES The stock exchanges and securities commissions published the following regulations regarding restricted shares: Restricted shares must be identified by the appropriate restricted share term. Disclosure documents—including information circulars, annual reports, and financial statements sent to voting shareholders—must also be sent to holders of restricted shares, and the documents must describe the restrictions on their voting rights. Restricted shares must be identified in the financial press with a code. Dealer and advisor literature must properly describe restricted shares. Trade confirmations must identify restricted shares. Holders of restricted shares must be given notice of shareholders’ meetings. They must also be invited to attend and be permitted to speak at the meetings. Minority approval is required for any corporate action that would result in the creation of new restricted shares. As an investment advisor, you should be aware of the protection offered to restricted shareholders, which may vary in terms of extent. RESPONSIBLE INVESTMENT Responsible investment refers to the incorporation of environmental, social, and governance (ESG) factors into the selection and management of investments. There is growing evidence that incorporating ESG factors into investment decisions can reduce risk and improve long-term financial returns. In Canada, responsible investing gained prominence during the 1970s and 1980s. At that time, it was commonly known as ethical or socially responsible investing. Since then, shareholder activism and corporate engagement have become commonplace. Canadian mutual funds, pension funds, and coalitions of shareholders work with churches, unions, and other responsible investors to engage with companies. Where necessary, they sponsor shareholder resolutions on a variety of ESG issues. Today, there is no one-size-fits-all strategy or approach to responsible investing. Responsible investors practice both values-driven approaches, which incorporate the investors’ moral or ethical beliefs, and valuation-driven approaches, which consider the materiality of ESG issues. There are numerous strategies available to serve the diversity of responsible investors, including ESG integration, shareholder engagement, screening, thematic, and impact investing. On the more technical side, there are even more sub-strategies, including carbon efficiency and ESG momentum, among others. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 9 ENVIRONMENTAL, SOCIAL, AND GOVERNANCE ISSUES Environmental, social, and governance issues are some of the most important drivers of change in the world today. They are also critical economic issues with significant implications for businesses and investors. Examples of ESG issues are as follows: Environmental Climate change Conservation of natural resources Waste management Water scarcity Social Diversity and inclusion Human capital management Human rights Indigenous and community relations Governance Corruption and bribery Executive compensation Risk and crisis management Supply chain management There are many sources of ESG information, including corporate ESG ratings and rankings, corporate sustainability reports, in-house research, ESG information disclosure in securities filings, and media coverage. Investors have a number of choices available to them beyond equities to pursue responsible investment. Responsible investments are found in all major asset classes, and numerous investment vehicles are available to retail investors, as follows: Community bonds Retail venture capital funds Exchange-traded funds Segregated funds Green bonds Separately managed accounts Guaranteed investment certificates Social bonds Mutual funds Sustainability- and transition-linked bonds Pooled products Sustainability bonds STOCK SPLITS AND CONSOLIDATIONS At any one time, a publicly traded company will have a set number of outstanding shares trading in the marketplace. The company’s board of directors may decide, as part of their corporate strategy, to alter the number of shares outstanding using a stock split or reverse stock split (or consolidation). Most companies believe it is good corporate strategy to keep the market price of their shares within a specific price range, say between $10 and $20, or comparable to the price levels of similar companies in their sector. The primary motive in using a stock split or reverse split is to make the company’s share price more affordable for investors. © CANADIAN SECURITIES INSTITUTE 8 10 CANADIAN SECURITIES COURSE      VOLUME 1 STOCK SPLITS With a stock split, the number of shares outstanding increases as the company will issue more shares to the current shareholders. After the split, the stock’s price will be reduced because the number of shares outstanding has increased. EXAMPLE In a four-for-one split, three additional shares are given for each share held by a shareholder. So, if you owned 1,000 shares of the company before the split, you would now own 4,000 shares after the split. If the market price of the shares was $100 before the split, the share price will be somewhere in the $25 range after the split. What is important to understand is that the investment value of your holdings would remain unchanged: Pre-split value: $100 × 1,000 shares = $100,000 After the split: $25 × 4,000 shares = $100,000 When the market price of a company’s shares is too high, a stock split is an effective means to reduce the price. The market price of the new shares reflects the basis of the split, and each shareholder’s total shareholdings in the company increase accordingly. The split itself does not affect the dollar value of the company’s equity, nor does it change the proportion and value of a shareholder’s stake. Equity per share is reduced as the total number of shares outstanding increases, but the equity section of the statement of financial position remains unchanged. REVERSE STOCK SPLIT When the market price of a company’s shares is too low, a reverse stock split can be used to raise the price. The new price reflects the basis of the consolidation, and each shareholder’s total shareholdings in the company are reduced accordingly. EXAMPLE If a reverse split of one new share for 10 old shares were implemented, a shareholder owning 100 shares of stock would now own only 10 new shares. For example, if the shares were selling at $0.25 before the reverse split, the new shares would trade near $2.50 per share. The total dollar value of the holdings would not be affected: $0.25 × 100 shares before consolidation = $2.50 × 10 shares after consolidation. Reverse splits occur most frequently when a company’s shares have fallen in value to a level that is unattractive to investors with large amounts of capital. Companies use them when they are in danger of being delisted by a stock exchange because their share price has fallen below the exchange’s minimum share price rule. A reverse split raises the market price of the new shares and can put the company in a better position to raise new capital. CANADIAN DEPOSITARY RECEIPTSTM According to the World Bank, Canada represents approximately 3% of the world’s capital markets, which means the average Canadian’s direct exposure to international markets is limited if they focus on investing in domestic stocks. But there are disadvantages to investing in international stocks, including exchange rate fees, foreign exchange rate risk, and, in some cases, high stock prices that make some international company shares inaccessible. