PREFERRED STOCKS AND SENIOR SECURITIES. PART I.
We have reviewed the definitions of a common stock in the previous article. Let’s see what’s the difference between the common and preferred stocks.
Preference shares, also called preferred shares, are so-named because preferred shareholders have a higher claim on the issuing company's assets than common shares shareholders.
Or to put it differently: Preferred stock refers to a class of ownership that has a higher claim on assets and earnings than common stock has.
In the unfortunate circumstances for the company (i.e. when the company files for bankruptcy protection and the shares must be redeemed), preferred shareholders must be paid for their interest in the company before common shareholders. They are more “senior” to common shares.
When the company issues the preferred shares, they guarantee dividend payments at a fixed rate, while common shares have no such guarantee but still may offer some dividends. In exchange, preferred shareholders give up the voting rights that benefit common shareholders.
Since we did not discuss what the dividend is, here is a short explanation that will help you to understand the advantages of preferred shares.
The companies that have big cash flows and don't need to reinvest their money are the ones that usually pay out dividends to their investors. A dividend is the total income an investor receives from a stock or another dividend-yielding asset. The term dividends per share refers to the total dividend a company pays out over a 12-month period, divided by the total number of outstanding shares. A company uses this calculation to share profits with its shareholders.
I usually prefer when the stock dividends are quoted using the dividend yield. While the dividend rate is expressed as a dollars per share, the dividend yield is presented as a percentage. It is easier to understand and is more meaningful.
Example: Compass Diversified Holdings company (ticker CODI) offers $1.44 dividend per share or 7.83% yield/year. So, if you spent $10,000 to buy CODI, you can expect $783 in dividends at the end of a year. Normally it is paid monthly or quarterly. Many foreign companies pay the dividends once or twice a year.
Four Types of Preferred Shares
The preferred shares are little more complicated than common, and they can be one of four main types:
- callable shares
- convertible shares
- cumulative shares and
- participatory shares
So, let’s have some fun with preferred shares!
Callable shares are preferred shares that the issuing company can choose to buy back at a fixed price in the future. This condition benefits the issuing company more than the shareholder because it basically enables the company to put a cap on the value of the stock.
I personally buy callable shares for income purpose. When I research which one to buy, I want to ensure that two basic conditions exist (not to mention the company’s stability and the stock market condition):
- If the company has the right to buy back its shares, let’s say at $25 (the most common setup), I am trying to buy the stock when its value is below or equal $25. It is clearly logical, right? Why to buy for $26 if in a case the company has decided to redeem the shares at $25 level? I would lose ~4% instantly.
- I always look at the buy back date. For instance, the Compass Diversified Holdings Preferred Shares Series A (ticker CODI-A) can be redeemed on 7/30/2022, so I have about 3 years to collect the dividends (at this time, it’s 7.8%). It is worth to mention that the company can decide not to redeem at that date but continue offering the dividends but at a different rate.
If the company retains the right to repurchase callable shares at $25 a share, it may choose to buy out shareholders at this price if the market value of preferred shares exceeds this level. Callable shares ensure the company can limit its maximum liability to preferred shareholders.
The company has also the right to redeem the shares with callable option in-between (before maturity date) but at a premium.
Convertible shares are preferred shares that can be exchanged for common shares at a fixed rate and certain date. This can be especially lucrative for preferred shareholders if the market value of common shares increases.
Let’s assume you have the convertible preferred shares priced at $100, with a conversion ratio of five. The question is: when it would make sense to convert?
Only if the common stock moves above $20 the conversion would be worthwhile for the investor (5 x $20=$100). Would you convert if the share price of the common stock is $20.5 (5 x $20.5=$102.5)? It is 2.5% gain, right?
But hey, did you forget about the dividends that the preferred shares offer? If you have 5-7% almost guaranteed dividend why would you convert to get only 2.5% gain and lose the lucrative dividend?
As the common shares rise, it becomes more attractive to convert. If the common shares move to $25, the preferred shareholder would get $125 ($25 x 5) for each $100 preferred share. That's a gain of 25% if the investor converts and then immediately sells the common stock at $25.
