Power of Preferred Stocks
Despite being listed as equity on the balance sheet, preferred stocks usually have a fixed dividend and have more similarities to fixed instruments such as bonds than common stock. They have priority over common stock with regard to dividend distribution, but usually do not share in a company's success.
Before investing in preferred stocks, it is important to understand the important terms listed below:
Cumulative: Most preferred stock issues are cumulative, meaning that dividends will accrue even if they are not actually paid. The Board of Directors has to approve (declare) the payment of preferred and common stock dividends each quarter. However, during economic hardship, dividends may be suspended. Once the dividends are resumed, cumulative preferred shareholders must be paid all of their accrued dividends before common dividends, if any, are paid.
Redeemable: Most preferreds are also redeemable, or "callable," meaning the issuer has the right to call (redeem) the shares after a stated date.
Participating/Non-Participating: Participating preferred shares may receive additional dividends based on a predetermined formula using the issuer's profits. The participation dividend will be less than the amount paid to common shareholders, but this feature can add to the value of preferred shares. Most preferred stocks are non-participating.
Convertible: Convertible preferreds can be exchanged for common stock at a set price after a certain date. For example, in 1996, Microsoft (Nasdaq: MSFT) issued 12.5 million shares of 2.75% convertible, exchangeable, principal-protected preferred stock that was converted in 1999 for 1.1273 common shares.
Who Issues Preferred Stock? Most companies shy away from issuing preferred stock because it is an expensive form of capitalization. Preferred stocks pay dividends, which are paid from after-tax profits, while bonds pay interest, which is paid from pre-tax dollars. Therefore, preferred stock is more costly to corporations because they do not get a tax break.
There are a few benefits for the issuers of preferred stock. First, there is flexibility. Preferred stocks pay dividends, and if the issuer needs cash, dividends can be suspended at the discretion of the Board of Directors (unlike bond interest payments). Additionally, preferred shares are often used in mergers and acquisitions because they can be structured as a "guaranty," which gives assurance to the seller that the debt will be paid. This is most common when closely held or family companies are purchased. These preferred shares are frequently not traded publicly.
Preferred stock can be bought and sold just like common stock. Companies that issue them often have more than one series, using letters of the alphabet to distinguish them (e.g. Series A, Series B, etc.).
How to Evaluate Them: Preferred stocks have the characteristics of both equity and fixed income investing. It is important to understand what a company does and how it earns its income. Similarly to investing in corporate bonds, investing in preferred stock is more of a risk analysis than a company analysis. The primary issue with preferred stocks is the probability that the company will be able to continue to make the dividend payments.
Many companies with preferred stock also have unsecured debt. Unsecured debt has no collateral, as it is "secured" by the company's income rather than tangible assets like real estate or equipment. Many preferred stocks are rated by Standard & Poor's or Moody's. If preferred stocks are not rated by Standard & Poor's or Moody's, that could be a warning sign.
Even though the rating agencies above use slightly different grading scales, the general consensus is the following: anything rated below a "B" is considered high yield (i.e. "junk") and a "B" rating or above is considered investment grade. The closer to an "A" rating, the higher the quality of the issue. Also, a rating containing more letters will be higher, as an "AAA" rating is higher than an "A."
The value of a preferred stock can fluctuate with current market conditions. While the par value of many preferred stocks is $25, this price can go up as well as down. There is no guarantee of principal and there is no guarantee that the issuing company will be able to make all of the scheduled dividend payments. As with other fixed income products, preferred stocks are sensitive to interest rates and the underlying factors that impact those rates.
Vision Advisors believes that income oriented investors should give serious consideration to owning preferred stocks.