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 11 EXAMPLE Conner invested $10,000 in Canadian funds in an American stock that traded on the NYSE when the Canadian dollar was trading at $0.80 U.S. per Canadian dollar. After exchanging his money for U.S. currency and purchasing the stock, he decided to sell the stock three months later for a 12% gain. At the time of sale, the value of the Canadian dollar had increased to $0.84 U.S. dollars per Canadian dollar. After the sale, when Conner exchanged his U.S. dollars back to Canadian currency, he was left with $10,666, which represents a return of only 6.67%, far from the 12% gain on the stock that he had hoped for. Canadian Depositary Receipts (CDRs) are securities designed to give Canadians access to popular U.S. and global companies that trade on the NYSE and NASDAQ, but they are listed on the Cboe Canada Exchange in Canadian dollars. Trading CDRs in Canadian dollars removes the impact of fluctuating exchange rates. Although CDRs are a relatively new product for the Canadian markets, they were first introduced in the U.S. as American Depositary Receipts in 1927. One of the key features of CDRs is a built-in currency hedge, based on the CDR Ratio. The CDR Ratio is the method used to increase or reduce the number of underlying shares of the CDR based on how the Canada/U.S. exchange rate changes. The process virtually eliminates the effect of exchange rate changes on the investment. The CDR Ratio is adjusted daily, as follows: If the value of the Canadian dollar increases versus the U.S. dollar, the CDR is adjusted so that it represents a larger number of underlying shares. If the value of the Canadian dollar decreases versus the U.S. dollar, the CDR is adjusted so that it represents a smaller number of underlying shares. This daily adjustment helps to keep the dollar value of the investment relatively unchanged despite exchange rate fluctuations, and only the impact of the underlying stock’s price change affects the investor’s investment value. EXAMPLE Conner invested $10,000 in Tesla CDRs on the Cboe Canada Exchange at a price of $25 per CDR in September 2021. At the same time, Tesla shares were trading around $1,200 U.S. on NASDAQ. By late October, Tesla CDRs were trading at $28 per CDR when Conner closed his position. He gained 12% on his investment. Over that time, the value of the Canadian dollar increased from $0.78 U.S. per Canadian dollar to $0.81 U.S. per Canadian dollar. The change in the value of the Canadian dollar had no impact on Conner’s CDR investment. This example highlights a primary benefit of investing in CDRs – access to fractional ownership of high-priced stocks in lower-priced Canadian dollar versions. Other key features of CDRs are as follows: Dividends Canadian CDR investors are paid dividends from the underlying shares in Canadian dollars. Fees CDRs have no ongoing management fees. They also allow investors access to institutional foreign exchange rates. Liquidity CDR liquidity is dependent on the liquidity of the underlying security. The higher the trading volume of the underlying security, the higher the liquidity of the CDR. Therefore, it is possible for a CDR itself to have a low trading volume but still have narrow bid-ask spreads based on the underlying stock. © CANADIAN SECURITIES INSTITUTE 8 12 CANADIAN SECURITIES COURSE      VOLUME 1 Lower price per share Many of the largest global companies trade at high prices, which makes stock purchases inaccessible to the average retail investor. For example, when Amazon closed at $2,887.00 U.S. per share on the NASDAQ on April 22, 2022, the Amazon CDR closed on the Cboe Canada Exchange at $18.00 CDN per CDR on the same day. The price of a CDR is initially set to approximately $20 when first issued on the Cboe Canada Exchange. Qualified investments CDRs are qualified investments that can be held in registered retirement savings plans, registered retirement income funds, registered education savings plans, and tax- free savings accounts. Registered plans and tax-free savings accounts are covered in greater detail in Chapter 24. Taxation The current assumption regarding taxation is that owning CDRs is equivalent to owning the underlying stock. As such, a CDR owner may be subject to U.S. withholding taxes. It is recommended that CDR investors seek tax advice regarding how their investment will be treated and the U.S. Internal Revenue Agency forms that may be required for tax filings. Voting rights Canadians who invest in CDRs are entitled to vote based on the number of shares reflected by the total ownership of their CDRs. CIBC brought CDRs to the Canadian market in 2021. Listings on the Cboe Canada Exchange include Amazon, Apple, Home Depot, IBM, Netflix, Tesla, and Walmart, to name a few. READING STOCK QUOTATIONS Two kinds of stocks are traded during the day: those listed—and thus traded—on the stock exchanges, and the unlisted stocks that trade on the over-the-counter market. A typical quotation for stocks traded in Canada on the stock exchanges is shown in Table 8.2. Table 8.2 | BEC Inc. Stock Quotation 52 Weeks High Low Stock Div. High Low Close Change Volume 12.55 9.25 BEC 0.50 10.65 10.25 10.35 +0.50 6,000 This type of quotation, which may vary in format depending on the media source, is complex but useful. The quotation in Table 8.2 can be interpreted as follows: BEC common has traded as high as $12.55 per share and as low as $9.25 during the last 52 weeks. BEC common has paid dividends totalling $0.50 per share during the last 52 weeks. (Sometimes, an indicated dividend rate may appear if the company pays regular dividends and has recently increased a dividend payment.) During the day under review, BEC common shares traded as high as $10.65 and as low as $10.25. The last trade of the day in this stock was made at $10.35. The closing trade price was $0.50 higher than the previous trading day’s closing trade price. (Therefore, BEC shares closed at $9.85 on the previous trading day.) A total of 6,000 BEC common shares traded that day. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 13 Note that market prices used in stock quotations apply to standard trading units and exclude the commission expense for trades in listed stocks. COMMON SHARES What are the key features and benefits of common shares from the point of view of both the issuer and the investor? Complete the online learning activity to assess your knowledge. PREFERRED SHARES 3 | Describe the features, benefits, and risks of preferred shares. 