Never forget these two axioms:
Money frees us, but its pursuit enslaves us.
It’s not how much you have at the end; it’s how much you could have made.
OK, people.
Confession time.
I made a massive mistake and am now correcting the error of my ways. While going over the basics of stocks, I somehow ignored/forgot the ins and outs of preferred stock.
PWT: Physician, Wealth Thyself to the rescue!!!
SR: What a dork…
Preferred stock lies somewhere between common stock (I know. Common…it makes you sound like a peasant…and this whole time you thought you were a budding tycoon…Damn!) and bonds in terms of what you are owed by the company and what you owe the company or are restricted doing. As the owner of preferred stock, once the company is in bankruptcy and has to liquidate its assets, it cashes out to everyone it owes money to including bond holders and then owners of preferred stock and then finally common stock owners…if anything at all is left over…which there never is.
Generally speaking, preferred stock have dividends and those dividends are paid out as a higher priority than those of common stocks. Even when the company in question is cutting or suspending dividends for common stock, it will pay out the dividends for preferred stock. However, if the company falls into such a bad cash flow situation that all dividends are suspended, eventually even the dividends of some types of preferred stocks can and will be stopped (whereas others cannot such as cumulative preferred stock—more on this later).
Preferred stocks are actually rated by credit agencies similar to bonds, but they are almost always rated lower than the best bonds because bond holders are creditors (ie, the bank for the company, remember?) and the company owes them above all others.
There are many types of preferred stocks which you can learn about on your own if you’d like, but I would not be a regular investor in them unless you have been a stock investor for years and really understand the ups and downs of stock investing OR have a financial advisor that is doing so for you. Even then, your financial advisor should be able to explain to you why they are putting your hard earned money into this preferred stock rather the common stock of the same company or any other investment. If this isn’t the case, you should either ask or not be invested in the preferred stock in the first place.
As a preferred stock holder, you have no voting rights in the operations of the company which is OK for virtually all retail investors (regular Joe and Jill investors like you and me), but it does need to be noted.
There are multiple reasons a company may issue preferred stock, but on the retail investor side, it’s essentially one line of thinking that leads you to buy preferred stock. You want a large, well established company that issues preferred stock with a high dividend which is well protected. Think of something on the order of a bond, but that pays a higher dividend that a bond does in its yield (generally speaking) and doesn’t lock you in for multiple years necessarily.
Here is a quick rundown of the pros and cons of owning a preferred stock.
Pros of Preferred Stock:
- Higher fixed-income payments than bonds (usually) or common stock
- Lower investment per share compared to bonds
- Priority over common stocks for dividend payments and liquidation proceeds
- Greater price stability than common stocks typically
- Greater liquidity than corporate bonds of similar quality
Cons of Preferred Stock:
- Callability (Depending on the kind of preferred stock and/or the terms attached to it, the issuing corporation can expire the preferred stock like a bond (remember?) depending on the needs of the corporation at any given time.
- Lack of specific maturity date makes recovery of invested principal uncertain
- Limited appreciation potential (You’re making money on the dividends typically and not the share price of the preferred stock itself.)
- Interest rate sensitivity (Yes, interest rates will fluctuate and they can in turn affect the dividend rates on your preferred stock. As it becomes more expensive for the corporation to borrow money, then it will pinch down on money it has already borrowed from others (ie, you) when and where it can (such as it can with preferred stock and some types of bonds).
- Lack of voting rights (if this matters to you)
Due to its fixed higher dividend rate(s), preferred stock has become more popular over the years and especially so over the past decade. Ten years ago, in the first quarter of 2008, the entire preferred stock market was valued at approximately $100 billion which seems staggering except when compared to other securities. At that time, the common stock and funds total market value was $9.5 trillion (9500% more than that of preferred stock) and the total value of the bond market then was over $4 trillion (4000% more than that of preferred stock). The increase in the preferred stock market has been steady as it was $241 billion by mid 2015 and $34.1 billion of new preferred stock was issued in 2016 alone. However, again, it was dwarfed by the $22.71 trillion total value of all available stocks/funds/bonds at that time. In fact, just three years ago, the total preferred stock market was only 3% of the total value of just the CORPORATE bond market alone (exclusive of the municipal and federal bond markets).
One last thing of note for preferred stocks is how they are listed. Common stocks are just listed with the name of the company and what is known as the stock symbol or ticker symbol (such as Apple with AAPL or McDonald’s with MCD).
Preferred stocks however are listed in their own language such as the following:
Ashford Hospitality Trust Inc 8.45% Cum Pfd Ser D
SR: What in the name of all that holy is that abomination of a name mean?
Ashford Hospitality Trust Inc (Incorporated) is the name of the corporation issuing the preferred stock.
The 8.45% is the dividend yield that can reliably be expected as long the preferred stock is owned.
The Cum refers to…
SR: Yeah, hold it right there, Professor, We all know what that means…
PWT: Uh, yeah. ANYWAY…
That uh…abbreviated designation refers to the fact that this preferred stock is cumulative (see the links above for the most common types of preferred stock) meaning that if for any reason that the dividend is not paid at the expected time, then it is promised to be paid later (ie, the dividends/payments will accumulate).
The “Pfd” simply refers to the fact that it is preferred stock.
The “Ser D” means Series D refers to the fact that it is the fourth time preferred stock has been issued by this company. (Since D is the fourth letter of the alphabet, it indicates that it is the fourth offering of the preferred stock issued by this particular corporation.)
Dr. Know It All: Exactly how stupid do you think we are?
SR: Wait! Don’t answer that.
The way preferred stock is listed is as variable as the numbers and types of preferred stock.
Personally, I like it that way. It’s not meant to be confusing, but certainly can be. Consider it like a check against yourself or a speed bump to slow down you deploying your hard earned capital into the scary world. If you can’t understand every single bit of the listing of the preferred stock on your own (no cheating on the Internet!), then you shouldn’t invest in it. That’s a pretty good rule of thumb I would say.
I think this is a pretty good stopping point.
My apologies to all of you for skipping over this earlier, but maybe it was a good thing since this made for a more bite sized post to digest. (Self rationalization is also a good thing.)
I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.
Please spread the word about this blog to your family, friends, and colleagues.
Talk to you soon.
Until next time…