Investing in Preferred Shares FTW

Index funds and bond funds get most of the press in the personal finance community.  Real estate often gets noticed too.  Thankfully, there is another alternative.  A very good alternative that doesn’t get a lot of press.  This alternative will give you business-like returns without the uncertainty of equities.  It’s also legal and acceptable in every way.  It just gets ignored by the financial press.  I’m talking about preferred shares.

What are Preferred Shares?

Preferred shares are a bit unusual. You don’t often hear of individuals investing in them, but in my experience they are a fantastic investment.  The fact that they are ignored actually helps us attain higher returns.  

Interesting fact:  Preferred shares are a hybrid between stock (equity) and bonds (debt).  They are the mules of investing.  No wonder they don’t get a lot of interest!

When it comes to the “claim on assets”, preferred shares fall after bonds, but before regular equity. This means they are often considered riskier than bonds. This additional ‘risk’ (more on risk later) drives preferred shares to have higher dividend yields than bonds.  Rating agencies even ignore them.  The same rating agency may rate a company’s bond, but neglect to rate that same company’s preferred shares.

Preferred shares are considered equity on the balance sheet, but like bonds, preferred shares:

• Pay regular dividends.  Typically quarterly.
• Have a maturity date.  Set at the time of issue.
• Have a liquidation price, like bonds.  Usually this is $25 per share.

I keep saying “typically” and “usually” don’t I?  It’s no accident.  Each individual series of preferred shares issued can have different attributes. Even from the same company!  Some preferred shares may not have a maturity, they may be perpetual instead.  Some may have dividends that change given certain conditions.  Others may be convertible into regular shares.  In the event of dividend disruption, some preferred shares may need to pay-back missed dividends (key word: Cumulative).  A select few may even allow preferred holders to elect directors if certain conditions occur.  I’ve seen a huge gamut of possibilities over the years.  You’ll need to read carefully and understand what you’re buying.

Preferred shares can be complicated for individual investors, so I can see why they get ignored:  READING is required to play this game.  Uh oh!

Advantages of Investing in Preferred Shares

OK, if I haven’t scared you away with that big ‘R‘ word, then you don’t scare easily.  Good.  So now let’s talk about why preferred shares can be an advantage for financially independent individuals:

“Business-like” returns.  Here at Mr. Tako Escapes, we like to achieve business-like returns from our investments.  What does this mean?  Typically this is a yearly cash return of around 10-13% with the possibility of some capital appreciation.  Why 10-13%?  The average return on equity of a S&P500 business fluctuates around that number.  Typically newly issued preferred shares will only pay around 6-8%, but during times of ‘disruption’ they can be bought with yields exceeding that (more on this later).  This year, the S&P500 is down 5% already.  Meanwhile, preferred share prices haven’t moved and continue to crank out their business-like returns with little appreciation or applause.  Steady as she goes Captain!

“Safety of Principal”.  If an investor chooses preferred shares with a fixed redemption date and price, there is a very good chance he’ll be getting that price on the redemption date.  However, preferred shares are equity, so things are a bit flexible – redemption is not always required.  Typically, preferred share prices will hover right around that par value most of the time and get redeemed roughly on-time.

“Less Efficient Markets”.  If standard equity markets are “mostly efficient”, then preferred shares are in a less efficient market.  They are thinly traded (by comparison), and mostly ignored.  Occasionally when the company (or entire industry) dips into unprofitability, prices of preferred shares can jump around wildly.  This is a “good thing” and can help us achieve those business-like returns we crave.

Who Issues Preferred Shares?

Frequently, you will see banks, power utilities, insurance companies, and REITs issue preferred shares.  Although nearly any company can issue them, you’ll see these kinds of companies most frequently.  

Much of the time, preferred shares will be issued privately and the public will not have the ability to invest in that issuance.  Warren Buffett does this all the time.  He finds a company in some kind of temporary financial trouble, and bails them out with his cash.  In return he receives a private issuance of preferred shares, earning around 10%.  There’s that business like return again!  What we’re looking for are preferred shares traded on public markets (like the NYSE).

How to Invest in Preferred Shares

You can invest in preferred shares using any normal online broker.  The shares typically are more thinly traded than your typical stock, so I recommend using limit orders.

Finding preferred shares can be part of the challenge, but you may have seen the signs already…

Dividend Announcements.  Typically every quarter, a company that pays dividends will issue a press release.  That press release will contain the amount of the dividend for each share type.  If the company has publically traded preferred shares, you’ll see it here.