4 | Differentiate among the types of preferred shares. When a company needs to raise capital, there are generally three types of securities they can issue: bonds or debentures, common shares, and, less frequently, preferred shares (which are sometimes referred to as preferred stock or simply preferreds). Preferred shareholders are usually entitled to a regular dividend payment, subject to the discretion of the board of directors. Because of this income stream, most preferred shares are treated by investors like a type of fixed-income security. However, preferred shareholders are not in the same category as creditors holding typical fixed-income securities, such as bonds and debentures. As part owners of a company, along with common shareholders, preferred shareholders rank behind creditors in their claim to assets. Preferred shareholders do, however, have priority status over common shares in the event of bankruptcy or dissolution of the company. Some companies issue more than one class or series of preferred shares. When this occurs, each class or series is identified separately. If the rank of various outstanding preferred share issues is equal as to asset and dividend entitlement, the shares are described as ranking pari passu. EXAMPLE ABC Corporation Limited has four preferred share issues outstanding: 5.25% Class A preferred shares, Class B floating-rate preferred shares, 4.50% Class C preferred shares and 4.25% Class D preferred shares. Each issue has a par value of $25 per share and the four issues rank equally as to asset and dividend entitlement. The preferred shares thus rank pari passu with each other. PREFERRED SHARE FEATURES Preferred shares have several features that reflect their unique position relative to common shares and bonds and debentures. PREFERENCE AS TO ASSETS As mentioned already, preferred shareholders rank ahead of common shareholders but behind creditors and debtholders in their claim to assets. Preferred shareholders are therefore better protected than common shareholders but less protected than creditors and debtholders. Because preferred shareholders usually have no claim on earnings beyond the fixed dividend, it is fair for their position to be buttressed by a prior claim on assets, ahead of the common shares. The common shareholder must be content with anything that is left after all creditor, debtholder, and preferred shareholder claims have been met. © CANADIAN SECURITIES INSTITUTE 8 14 CANADIAN SECURITIES COURSE      VOLUME 1 PREFERENCE AS TO DIVIDENDS Preferred shares are usually entitled to a fixed or floating dividend expressed either as a percentage of the par or stated value or as a stated amount of dollars and cents per share. EXAMPLE DEF Inc.’s $25 par value 3.50% Series E Fixed Rate preferred shares, currently trading at $26.50 per share, pay a fixed annual dividend of $0.875 per share ($25 par value × 3.50% = $0.875 annual dividend). The quarterly dividend payment, when declared by the board of directors, is one-fourth of this amount, or $0.21875 per share. An investor who owns 1,000 shares would therefore receive $218.75 in dividends four times a year. GHI Ltd.’s $25 par value Series F Floating Rate preferred shares, currently trading at $24.75 per share, pay a monthly dividend equal to 75% of the average Canadian Bank Prime Rate during the month. If the average rate in the current month is 4%, the dividend would be $0.0625 per share ($25 par value × (0.75 × 4%) ÷ 12). An investor who owns 1,000 shares would therefore receive $62.50 this month, but monthly dividend payments in the future would be based on future values of the Canadian Bank Prime Rate. Dividends are paid from earnings, either current or past. However, unlike interest on a debt security, dividends are not obligatory; they are payable only if declared by the board of directors. If the board omits the payment of a preferred dividend, there is very little the preferred shareholders can do about it. However, in almost all cases, company charters provide that no dividends are to be paid to common shareholders until preferred shareholders have received full payment of the dividends to which they are entitled. Directors have the right to defer the declaration of preferred dividends indefinitely. In practice, however, dividends are paid if they are justified by earnings. Failure to declare an anticipated preferred dividend has unfavourable repercussions. Besides weakening investor confidence, the general credit and future borrowing power of the company will suffer. Because most preferred shares can be considered fixed-income securities, they do not offer the same potential for capital appreciation that common shares provide for investors. Should interest rates decline, preferred share prices will tend to increase in price, much like a bond. However, good corporate earnings will have no effect on a preferred share’s dividend or claim to assets. Therefore, the preferred share dividend rate is of prime importance to the preferred shareholder. OTHER FEATURES Beyond their place in the capital structure and entitlement to dividends, the following features can be built into a preferred share, either to strengthen the issuer’s position or to protect the investor’s position. Cumulative or non- Preferred share dividends can be cumulative or non-cumulative. If a company’s board cumulative dividends of directors votes not to pay one or more preferred share dividends when due, and the preferred share has a cumulative dividend feature, the unpaid dividends accumulate in what is known as arrears. All arrears of cumulative preferred dividends must be paid before common share dividends are paid or before the preferred shares are redeemed. With a non-cumulative dividend feature, arrears do not accrue, and the preferred shareholder is not entitled to catch-up payments if dividends resume. Most preferred shares in Canada have a non-cumulative dividend feature. Term to maturity Most preferred shares have no stated maturity date. Depending on the specific features of a preferred share, investors may not have the ability to force the repayment of the par value, therefore, a preferred share can be outstanding for an indefinite period. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 15 Callable feature Almost all preferred shares are callable, meaning they can be called or redeemed by the issuer at a stated time and stated price. Depending on when a preferred share is called, it may provide for the payment of a small premium above the issue price. The premium is compensation to the investor whose shares may be called for redemption. Retraction feature A preferred share with a retraction feature gives shareholders the right to force the company to buy back the shares on a specified date at a specified price. Some are issued with two or more retraction dates. The principle of retraction, or pulling back, is identical to the principle for retractable bonds and debentures, which we discussed in Chapter 6. The holder of a preferred share with a retractable feature can create a maturity date for the preferred by exercising the retraction privilege and tendering the shares to the issuer for redemption. With a hard retraction feature, the company must pay the redemption value in cash. A soft retraction feature allows the company to pay the redemption value in cash or common shares of the issuer. Voting privileges Virtually all preferred shares are non-voting if preferred dividends are paid on schedule. However, after a stated number of preferred dividends have been omitted, it is common practice to assign voting privileges to the preferred shares. TYPES OF PREFERRED SHARES The Canadian preferred share market has undergone many changes in the past few decades, sometimes in response to regulatory changes, sometimes dues to changes in investor demand. Changes have driven issuers and their investment bankers to come up with