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Over the past few months, we’ve highlighted several companies that have huge potential for growth.
There’s a good reason for that. Our mandate at Money Morning is to prepare you to make investments — and there’s no better way to give yourself the opportunity to make huge triple-digit returns than with carefully chosen small-cap stocks.
But small-caps occupy a tiny corner of the investing universe. Sure, they can go up a lot — but you have to accept the risk that they can go down a lot too. What’s more, small-caps rarely pay dividends. That means they don’t suit everyone.
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Safety versus potential gains…it’s an age-old trade-off.
So what if we told you that you could have the best of both worlds?
Most Aussie investors want to have their cake and eat it too.
We as a people crave assets that pay a regular stream of income — but we’re also a nation of punters.
That goes some way to explain the national obsession with property.
Beyond bricks and mortar, when most people think about investing, their mind goes either to stocks, which provide the potential for capital gains, or bonds, which provide safe and steady fixed income.
It looks like interest rates on bank deposits will stay at rock bottom for some time to come. That means you have to get creative if you want assets that pay reliable income with a reasonable view to capital growth. You have to get even more creative if, unlike a property investment, you want the option of selling those assets at a moment’s notice.
Well, we’ve found an investment that offers the safety of a bond and the upside potential of a stock.
The majority of private investors have never even heard of this kind of investment, but it’s popular with institutional investors — the kind that manage billions of dollars.
Even better, you can buy it through your broker with a single click of your mouse.
You might be wondering, what kind of investment combines bond-like safety with stocks’ potential for capital gains? Here are the details…
We’re talking about preference shares. In Australia, brokers often market them as ‘hybrids’. Here’s how they work.
When you own a stock, you own a small part of a business. When that business does well, you should profit through rising share prices and dividends. But when times get tough — like they did in Australia after 2008’s global financial panic — the company might cut those dividends. That means less cash in your pocket.
In contrast, bondholders don’t own a stake in the business. They just extend it a loan. The company pays the bondholder an agreed interest rate for the duration of the bond. At the end of the bond’s life, the company pays back the loan.
But preference shares sit in the middle. If you buy them, you can think of yourself as a ‘part-owner’ of a business.
Preference shares are freely tradeable on the Australian Securities Exchange (ASX). Much like ordinary shares, their price rises and falls depending on how the market views the company’s prospects.
But here’s the key difference — the company is contractually obligated to pay its preferred dividends before it pays any ordinary income.
That means a dividend-paying stock like Commonwealth Bank of Australia [ASX:CBA] would have to cut its ordinary dividend to zero before reducing its preferred payments by a single cent.
It gets better for preferred shareholders. Many preferred dividends are cumulative. That means if a company hits the skids and can’t pay its preferred dividends for a year or two, it has to catch up on those payments in better times before it can even consider paying any regular dividends. That reduces the risk for preference shareholders of missing any income.
You can think of preference shares as ‘VIP’ shares. Owning these securities can take you behind the velvet rope and grant you financial privileges that ordinary shareholders can’t access.
Just like VIP access to an exclusive nightclub, these privileges don’t come free of charge.
Preference shares in a company typically trade at high prices relative to ordinary shares. Obviously, people are usually willing to pay up for power and privilege.
That means the potential for capital gains is lower than that of ordinary shares.
You have to understand, too, that preference shares are not risk-free. Indeed, sometimes when the stock market goes pear-shaped, they can burn investors just as badly as ordinary shares. That’s because the company might suspend a cumulative dividend and the price of the preference shares on the ASX can take a nosedive — and right when you need high trading volume to sell your position, you find that liquidity dries up.
But in the end, preference shares offer safer dividends than stocks and stronger potential for capital growth than bonds.
If you’re not looking for big capital gains, but are hunting for deep streams of income — you’d do well to consider these ‘VIP’ shares.
Cheers,
Tim Dohrmann,
Editor, Money Morning
The post Revealing Your Ticket to ‘VIP’ Investing appeared first on Stock Market News, Finance and Investments | Money Morning Australia.