I have emphasized the word immediately because the danger in converting is that the investor instantly becomes a common shareholder. Common shares are much more volatile comparing to preferred, and if the price of common share will swing in undesirable direction (for instance, down to $15), and the investor didn't sell at $25, the common shares would worse less than they were before. You would get $15 x 5=$75 in common shares for each $100 preferred share, not to mention you would no longer receive a fixed dividend.
The conversion back to preferred shares is not allowed.
Preferred shares that include a cumulative part protect the investor against a downturn in company profits. If revenues are down, the issuing company may not be able to afford to pay dividends. In that unfortunate case, cumulative shares require that any unpaid dividends must be paid to preferred shareholders before any dividends can be paid to common shareholders.
For instance, if a company guarantees dividends of $5 per preferred share but cannot afford to pay for two consecutive years, then it must pay a $15 cumulative dividend in the third year before any other dividends can be paid.
Participatory preferred shares provide an additional profit guarantee to shareholders with some condition: they guarantee additional dividends if the issuing company meets certain predetermined profit target, and those shareholders who bought participatory shares receive dividend payments above the normal fixed rate.
Dividends paid first
Preference shares have a fixed dividend that must be paid before any dividends can be paid to common shareholders.
Higher claim on company assets or low risk tolerance
In addition, in the event of bankruptcy and liquidation, preferred shareholders have a higher claim on company assets than common shareholders do. This makes preference shares particularly attractive to investors with low risk tolerance. The company guarantees a dividend each year, but if it fails to turn a profit and must shut down, preference shareholders are compensated for their investments sooner.
Additional investor benefits
Other types of preference shares carry additional benefits (Convertible shares, Participating shares). This variety offers the type of investment that can be a relatively low-risk way to generate long-term income.
There are two advantages for the issuing company:
Lack of shareholder voting rights
It means ownership is not weakened by selling preferred shares the way the common shares are sold by shareholders (including selling short – will be discussed in the next articles). With the lower risk to investors, the cost of raising capital for issuing preferred shares is lower than that of issuing common shares.
Right to repurchase shares
Companies can also issue callable preferred shares with the right to repurchase shares at their discretion. This means that if callable shares are issued with a 6.5% dividend but interest rates fall to 4.5%, the company can purchase any outstanding shares at the market price and then reissue shares with a lower dividend rate what will reduce the cost of capital. Of course, this action will hurt shareholders.
Disadvantages of Preference Shares
Preferred shares also present disadvantages for investors.
Investors can't vote
Preferred shareholders do not have the same ownership rights in the company as common stock shareholders.
With rising interest rates, the preferred shares could be less attractive
When and if interest rates rise, the fixed dividend that used to be so lucrative can quickly look like less of a bargain as other fixed-income investments could be purchased with higher dividends.
Dividends for preferred shareholders do not grow
In bad market conditions, preferred shareholders are covered, but in a bull market they do not benefit from increased dividends or share price of the common shares (unless you buy convertible shares and convert them to common if the share price is attractive).
How to Research Preference Shares
I normally research preferred stocks using several sources. You can use YahooFinance, Dividend.com, Morningstar.com, QuantumOnline.com, You may also find nice discussions on preferred stocks at SeekingAlpha.com web site - great source for information exchange on dividend-producing stocks including Preferred. I extract the data and enter into my spreadsheet that is automatically updating the quotes online.
The spreadsheet allows me to compare many preferred stocks and monitor the signals (blue - when the stock price is above $25, violet when the volume is above 120%, etc.).
For unexplained reason, the preferred stocks at different sites could have different tickers. For instance, the CODI-A ticker is on Google, CODIPA is on MorningStar.com, CODI_pa on Investing.com, etc. Another variation is CODI.PRA.
NEXT STEP: SENIOR SECURITY. PART II.
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Author's Note: I am not an investment professional but I am learning investing for more than 20+ years every day. Please excuse any typos. I assure you that I will do my best to correct any errors if they were overlooked. I don’t have any stocks mentioned here in my portfolio and do not plan buying them in the next 72 hrs.
Sources: I have no associations with mentioned web sites or businesses and did not intend promoting them. I also do not sell investment software but rather share “for free” with fellow investors if I did not pay for any piece of it.
Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before following any investment strategies or rules mentioned or recommended.