new ways to package a stream of dividends that investors crave while also ensuring that the terms and features keep pace with regulatory requirements. FIXED-RATE PERPETUAL PREFERRED SHARES As their name suggests, fixed-rate perpetual preferred shares pay a fixed quarterly dividend, typically expressed as an annual percentage of the issue price, and have no stated maturity date. Like almost all Canadian preferred shares, however, issuers have the right to call or redeem fixed-rate perpetual preferred shares on established dates at prices set at the time of issue. The first call date is normally five years after the issue date, with a call price slightly above the issue price. The call price then declines by a set amount each year, so that it equals the issue price after five years. Issuers then can call the preferred share each year thereafter at a call price equal to the issue price. EXAMPLE The holders of ABC Corporation Limited’s $25 par value, 5.25% Class A Non-Cumulative Redeemable fixed-rate preferred shares are entitled to fixed, non-cumulative cash dividends, if declared by the board of directors, at a rate of 5.25%, or $1.3125 per share per year, payable quarterly on the last day of March, June, September, and December at a rate of $0.328125 per share. Subject to certain provisions, the Class A preferred shares are redeemable at ABC Corporation Limited’s option at the following prices: $26.00 per share on or after March 31, 20x1, but prior to March 31, 20x2; $25.75 if redeemed on or after March 31, 20x2, but prior to March 31, 20x3; $25.50 if redeemed on or after March 31, 20x3, but prior to March 31, 20x4; $25.25 if redeemed on or after March 31, 20x4, but prior to March 31, 20x5; $25.00 if redeemed on or after March 31, 20x5. © CANADIAN SECURITIES INSTITUTE 8 16 CANADIAN SECURITIES COURSE      VOLUME 1 As with the market price of bonds and debentures, if interest rates rise, the fixed dividend payment becomes less valuable to investors, and the market price of fixed-rate perpetual preferred shares will fall. If interest rates decline, the fixed dividend payment becomes more valuable to investors, and the market price of perpetual preferred shares will rise. FLOATING-RATE PREFERRED SHARES Floating-rate preferred shares pay a dividend that adjusts, or floats, based on either a percentage of the Canadian Bank Prime Rate or the yield on 3-month Government of Canada Treasury bills plus a spread. Some floating-rate preferred shares pay dividends quarterly while others pay monthly. Dividend payments can be based on the value of the floating-rate benchmark on the previous dividend payment date or on the average value of the floating-rate benchmark during the current period. Floating-rate preferred shares do not have a stated maturity date but can be called by the issuer, usually after a set period after the issue date and regularly thereafter, at prices determined at the time of issue. EXAMPLE The holders of ABC Corporation Limited’s $25 par value, floating-rate Class B Non-Cumulative Redeemable preferred shares are entitled to variable, non-cumulative cash dividends if declared by the board of directors. The dividends are payable on the last business day of March, June, September, and December, with the annual variable dividend rate being equal to the sum of the yield on the 3-month Government of Canada Treasury bill at the beginning of the quarter plus 2.62%. Subject to certain provisions, the Class B preferred shares are redeemable at ABC Corporation Limited’s option at $25.50 per share. Some companies issue floating-rate preferred shares directly, but most floating-rate preferred shares in Canada result from shareholder options embedded in fixed-rate preferred shares. FIXED-RESET PREFERRED SHARES Fixed-reset preferred shares are preferred shares with fixed dividend rates that periodically change, or reset, according to a formula or process outlined at the time the shares are issued. There have been two broad types of fixed-reset preferred shares issued in Canada: rate-reset preferred shares and fixed / floating preferred shares. Rate-reset preferred shares have an initial 5-year term during which shareholders are paid a fixed dividend rate based on the yield to maturity on the 5-year benchmark Government of Canada bond plus a spread. The spread represents the market’s view of the issuer’s creditworthiness at the time the preferred shares are issued, with a smaller spread indicating superior creditworthiness compared to a larger spread. At the end of the initial five-year term, and every five years thereafter, the issuer can call the shares for redemption at the initial offer price. If the issuer does not call the shares, shareholders can choose between two options: 1. Keep the preferred share, but with a dividend rate for the next five-year period reset to the current yield to maturity on the 5-year benchmark Government of Canada plus the same spread that was used to determine the fixed rate during the initial five-year period. 2. Exchange the fixed-rate preferred share for a floating-rate preferred share. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 17 EXAMPLE The holders of ABC Corporation Limited’s $25 par value, Class C Non-Cumulative Redeemable fixed-reset preferred shares are entitled to fixed, non-cumulative cash dividends if declared by the board of directors. The dividends pay at a rate of 4.50%, or $1.125 per share per year during the initial five-year period, payable quarterly on the last day of March, June, September, and December at a rate of $0.28125 per share. For each five-year period after the initial five-year period, holders of the Class C preferred shares will be entitled to fixed, non-cumulative cash dividends if declared by the board of directors. Dividends are payable quarterly on the last day of March, June, September, and December in an amount per share per year determined by multiplying the sum of the then-current 5-year Government of Canada bond yield and 2.62% by $25. Subject to certain provisions, holders of the Class C shares will have the option to convert their shares into Class B Non-Cumulative Redeemable floating-rate preferred shares at the end of the initial five-year period and every fifth year thereafter. Also subject to certain provisions, the Class C preferred shares are redeemable at ABC Corporation Limited’s option at $25 per share at the end of the initial five-year period and every fifth year thereafter. Fixed-reset preferred shares can also be issued in the form of a fixed / floating preferred share. These are like rate- reset preferred shares in that they pay a fixed dividend for an initial five-year term. After that period, if not called by the issuer, shareholders have the option to continue receiving fixed-rate dividends that have been reset or receive a floating-rate preferred share. Unlike rate-reset preferred shares, however, the fixed-rate dividend is not tied to a specific spread above the 5-year Government of Canada bond. Instead, it is determined by the issuer subject to certain minimum conditions specified at the time of issue. The option to convert to a floating-rate preferred share is available to fixed-reset preferred shareholders every five years on the anniversary of the issue date. EXAMPLE The holders of ABC Corporation Limited’s $25 par