Preferred stocks have become a popular asset class in recent years.
While I think passive investing is the best choice for most people and the evidence shows a majority of active mutual funds and active investors don’t beat the market, I do think active investing makes sense for preferred stock.
What is preferred stock?
Preferred stock is a class of shares in a company that is technically equity and not debt. Unlike common shares, preferred shares can’t vote. Also unlike common shares, the dividend paid by preferred stock is fixed.
Unlike loans or bonds, the preferred shares usually have no maturity date. This means the dividend will be paid forever unless the company buys the shares back (calls) or has financial hardships and is unable to pay.
Preferred stock is somewhere between a long-term bond and common stock.
- Preferred stock dividends may not be cut. Their dividends also can’t be suspended unless common stock dividends have also been suspended. Many preferred shares have a feature of cumulative dividends. This means that if the preferred dividend is suspended and then resumed, all previously missed dividends will be paid if the dividend starts back up.
- Most preferred shares have a call feature that allows the issuing company to buy back shares at a predetermined price referred to as par value. Some shares can be called in exchange for common stock, similar to a convertible bond. Some shares are set to automatically convert into common stock at some time in the future.
- Many preferred shares are thinly traded and may have large spreads between bid and ask prices.
- Preferred shares often have a dividend yield that is higher than a 20-30 year bond and depending on market conditions, usually, pays a higher yield than common stock in the same company. The trade-off is the dividend amount will never increase.
- Preferred stock dividends are usually taxed as ordinary income, but not always.
Active vs. Passive
I believe that these nuances create a reasonable opportunity for active investing to outperform passive.
There are many passive ETFs and “smart beta” ETFs that invest in preferred stock. I’ll use PFF as my example because it is well known and popular.
PFF holds a large amount of diversified preferred stock. If you peek under the surface, you’ll see that many shares it holds are:
- Above par value – remember how companies can buy shares back at a predetermined price? If your preferred stock is trading at $28 and par is $25, you may lose $3 at any time without notice.
- Junk – since they try to own everything, that includes preferred stock in penny stock companies, nearly defunct companies, companies with junk-rated debt – crap you probably don’t want to own.
- Lopsided – Financial and real estate companies issue a lot of preferred stock. If you buy something like PFF, it will be heavy in those sectors.
It would not be fair to leave off the benefits of investing in a passive fund like PFF.
- Instant diversification – If you don’t have enough money to build a diversified preferred stock portfolio, a fund like PFF can give you instant diversification.
- Usually monthly dividends – Many preferred stock ETFs pay monthly dividends, but they vary month to month.
- Access to “expensive” shares – While a lot of preferred stock has a par value of $25, there are shares out there that cost hundreds and even tens of thousands of dollars. If you own a fund like PFF, you get exposure to those shares you may not be able to afford.
When I look to build a preferred stock portfolio, I go through these checks:
- Near or below par value? A common par value is $25 in the preferred stock world. If you simply search for preferred stocks under $25 or $26 you’ll reduce your risk of loss if the stock gets bought from you without notice at $25. It’s ok to pay a little over par – a preferred stock could last 10+ years before it is called, especially if interest rates are rising.
- Check the common stock. How is the company doing? Is their common stock also doing well? If you see that the common stock has fallen 10-25%, that may not be a concern for you as a preferred shareholder as long as it looks like maybe just a temporary downturn that the company will get through. But if you see it has cratered 30-90%, beware. I don’t investigate further in those cases. I just move on.
- What’s the company’s bond rating? Some preferred stock is rated by the rating agencies, but most aren’t. However, most companies with preferred stock also have bonds. Go look up their bonds and see how they are rated. Are they somewhere in the A-B spectrum? The rating may be old and not reflect the current status of the company. Are their bonds trading at healthy prices or steep discounts? If steep discounts, you may want to avoid because that could signal trouble.
- What industry are they in? Will that industry have good prospects over the next 20 years?
- How does it fit with your portfolio diversification? Try not to be too overweight in one sector.
- Dividend yield. Is this going to pay you enough of a dividend to have an expected return that fits your goals? Is the dividend counted as ordinary income or qualified? That will help you decide which account to own it in. Make sure to calculate the yield yourself. I find sites like Google Finance have unreliable dividend yield % calculations for preferred stocks. I don’t know why, but they are just often wrong. Add up the annual dividends and divide by the current price.
- If you find one you want to buy, make sure to use a limit order and set your price and stick to it. Sometimes you may have to wait a while for the trade to execute if the shares are thinly traded.
Preferred stock is both interesting and boring at the same time. You give up the prospects of significant capital appreciation (unless you go bottom fishing, I mean, value buying) in exchange for a reliable income stream and (usually) stable value. You also give up future dividend increases. You buy it and sit back and wait for the dividends to roll in. Keep tabs on your companies to make sure their prospects still look fine and they are still healthy.