How to be a better investor: Lesson 4

“Is it easy to invest?” is a very important question. What if the share price spread is just too wide? Investment expert Julian Hofmann explains how understanding the capital structure of a company makes it easier for you to assess how easy it will be to sell out and make a profit.

It is unclear whether George Orwell was much interested in the stock market, but he would have recognised the fact that while all investors are created equal, some are created more equal than others. A slightly laboured metaphor, perhaps, but understanding where you sit as an investor in the hierarchy of ownership is an important part of due diligence process. 

At the end of the day, it comes down to how easy it is for you to book profits on your investment and understanding the issues that can complicate this process. 

For instance, the size of the free share float – how many shares are readily available on the open market - will determine their liquidity and with it the share price spread. The spread will tell you how easy it is for you to offload the shares and book a profit – the wider the spread, the likely longer and more expensive that process will be.  The average size of a free float on the market today is around 32%.

• Discover more lessons on how to be a better investor here

Funny structures and family holdings

Listed companies that come with large family holdings are an example of a scenario that requires careful investigation before making an investment. Finding out the information is straightforward as any annual report will list the major shareholders and the precise size of their holdings. 

The Organisation for Economic Development (OECD) reckons that family holdings and those belonging to “strategic individuals” make up 7% of the total capitalisation of the top 10,000 companies in the world. That seems like chicken feed when compared with the 41% ownership that institutional investors can claim, but there is often a symbiotic relationship between the two groups that you need to wary of.

The argument is best illustrated by the UK Shareholders Association (UKSA). It says that a family holding of just 30% of the total share float is enough to exercise effective control of a company, partly because institutional investors tend to take a “hands-off” approach to getting involved in decision-making. This could result, the UKSA reckons, in a situation where the wishes of shareholders outside of the inner circle can be ignored and their interests left unrepresented in the decision-making process. 

Family-controlled companies have pros and cons and it worth listing them to gain a better understanding of the problem.

A short squeeze

One of the more entertaining family corporate feuds of recent times was between the notoriously quarrelsome members of the Porsche clan, specifically Wolfgang Porsche and Ferdinand Piech – the grandsons of Ferdinand Porsche. The Porsche Automobil Holding (XETRA:PAH3) company tried for years to engineer a reverse takeover of Volkswagen (XETRA:VOW3) – viewed by the family as a birth right.

This culminated in an audacious attempt by Porsche, with Wolfgang Porsche’s blessing, to seize control of the much larger VW through a series of complex cash-option positions. The result was a massive squeeze on short sellers who had been betting against a fall in VW’s ordinary share price – at one point the shares rose 1,000% in value.

Unfortunately, the attempt ultimately crippled Porsche as it still could not buy a big enough stake in VW, while the borrowings it had taken on to build its position could not be refinanced. The company ended up being taken over by VW, handing effective control back to Piech, who already had a 10% holding in Porsche.

DUE DILIGENCE LESSON: Beware troublesome family relations. 

Family empires exert influence in countries such as Japan, where are they called Zaibatsu, or South Korea, where companies like Samsung are known as Chaebol and have traditionally carried huge political clout. In the US, the Ford family still controls around 40% of the publicly listed Ford Motor Company (NYSE:F) through a system of special class “B” shares. 

Ford is an interesting case in whether family control can translate into better long-term decision-making. The company bit the bullet in 2006 and decided to radically restructure its operations and sell-off its underperforming marques. By the time the financial crisis hit two years later Ford managed to get through without a government bailout, something that the institution-controlled General Motors (NYSE:GM) couldn’t avoid. 

A matter of preference

The preference shares are another mechanism that establishes a hierarchy of shareholders. In the UK market context, preference shares carry no voting rights but guarantee an annual dividend. Banks and other financial institutions often issued them as a way of diversifying their capital base, but without diluting the ownership control of their existing shareholders. As such, in the hierarchy of the capital structure they sit below equity. 

A diverse range of companies have issued preference shares, including the likes of sugar supplier Tate & Lyle (LSE:TATE), petroleum giant BP (LSE:BP.) and engineer Rotork (LSE:ROR) over the years and investors appreciate their generally higher dividend yields and guaranteed payment rights. However, they can be cancelled if a company sees no more use for them, at the same time their eligibility as tier one capital (the highest designation for capital) is being phased out and it seems certain that the market for prefs will shrink over time. 

It really comes down to what matters to you most in your investment goals. Do you go for security of income over the possibility of greater rewards? In which case, buying a lower category of share that has a rock-solid dividend might work for you in the long-term. The key point is that you have gone through enough of a due diligence process to make that decision a well-informed one.