value, Class D Non-Cumulative Redeemable fixed-reset preferred shares are entitled to fixed, non-cumulative cash dividends, if declared by the board of directors, at a rate of 4.25%, or $1.0625 per share per year, during the initial five-year period. The dividends are payable quarterly on the last day of March, June, September, and December at a rate of $0.265625 per share. For each five-year period after the initial five years, holders of the Class D preferred shares will be entitled to fixed, non-cumulative cash dividends if declared by the board of directors. The dividends are payable quarterly on the last day of March, June, September, and December in an amount per share per year determined by ABC Corporation, provided that the annual rate shall not be less than 125% of the then-current 5-year Government of Canada bond yield. Subject to certain provisions, holders of the Class D shares will have the option to convert their shares into Class B Non-Cumulative Redeemable floating-rate preferred shares at the end of the initial five-year period and every fifth year thereafter. Also subject to certain provisions, the Class D preferred shares are redeemable at ABC Corporation Limited’s option at $25 per share at the end of the initial five-year period and every fifth year thereafter. Fixed / floaters used to be the dominant issue type in Canada, but they have since been surpassed by rate-reset preferred shares because of the extra degree of certainty associated with the calculation of the reset rate. WHY COMPANIES ISSUE PREFERRED SHARES In comparison with debt, preferred shares are usually more expensive for a company because dividends paid are not a tax-deductible expense. However, when all considerations are weighed, there may be sufficient advantages to justify a new preferred share issue. © CANADIAN SECURITIES INSTITUTE 8 18 CANADIAN SECURITIES COURSE      VOLUME 1 PREFERRED SHARE ISSUE VERSUS DEBT ISSUE From a company’s viewpoint, preferred shares do not generally create the demands that a debt issue creates. They do not usually have a maturity date, and if a preferred dividend payment is omitted, no assets can be seized by preferred shareholders. A corporation will choose to issue preferred shares rather than debt in the following circumstances: It is not feasible for the company to market a new debt issue because existing assets are already heavily mortgaged. Market conditions are temporarily unreceptive to new debt issues. The company has enough short- and long-term debt outstanding (i.e., its debt-to-equity ratio is high). The directors are reluctant to assume the legal obligations to pay interest and principal. The directors decide that paying preferred share dividends will not be onerously expensive. PREFERRED SHARE ISSUE VERSUS COMMON SHARE ISSUE When a company has decided that it will not, or cannot, issue bonds or debentures, it may find that conditions are not favourable for selling common shares either. The stock market may be falling or inactive, or business prospects may be uncertain. In such circumstances, preferred shares might be marketed as a compromise acceptable to both the issuing company and investors. Preferred shares also offer the advantage of avoiding the dilution of equity that results from a new issue of common shares. DID YOU KNOW? Because preferred shares typically do not have any claim on shareholder’s equity beyond their par value, the issuance of preferred shares does not affect the common shareholders’ equity claims. Likewise, it does not reduce the proportional ownership of common shareholders. WHY INVESTORS BUY PREFERRED SHARES Investors buy preferred shares for several reasons, including their yield, their tax treatment, and their ability to help diversify a portfolio of common shares and bonds. Higher yields than bond yields Generally speaking, the dividend yields on preferred shares have been greater than the yields to maturity on bonds. This makes preferred shares attractive to investors who are trying to generate income from their portfolios. Preferential tax treatment For individual and corporate investors, the dividends received on Canadian preferred shares benefit from the dividend tax credit. This means that the after-tax yield advantage of preferred shares is even greater than the pre-tax yield advantage. We discuss taxation of dividends more thoroughly in Volume II. Portfolio diversification Historically, the returns provided by preferred shares have had a relatively low correlation to common shares and bonds. This makes them attractive from a portfolio construction standpoint because it means preferred shares offer diversification benefits – either higher returns without higher risk or lower risk without lower returns – when they are added to a portfolio consisting of common shares and bonds. RISKS OF INVESTING IN PREFERRED SHARES While preferred shares can be attractive investments to many investors, they are not risk free; in fact, their risks are similar to those of fixed-income securities. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 19 INTEREST RATE RISK Because they represent a claim on a stream of dividends, preferred shares are sensitive to the general level of interest rates. A specific preferred share’s sensitivity to interest rate fluctuations depends on several factors, particularly whether the dividend is fixed or floating, the size of the dividend, and the time to the next redemption date. When interest rates rise, the prices of fixed-rate preferred shares tend to fall because the fixed dividend will be worth less to investors in a higher rate environment. In addition, in a rising-rate environment, fixed-rate preferred shares with a low dividend and longer term to maturity, all else being equal, will fall more than a preferred share with a higher dividend and shorter term to maturity. The reverse is true in both cases when interest rates fall. Floating-rate preferred shares, on the other hand, are much less sensitive to interest rates because investors know the dividend will reset up or down each quarter based on the prevailing level of interest rates. That said, between dividend payment dates, it is possible for the price of floating-rate preferred shares to increase in anticipation of higher future dividends. CREDIT RISK In addition to the terms of a specific preferred share, investors assess the creditworthiness of preferred share issuers when deciding how much they are willing to pay for the preferred share. Because preferred shareholders rank below all creditors and bondholders in the event of bankruptcy, preferred share prices can be quite sensitive to changes in perceived creditworthiness, especially when that perception goes down. In that case, the price of the issuer’s preferred shares will likely fall, with the biggest declines occurring in the prices of fixed-rate perpetual preferred shares and those that appear less likely to be called in the near term, indicating they may be outstanding for an extended period. DID YOU KNOW? Many issuers of preferred shares obtain a credit rating from a designated credit rating organization. These ratings help investors determine the relative creditworthiness of the various issuers of preferred shares. In Canada, preferred share credit ratings are published by Standard & Poor’s and DBRS Morningstar. CALL