Searching.  Searching for your favorite companies will occasionally result in some preferred share search results.  They usually have the same symbol as the company with ‘-PX‘ or ‘-PRX‘ added (where X is the issuance series). Depending upon where you search, different symbols might be used for the same thing.  Here’s an example from Yahoo Finance:

The SEC.  The Securities and Exchange Commission will have all the necessary documents on-file to understand a possible investment in a company’s preferred shares.  You’ll want to look at the prospectus (424b5) and the last few 10Q and 10K reports to understand the financial state of the company.  For our Sunstone example, here is the relevant prospectus.

When to Buy?

Typically I buy preferred shares when there is some kind of market disruption that creates silly prices.  That’s when those markets get inefficient.  In 2009 and 2010, I was buying up Hotel REIT preferred shares at half-of-par value.  I couldn’t get enough of them!  This lead to some excellent returns, with 16% yields and capital appreciation of 100% (after prices returned to normal a few years later).  Most have already been redeemed for the full par value.  Fast forward 5 years later, and we only have a few Hotel REIT preferred shares left.  Some of them are the SHO-PD’s, as seen in the example above.  I don’t expect any problems – they should be redeemed in a few months at par value.  Making this foray into preferred shares, highly profitable. 

A Word About Risk

I could spend an entire blog post talking about risk, but that would be boring to most everyone (I think).  Risk is typically measured by ‘alpha’, and ‘beta’ measures.  Feel free to look up those measures if you are not familiar.  I think those measurements are nonsense.  Alpha and beta attempt to understand risk based on share price movements…which is completely wrong-headed if markets are acting inefficiently (as they sometimes do).  In the case of preferred shares, they frequently are not rated by rating-agencies, and measurements like alpha and beta would not be appropriate because return is not based upon how the stock market moves, but rather the financial state of the company.

In my mind, the only way to truly understand risk when investing in preferred shares is to think about probability.  What are the possible outcomes of a given investment and what is the probability that those outcomes will occur?  Once you understand those two things you can understand if you’ll have a winning investment. With preferred shares there are several general outcomes (from worst to best):

• Liquidation. The company has no hope of recovery, and needs complete liquidation.  This is the worst possible outcome.  Typically the tax-man, banks, and bondholders are going to suck up all the residual asset value in the event of a business failure.  Outcome: $0.

• Suspended Dividends.  The company may choose to stop paying dividends for a time.  Typically the business needs to be repaired or assets need to be sold to pay back creditors.  This has happened to me when investing in preferred shares.  In my case, a clause in the issuance allowed preferred shareholders to elected an additional director with our interests in mind. Assets were sold, and back-dividends were paid-in-full.  The shares were also redeemed on-time.  Outcome: It varies.  Sometimes things will work out fine, other times this may preclude business failure.

• Dividends paid regularly, redemption delayed (or non-existent).  It may happen that a company is a bit short on cash and can’t redeem the preferred shares on-time.  Perhaps they can’t refinance at a reasonable rate.  In these eventualities, the company skips redemption of the preferred shares, but continues paying regular dividends.  This is not necessarily a bad outcome.  Many preferred shares are often ‘perpetual’, and the company has no intention redeeming them.  In this case, if you need to get out of the investment – you can sell the shares on the open market.  Outcome: Full-investment return (usually) + dividends.

• Dividends paid, redemption on-time.  This is the most common scenario and the happiest outcome for investors.  Outcome: Full-investment return + dividends. 

Try to determine the probability of these events before you invest!  The only way you can do that is by studying the financial state of the company.  Again, there I go with that ‘Reading‘ thing.  I’ve said it a couple times….must be important.

Not For Everybody

Initially, I hesitated writing this article, but it was important to me (and my family).  Preferred shares were one of the keys to unlocking our financial independence.  They require a bit of extra work, reading prospectuses and company financial reports.  I happen to enjoy it, but I realize that the extra work isn’t for everybody.  If that’s the case for you, it’s probably best that you stick with index funds and have everything set to ‘auto‘.  

Like any good photographer will tell you … the automatic settings won’t give you the prettiest pictures.  If you are willing to do a little extra work, the returns can be outsized.  This applies to most things in life.

“The mule always appears to me a most surprising animal. That a hybrid should possess more reason, memory, obstinacy, social affection, powers of muscular endurance, and length of life, than either of its parents, seems to indicate that art has here outdone nature.” –Charles Darwin

[Image Credit: Flickr, modifications by Mr. Tako]

[Image Credit: Wikipedia, modifications by Mr. Tako]