This following is a contribution by William Cowie. Read more about him in his bio after the post. Note: This post is not intended as investment advice, merely one more source of information. Please see an investment professional for qualified investment advice.
What is preferred stock and why should you care? Preferred stock is a class of investment many people overlook. Stock (commonly called equity) represents a piece of ownership in a corporation and comes in two flavors, common and preferred.
Common stock is well named — it’s by far the most common form of stock. Any newspaper or online service providing stock quotes normally list common stock prices. The price quotes you see for Apple, Facebook, IBM, Caterpillar, Best Buy are usually for their common stock. In fact, common stock is so, well, common that nobody thinks twice about it.
Few people are aware there is another type of stock. Every corporation has common stock, but very few corporations have preferred stock.
The common stock of a corporation confers voting rights; preferred stock usually doesn’t. For instance, owning 51% of the common stock will give you control of a corporation, even though you own none of its preferred stock.
So what is this mysterious type of stock then? Legally, it’s a type of stock that enjoys certain preferences, which is where the name comes from.
The first preference is liquidation rights. When a corporation gets dissolved, all creditors are paid first (including bonds). If, after that, any money is left over, preferred stockholders get first dibs. Common stockholders are the last to get paid, after preferred stockholders.
First dibs on dividends is another important preference preferred stockholders get. Common stock owners cannot collect dividends until the preferred stock owners receive theirs.
Dividends get right to the core of preferred stock. All preferred stock pay dividends while dividends on common stock are not a given. In fact, preferred stock exists to pay dividends and are mainly invested in to get those dividends.
Key Details To Look For
There are two important details to look for in preferred stock.
The first is probably the most important. The dividend rate is fixed at the time the stock is issued. One of the most famous examples in recent times was Warren Buffett’s purchase of Goldman Sachs 10% preferred stock. Mr. Buffett’s dividend will always be 10% of the face value of the stock as long as the shares are outstanding. It won’t go up, it won’t go down, and it won’t go away.
The second detail is usually present but not always. Some preferred shares are considered “cumulative” which refers to what happens when a company can’t pay dividends. In tough times, if a corporation doesn’t have sufficient cash to pay dividends, it may skip them on all shares, common or preferred. However, if the preferred stock is “cumulative preferred” all unpaid dividends accumulate and have to all be paid, or caught up, before any common stock dividends are resumed.
There are other wrinkles to watch for. Some preferred stock is redeemable for a set price at the discretion of the issuer. Some preferred stock is convertible into common stock at a certain common stock price, usually by a fixed date.
So Now That We Know What Preferred Stock is Why Should You Want It?
The first reason is less risk. Prices for preferred stock rarely fluctuate much from their issuing price. Rarely isn’t never, though; in the past financial crisis, almost all preferred shares dipped along with common stocks. Most of the time the dividends were either continued or, if suspended, were accumulated and their price returned right to where they belonged soon after.
One of the biggest objections many investors have against stock investing in general is the risk that the price of the stock will go down. With preferred stock that risk is much lower. There still is some, but it’s fairly easy to predict where the stock will bounce back to, and they almost always do in a fairly short time, because of the fixed dividend.
A predictable dividend is another reason. Aggressive investors look down on preferred stock, because there is no upside for either the dividend or the stock price. In these days of low yields on all investments, getting 6% at relatively low risk beats many other fixed income opportunities and the safety of a cumulative dividend means that sooner or later you’ll get your dividend.
Many preferred stocks I’ve been looking at have an issue price of $25, and the dividend (usually paid quarterly) is calculated based on that price. For instance, an 8% preferred stock will pay $2 per year, paid out as 50 cents per share per quarter. It’s nice to have a predictable income flow that beats today’s savings account rates.
How Do You Invest in Preferred Stock?
This is where investing in preferred stock gets a little tricky. Preferred stocks are not listed anywhere you usually go to look for stock prices. They do exist though and their price quotes can be tracked down. You have to know their names and ticker symbols to track down a quote. The Preferred Stock Channel is one way to get started.
Many corporations who issue preferred stock issue several “series.” Each issue of preferred stock has a unique dividend rate and specific terms. One issue may be cumulative and/or redeemable, the next one not. And so, when you look up ticker symbols, it’s important to look at the various series. Strategic Hotels and Resorts (Ticker BEE), for instance, is a hotel REIT with several series:
Series A (Ticker BEE.PRA) 8.37% cumulative, redeemable
Series B (Ticker BEE.PRB) 8.25% cumulative, redeemable
Series C (Ticker BEE.PRC) 8.25% cumulative, redeemable
In this case, the differences are subtle, but in other cases, one of the series may not be redeemable, and so forth. Not rocket science, just something to look out for.
Once you track down the ticker symbols, it’s pretty straightforward — you simply place an order with your broker like you would for any other stock. Just be sure the ticker you use in the buy order is for the preferred, and not the common. (In other words, it needs to have the suffix “.PRx” where x typically is the series number.)
As a general rule, there is one variable that affects the risk, and the price, of preferred stock. That is the level of debt the corporation has. If the corporation has little or no debt, the preferred stockholders are king of the hill and the stock is relatively low risk. If, on the other hand, the corporation carries debt more than about 50% of its stockholder equity, the risk level increases significantly. Those are also the preferred stocks whose prices are more susceptible to dips.
For example, at the bottom of the 2008-09 stock market crash, Host Hotels, a fairly conservative company with little debt had its preferred stock price fall just a little while the world crashed around it. Strategic (the example above) was laden with debt at the time, and the price of its preferred stock fell to below $2, from its usual $25.
I stumbled on this class of stock in 2008 in an online chat with someone. He simply asked a question: have you considered preferred stock? I hadn’t, and so I spent some time doing research. The company I owned at the time had done work with several hotel REITs and so, using the Peter Lynch philosophy of investing in what you know, I researched them and found several with preferred stock.
As it turns out, I got very lucky by discovering them at a time when their prices were depressed. That’s when I also saw how the level of price risk were driven by their debt levels. I’m not much of a riverboat gambler, so I passed on the BEE opportunity which, in hindsight, would have yielded me an annual dividend of 100%… because with those debt levels I could have lost everything. I settled for a company that had moderate debt levels and therefore a moderate upside of “only” 400% — such are the bargains we find at the bottom of a recession.
Being retired, income from investments is important, and therefore preferred stocks form a core part of my portfolio. I know their price may dip every decade or so, but I’m also confident that they will recover. And in the meantime the income stream continues. If dividends get suspended, they accumulate, and for that eventuality I cover myself with an emergency fund.
The purpose of this post was to shine the spotlight on a type of investment many overlook for no reason other than they don’t know anything about them. As with any investment, pick what resonates best with you, and only after you do your homework.
William Cowie is the author of the email micro-course “Create Income Security Through Economic Swings — Using The Rhythm Taught By Nature Herself”. Right now you can get it free at http://www.dropdeadmoney.com.