RISK Because almost all preferred shares are callable at the option of the issuer, investors are subject to call risk, which is the risk that they will be forced to give up their preferred shares when it is not in their best interest, which usually occurs when preferred shares are trading at a premium to their par value. The call risk of preferred shares is the biggest reason their upside price potential is limited. Investors are hesitant to bid up the price of a preferred share too high because they know the issuer will likely call it for redemption when the market indicates that it can probably issue a new preferred share with more favourable terms. EXTENSION RISK A corollary to call risk is extension risk. If a preferred share does not have a retraction feature, the issuer has the sole ability to determine when it will return the par value to investors. It can effectively keep extending the repayment date by simply not calling the preferred share for redemption. Investors can always sell their preferred shares in the market, but if the market price is below the par value, then there is a strong possibility it won’t be redeemed at the next redemption date. LIQUIDITY RISK The total market value of preferred shares in Canada is a fraction of the market value of common shares and bonds and debentures. As a result, the value that changes hands each day through trading on Canadian exchanges is also small. Furthermore, the fact that a good portion of many preferred shares is held by individual investors means that © CANADIAN SECURITIES INSTITUTE 8 20 CANADIAN SECURITIES COURSE      VOLUME 1 the liquidity in any individual preferred share is quite low. While it is easy to buy or sell a small quantity of most preferred shares without a big impact on price, any orders for quantities of significant size can be hard to execute quickly without the investor having to pay a premium or sell at a discount to the perceived fair value price. FOR INFORMATION ONLY Since 2013, all preferred shares issued by Canadian banks have been structured as non-viability contingent capital (NVCC), so that they qualify as Tier 1 Capital as defined by the Office of the Superintendent of Financial Institutions (OSFI). For a bank, capital is essentially the book value of its equity or the difference between its assets and liabilities. Tier 1 capital includes the book value of common shares, retained earnings as well as certain other equity securities. The designation of preferred shares as NVCC means that it is possible for OSFI to force the conversion of the preferred shares into common shares of the bank upon certain triggering events that require the bank to be recapitalized in periods of extreme distress. In 2020, OSFI accepted a new type of debt security, called a liquid recourse capital note (LRCN), as Tier 1 Capital. These securities rank pari passu with the banks’ preferred shares. They have a fixed term, a fixed interest rate that resets every five years to the 5-year Government of Canada bond yield plus a spread, and can be called by the issuer on every reset date. These features make them like rate-reset preferred shares. But, as a debt security, the interest payable on LRCNs is tax deductible by the bank, making them more advantageous to issuers from a cost of capital perspective. Liquid recourse capital notes can be purchased by institutional investors only, but they are an attractive alternative to federally regulated banks that are subject to OSFI’s capital requirements. Ultimately, they may affect the supply of preferred shares from these important issuers. PREFERRED SHARES What are the key features, unique benefits, and risks of the various types of preferred shares? Complete the online learning activity to assess your knowledge. STOCK INDEXES AND AVERAGES 5 | Summarize the important stock indexes and averages. Stock indexes or averages are indicators used to measure changes in a representative grouping of stocks, such as the S&P/TSX Composite Index or the Dow Jones Industrial Average (DJIA). These indicators are important tools, and are used for the following purposes: Gauge the overall performance and directional moves in the stock market. Enable portfolio managers and other investors to measure their portfolio’s performance against a commonly used yardstick within the stock market. Create index mutual funds. Serve as underlying interests for options, futures, and exchange-traded funds. A stock index is a time series of numbers used to calculate a percentage change of this series over any period of time. Most stock indexes are value-weighted and are derived by using the total market value (i.e., market capitalization) of all stocks used in the index relative to a base period. The total market value of a stock is found by multiplying its current price by the number of shares outstanding. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 21 DID YOU KNOW? Many organizations that construct indexes have additional construction rules for the indexes they publish. For example, most of the S&P market capitalization-weighted indexes are float-adjusted. The float refers to common shares issued to the public that are available for trading by investors and excludes those shares held by company officers, directors, or investors who hold a controlling interest in the company. A float-adjusted index means the index calculation only reflects those shares that are considered to be part of the float. Each day, the total market value of all stocks included in the series is calculated, and this value is compared to the initial base value to determine the percentage change in the index. EXAMPLE The S&P/TSX Composite Index closed at a value of 15,562. A year later, the same index closed at a value of 16,385. The change in the index translates into a gain of 5.29% for the year—calculated as follows: (16,385 - 15,562) ´ 100 15,562 In a value-weighted index, such as the S&P/TSX Composite Index or the S&P 500, companies with large market capitalizations dominate changes in the value of the index over time while companies with small market capitalizations have less of an impact. A stock average is the arithmetic average of the current prices of a group of stocks designed to represent the overall market or some part of it. Within a stock index, each stock has a relative weight based on the stock’s market capitalization. In contrast to a market-weighted stock index, stocks included in an average are composed of equally weighted items (i.e., no specific weights are applied when constructing the average). A stock’s relative weight within an index can change every day, whereas a stock’s weight within an average is always the same. However, stock averages are price- weighted, which means that movements in the average are tied directly to changes in the prices of the various stocks included in the average. This occurs because some prices are higher than others and will naturally have a greater influence on the average as a whole. EXAMPLE Even though no specific weights are applied when constructing the average, a stock that trades at $100 per share and falls by half to $50 will have a greater impact on the average than a stock that trades at $10 per share and drops by half to $5. CANADIAN MARKET INDEXES In Canada, the Toronto Stock Exchange (TSX) and the