[Weekend Money]Preferred Shares, Are There Fake and Real Ones?

Classified by pre- and post-1996
Potential for buyback and cancellation of old-type preferred shares

As the gap between preferred shares and common shares widens, investors seeking undervalued preferred shares need to distinguish between "real" preferred shares and "fake" preferred shares.

According to Mirae Asset Securities, as of the end of January this year, the average discount rate of the top 10 preferred stocks by market capitalization versus their corresponding common stocks was 75%, about 20 percentage points wider than 55% at the end of January last year. The combined market capitalization of the top 30 preferred stocks has also expanded from around the mid-8x level of their corresponding common stocks in the past to as high as 10x now.

Yoo Gunho, analyst at Mirae Asset Securities, said, "In phases where the discount widens, strategies to buy undervalued preferred shares are repeatedly proposed," adding, "However, this contains the error of generalizing preferred shares as a single asset class. Investors should consider scenarios in which they can generate alpha by distinguishing the structural differences between old-type preferred shares and new-type preferred shares."

Old-type preferred shares are those issued before the 1996 amendment to the Commercial Act and are usually traded under ticker names such as "Company name+U" in Korean. When a "B" is attached, it refers to new-type preferred shares issued after the 1996 amendment to the Commercial Act.

Old-type preferred shares typically pay an additional dividend of 1% of par value, but they offer no further rights or protective mechanisms. Analyst Yoo explained, "They provide only a small additional dividend compared with common shares, while neither downside protection on dividends nor voting rights are guaranteed, so in economic substance they are non-voting common shares, that is, 'fake preferred shares'." New issuance of old-type preferred shares is no longer possible, but previously issued shares are still in circulation.

By contrast, many new-type preferred shares issued after the 1996 amendment to the Commercial Act include structures that guarantee a minimum dividend rate and either adopt a participating dividend structure, which pays out any incremental dividend increases granted to common shares, or a cumulative dividend structure, which accumulates and pays out unpaid dividends at a later time. Analyst Yoo said, "They are 'real preferred shares' in the sense that they confer genuinely preferential rights, such as granting voting rights if dividends are not paid."

When the preferred share discount widens, strategies to buy undervalued preferred shares attract attention. However, it is necessary to distinguish whether the discount is an irrational mispricing or a structural price difference that reflects differing levels of risk. Analyst Yoo said, "The essence of the price gap between common and preferred shares lies not in voting rights, but in economic rights, namely the difference in capital gains and dividends, and this stems from the risks borne by shareholders," adding, "If a gap exists between stocks that bear the same level of risk, that gap constitutes a genuine mispricing that can be exploited as an investment strategy." He continued, "Although common shares and old-type preferred shares are exposed to the same business risks, the lack of adequate protection mechanisms for the latter has led to a structurally large discount."

In particular, as the rights of old-type preferred shares are expected to be normalized through an amendment to the Commercial Act, a selective investment strategy aligned with this change is deemed necessary. Analyst Yoo said, "With the amendment to the Commercial Act codifying directors' fiduciary duty of loyalty to shareholders, discriminatory treatment of the rights attached to old-type preferred shares can now become an issue, and companies have an incentive to resolve it." Potential scenarios in the process of normalizing the rights of old-type preferred shares include: (i) a share price re-rating to the level of common shares; (ii) conversion into new-type preferred shares; and (iii) full buyback and cancellation. Among these, the most realistically feasible method is full buyback and cancellation. Analyst Yoo explained, "In the case of full buyback and cancellation, it can improve return on equity (ROE) and drive an earnings-per-share (EPS) re-rating for common shares, which can in turn lead to a rise in the share price."

This content was produced with the assistance of AI translation services.