Investing in stocks: The hidden drawbacks of split-share corporations

Members of Pat McKeough’s Inner Circle enjoy a double benefit when it comes to taking advantage of our investment research. They get to address investment questions directly to Pat and his research associates; AND they get to see all other members’ questions, and our answers (of course, we eliminate any personal information). Members usually ask about stocks they own or are thinking of buying. Some of these stocks are so attractive that we eventually add them to our recommendations. Others are sells. In many cases, in addition to our specific advice, we provide valuable background information.

For instance, one member recently asked us about investing in stocks through split-share corporations, which are a good example of a structured financial product.

Structured products are investments that come with special characteristics that make them superficially attractive to investors. However, they tend to be far more profitable for brokers. That’s because, once commissions and other fees come out of these investments, it’s unlikely that you’ll wind up with a profit to match your risk.

To give you a clear sense of the drawbacks of investing in stocks through split-share corporations, I’d like to share our Inner Circle member’s question, along with our response. I hope you enjoy and profit from it.

Q: Your comments on Dividend 15 Split Corp. would be appreciated. The return looks impressive and it holds many of the stocks you recommend. Keep up the good work, I’ve been in the Inner Circle for years and have profited nicely by investing in stocks you recommend. Many thanks.

A: Dividend 15 Split Corp., $11.69, symbol DFN on Toronto (Shares outstanding: 11.2 million; Market cap: $131.2 million), is a split-share investment corporation that holds shares of 15 companies: BCE Inc., CI Financial Corporation, AGF Management, TransAlta Corporation, SunLife Financial, Canadian Imperial Bank of Commerce, TransCanada Corporation, Manulife Financial, TD Bank, TMX Group, Royal Bank of Canada, Loblaw, Bank of Montreal, Telus Corporation and Enbridge.

The company can also invest up to 15% of its portfolio in other equity issues.

Dividend 15 Split Corp. has two share classes: Dividend 15 Split Corp. capital shares (Toronto symbol DFN), and Dividend 15 Split Corp. preferred shares (Toronto symbol DFN.PR.A).

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A split-share company issues two classes of shares. Usually, the capital shares get all or most of the capital gains and losses, and the preferred shares get most of the dividend income. In the case of Dividend 15 Split Corp., the preferred shares get a fixed monthly dividend of $0.04375 a share ($0.525 a year). That gives them a 5.1% yield.

Holders of the capital shares get a monthly dividend of $0.10 per share, for a 10.3% yield.

The company’s portfolio does not pay enough dividend income to pay preferred dividends, management expenses and fees, and a dividend for the capital shares. To make up the difference, the company has to make capital gains by trading the portfolio’s securities. It also aims to raise its returns by writing call options on the portfolio’s securities.

Frequent trading and selling call options carry heavy costs

Selling call options generates an income stream for Dividend 15 Split. However, selling calls also tends to diminish any capital gains that its portfolio might generate. When the stocks Dividend 15 Split owns go up, holders of the call options the company has sold will exercise those options and buy the stock from the company at the price fixed by the option’s terms. Meanwhile, Dividend 15 Split will want to hold on to its losers — stocks it owns that are going down — to offset its obligations under the call options that it has sold.

Options trading tends to generate a lot of brokerage commissions that eat away at the investors’ capital. Management fees and performance bonuses also erode capital.

The managers of Dividend 15 Split Corp.’s portfolio aim to keep most of their holdings in the range of 4% to 8% of the portfolio’s overall value. That means they will need to rebalance their portfolio’s holdings from time to time. This selling and buying also generates commission expenses.

Investing in stocks through split shares may increase your tax bill

The split shares will wind up on December 1, 2014. That’s a drawback to split shares in general, and Dividend 15 Split shares in particular — you’ll be forced to cash in your investment and deal with the tax consequences at that time, and you’ll face additional brokerage costs to reinvest the proceeds after you redeem your shares.

Although we like many of the stocks it holds, we advise against investing in either class of Dividend 15 Split Corp. shares.

If you have investment questions, or if you’d like to ask us about stocks you’re considering buying (or selling), you should join my Inner Circle service. Click here to learn more.