TSX Venture Exchange compile and publish indexes of stock prices for a variety of industry classifications. These indexes, their dividend yields, and the price-to-earnings ratios based on the S&P/TSX Composite Index can be found in the TSX Monthly Review, the Bank of Canada Review, and in financial newspapers in Canada and elsewhere. THE S&P/TSX COMPOSITE INDEX The Toronto Stock Exchange began its first stock price indexes in 1934. Many changes and revisions have been made to the index over the years. Figure 8.2 illustrates the growth of the market since 2003. © CANADIAN SECURITIES INSTITUTE 8 22 CANADIAN SECURITIES COURSE      VOLUME 1 Figure 8.2 | S&P/TSX and S&P/TSX 60 indexes 1,400 S&P/TSX S&P/TSX 60 24,000 1,300 Legend: 22,000 S&P/TSX Composite Index S&P/TSX 60 Index 1,200 20,000 1,100 18,000 1,000 16,000 14,000 900 12,000 800 10,000 700 8,000 600 6,000 500 4,000 400 2,000 0 300 2000 2005 2010 2015 2020 2025 Year Source: Bloomberg The S&P/TSX Composite Index measures changes in the market capitalization of the stocks in the index. A stock’s weight within the index changes if its price or the number of shares outstanding changes. The index has a floating number of stocks. To be included in the index, a stock must meet specific criteria based on price, length of time listed on the exchange, trading volume, capitalization, and liquidity. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 23 The stocks included in the S&P/TSX Composite index are also classified by industry, based on the Global Industry Classification Standard. This standard was developed jointly by S&P and MSCI (Morgan Stanley Capital International Inc.) for use in all their indexes and is accepted worldwide. An index has been created for each sector. Table 8.3 lists the 11 major industry sector indexes within the S&P/TSX Index. Table 8.3 | 11 Sectors of the S&P/TSX Composite Index Consumer Discretionary Information Technology Consumer Staples Materials Energy Real Estate Financials Communication Services Health Care Utilities Industrials Based on market capitalization, some sectors are weighted more heavily than others in the S&P/TSX Composite Index. For example, Financials and Energy account for more than half of the weight on the index. However, Health Care, Utilities, and Information Technology account for approximately 5% combined. To interpret the indexes, it is important to understand the distinction between point changes and percentage changes. Based on the starting level of 250 for an index, for example, a 1% change in the index is equivalent to 2.5 index points (calculated as 0.01 × 250). Similarly, a 1% change in other widely quoted indexes is not the same in terms of net point changes. For example, a 1% change is approximately: 280 points when Tokyo’s Nikkei 225 is trading around 28,000 (calculated as 0.01 × 28,000) 41 points when the S&P 500 is trading around 4,100 (calculated as 0.01 × 4,100) Therefore, as indexes move up and down, the percentage change is a more accurate reflection of market performance than net point changes. Also, when a percentage change in the S&P 500 is compared to a percentage change in the S&P/TSX, currency values should be taken into account. An investment in the S&P 500 is in U.S. dollars, whereas an investment in the S&P/TSX would be made in Canadian dollars. THE S&P/TSX 60 INDEX The S&P/TSX 60 Index includes the 60 largest companies that trade on the TSX as measured by market capitalization and is broken down into 11 sectors that cover all S&P/TSX Index subgroups. All stocks listed on this index must also be included in the S&P/TSX Composite Index. THE S&P/TSX VENTURE COMPOSITE INDEX The S&P/TSX Venture Composite Index is a Canadian benchmark index for the public venture capital marketplace. Managed by Standard & Poor’s, it is a market capitalization-based index meant to provide an indication of performance for companies listed on the TSX Venture Exchange. The index does not have a fixed number of companies and is revised quarterly based on specific criteria for inclusion and maintenance policies. TSX Venture Exchange-listed companies are eligible for inclusion in the S&P/TSX Venture Composite Index if they are incorporated under Canadian federal, provincial or territorial jurisdictions and represent a relative weight of at least 0.05% of the total index market capitalization. Stocks eligible for inclusion must generally be listed on the TSX Venture Exchange for at least 12 full calendar months as of the effective date of the quarterly revision. © CANADIAN SECURITIES INSTITUTE 8 24 CANADIAN SECURITIES COURSE      VOLUME 1 U.S. STOCK MARKET INDEXES THE DOW JONES INDUSTRIAL AVERAGE Although normally around 2,000 issues trade daily on the New York Stock Exchange, the most publicity is given to the trading performance of the 30 issues that make up the Dow Jones Industrial Average. The DJIA has been criticized because so few companies are included in this average, which means that it is not a truly representative indicator of broad market activity. Also, because it is price-weighted, when a higher-priced stock rises, it may distort the average. Even with the DJIA’s shortcomings, many people still use it as if it were an overall indicator of market performance. The DJIA is calculated by adding the prices of each of the 30 issues in the average and dividing by a specially calculated divisor. The divisor was initially the number of stocks in the average – originally 14 (12 railways and 2 industrials). Because of obvious distortion through stock splits (a 2-for-1 split would mean a $100 share would become $50 in the average after the split), the divisor was adjusted downward for each split. It is important to view the DJIA in perspective. Because it comprises such a small number of components, day-to- day changes may appear more dramatic than they actually are. Also, since the DJIA is composed of blue-chip stocks with a typically lower risk profile, it tends to underperform the broader market over the longer term. THE S&P 500 Because the Dow Jones average is not completely satisfactory as an indicator of broad market performance, other market indexes have been developed, such as the Standard & Poor’s 500 Stock Composite Index. This index is based on a large number of industrial stocks, some financial stocks, some utility stocks, and a smaller number of transportation stocks, which are weighted in the index by their market capitalization. Since the S&P 500 is weighted by market capitalization, more heavily weighted stocks have a greater effect on the value of the index. The S&P has become the main gauge for measuring the investment performance of institutional investments in the United States because of its broad industry coverage and the method of weighting the index. Many institutional investors have created investment funds that track the S&P 500. OTHER U.S. STOCK MARKET INDEXES This list is by no means exhaustive, but it includes the most well-known indexes. Many other U.S. indexes exist. The NYSE Composite The NYSE Composite Index is a market capitalization index that includes all the listed index common equities on the New York Stock Exchange. There are additional indices for industrial, transportation, utility, and financial corporations. NYSE American index This market-weighted index is based on all the stocks listed on the NYSE American exchange. The NYSE American is a leading exchange for small-cap companies. The NASDAQ The NASDAQ composite index is a capitalization-weighted index of more than Composite Index 3,000 issues. The NASDAQ market capitalization is about 80% of the NYSE market capitalization. The Value Line Value Line is a composite index of more than 1,600 stocks that is calculated by taking Composite Index an average of the daily percentage change in each stock within the index. This equal- weighted index was created by Wilshire Associates and is the broadest available barometer of all the U.S. indexes, and includes companies that are listed on the NYSE, NASDAQ, NYSE American, and the TSX. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 25 INTERNATIONAL MARKET INDEXES AND AVERAGES As the economy becomes more global, it makes sense for investors to diversify their equity portfolios by investing not only in various industries and stocks but in different countries. As the economies of more and more countries mature, their equity markets grow in size and sophistication, and it becomes easier for foreign investors to enter. Most funds that invest outside Canada prefer the large, liquid global stock markets, some of which are noted below. Nikkei Stock Average This is the Tokyo Stock Exchange average. The average is calculated like the Dow Jones (225) Price Index average and is updated every 15 seconds. The index is well known both inside and outside Japan. The FTSE 100 Index This index consists of the 100 largest listed companies listed on the London Stock Exchange and is one of the most widely followed indexes in the United Kingdom. It is calculated using the market capitalization of the stock and is recalculated on a minute- by-minute basis. The DAX Performance The DAX consists of 30 major Frankfurt Stock Exchange blue-chip stocks and is the most Index widely followed index on the German securities market. The index is weighted by market capitalization. Dividends and income from subscription rights are reinvested in the index. The CAC 40 Index The CAC 40 Index is based on 40 of the largest 100 companies listed on the Paris Stock Exchange. It is calculated on a market capitalization basis. The Swiss Market The Swiss Market Index is Switzerland’s blue-chip index, which makes it the most Index important in the country. The index is made up of 20 of the largest and most liquid stocks on the Swiss market, ranked by market capitalization. However, in the past 30 years, interest has developed in riskier, more exotic markets such as those of China, India, Turkey, Sri Lanka, Korea, and Mexico, which also have stock indexes. ENVIRONMENTAL, SOCIAL, AND GOVERNANCE INDEXES Indexes that incorporate ESG criteria are composed of companies deemed to be strong ESG performers by a third-party research firm. The MSCI Canada ESG Leaders Index and the MSCI World ESG Leaders Index are examples of ESG indexes. MSCI Canada ESG This index consists of large and mid-cap companies in the Canadian market with strong Leaders Index ESG ratings. The MSCI Canada ESG Leaders Index has consistently outperformed the broader MSCI Canada Index since 2007. The market downturn in the first quarter of 2020 affected all stocks, but the Canada ESG Leaders Index saw less of a downturn than the broader Canadian market. MSCI World ESG This index is a market capitalization-weighted index that provides exposure to Leaders Index companies with strong ESG ratings while excluding companies whose products have negative social or environmental impacts. The index is designed for investors seeking a broad, diversified sustainability benchmark with a relatively low tracking error to the underlying equity market. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 8 26 CANADIAN SECURITIES COURSE      VOLUME 1 SUMMARY In this chapter, we discussed the following aspects of common and preferred shares: The benefits of common share ownership can include capital appreciation, dividend income, voting privileges, favourable tax treatment, easy marketability, access to the board of directors, and limited liability. ESG issues are some of the most important drivers of change in the world today. ESG considerations include climate change, water scarcity, Indigenous and community relations, and diversity and inclusion. A stock split increases the number of shares outstanding, whereas a consolidation reduces the number of shares outstanding. In both cases, the market price changes, but the overall value of the investors’ share of ownership remains the same. In terms of the right to receive payment if a company is liquidated, preferred shareholders rank below the company’s creditors and above the company’s common shareholders. Canadian Depositary Receipts give Canadians access to U.S. and global companies, but in Canadian dollars and in fractional amounts that trade on the Cboe Canada Exchange. Trading in CDRs removes the impact of fluctuating exchange rates and gives Canadians access to high-priced stocks that would normally be inaccessible to regular retail investors. Preferred shareholders are usually entitled to a regular dividend payment, subject to the discretion of the board of directors. Because of this income stream, most preferred shares are treated like a type of fixed-income security. Preferred shares rank ahead of common shareholders but behind creditors and debtholders in their claim to assets. In almost all cases the charters of companies provide that no dividends are to be paid to common shareholders until preferred shareholders have received full payment of the dividend to which they are entitled. Fixed-rate perpetual preferred shares pay a fixed quarterly dividend and have no stated maturity date. Like almost all Canadian preferred shares, however, issuers have the right to call or redeem fixed-rate perpetual preferred shares on established dates at prices set at the time of issue. Floating-rate preferred shares pay a dividend that adjusts, or floats, based on either a percentage of the Canadian Bank Prime Rate or the yield on 3-month Government of Canada Treasury bills plus a spread. Fixed-reset preferred shares are preferred shares with fixed dividend rates that periodically reset according to a formula or process outlined at the time the shares are issued. Companies issue preferred for the following reasons: It is not feasible for the company to market a new debt issue because existing assets are already heavily mortgaged. Market conditions are temporarily unreceptive to new debt issues. The company has enough short- and long-term debt outstanding. The directors are reluctant to assume the legal obligations to pay interest and principal. The directors decide that paying preferred share dividends will not be onerously expensive. Investors typically buy preferred shares for their higher yields than bond yields, preferential tax treatment, and portfolio diversification. © CANADIAN SECURITIES INSTITUTE  CHAPTER 8      EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 27 Investing in preferred shares carries the following risks: Interest rate risk Credit risk Call risk Extension risk Liquidity risk REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 8 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 8 FAQs. © CANADIAN SECURITIES INSTITUTE