BUFFETTS BOOKS ACADEMY: INTERMEDIATE COURSE
LESSON 22: WHAT IS PREFERRED STOCK
LESSON OBJECTIVES
- Learn what a preferred stock is.
- Learn what are some considerations when buying a preferred stock.
LESSON SUMMARY
In this lesson we learn to think about a preferred share as something that is more risky than a bond, but less risky than a common stock. A preferred share has similarities of both bonds and common stock. It is similar to a bond in the sense that it pays dividends. Dividends for a bond are called ‘coupons’, but the two concept are not too far away from each other. One important difference is that preferred shareholders receive their fixed payments before the common shareholders, but after the bond holders receive their coupons.
A preferred stock is similar to a common in the sense that it is a piece of equity in the business. However, that piece of equity will only materialize is the company should default, and preferred shareholders would in that case receive their claims to the business before the common stock holders (but after the bond holders). Very often it is only bonds holders that would be paid fully or even just partly in the case of bankruptcy.
Related Article: What is a Preferred Stock?
A preferred shared operate very similar to a bond. It has a face value and a dividend with combined let you calculate the yield of the preferred share. Consider a preferred share with a face value of $25 and a dividend of $1.50. That is equivalent to a yield of 6%. Often a preferred share does not have a term. It means that the share is out on the market, and does not mature in theory. In practice the issuer will often buy it back at some point of time in the future under conditions beneficial for the company.
Certificate of Designation for a preferred share is disclosing the necessary information, and is something that is highly recommended to read before investing. If you haven’t had heard too much about preferred share before the video, it should come as no surprise. Preferred shares is far from as common as common stock and bonds in financial markets.
When you read the certificate of designation it is crucial to notice if the preferred share is cumulative preferred. That means that you will eventually get your dividend, but the issuer has the opportunity to delay payment. This is a good thing compared to a non-cumulative preferred share. In this case the company can simple choose not to pay on either now or in the future. This is bad, and you should avoid this type of security.
The reason of a company to issue preferred shares can in general be divided into three arguments.
Raising money.
All companies require capital, and just as the bond and common stock offering is a way to raise capital, so is preferred shares.
Flexibility to make or delay payments.
The great thing about preferred shares is that there is no obligation to pay dividends on time. This is contrarily to the obligations to pay out coupons to bond holders. The company has the flexibility to delay payment, and in some cases not even pay them out.
Retain equity of the business for common stock holders in the long run.
It is the common stock holders who own the company. By issuing preferred shares the equity is still retained, and at the same time benefit from the extra capital. One method that the common stock holders gain in connection to this is if the preferred share is callable. It says in the certificate of designation if the certificate is callable, but it is the case the vast majority of the time.
To fully understand the properties of whether a preferred share is callable imagine that a preferred share is issued at 6% yield. The interest rate drops, and the company now has the option to raise capital through 4% preferred shares. What would happen just before that is that the company would call back the preferred shares at 4%. As an investor this is something as an investor should be prepared for.
Another thing that characterizes many preferred shares is the adjustable rate of dividend. You can also find that information in the certificate of designation. What adjustable rate means is that dependent on the interest rate your dividend will also be adjusted. In other words: not only does the company have the option to delay your payment, and even in some circumstances omit it, your dividend can also fluctuate, which is a clause that is typically not in favor of the investor.
Finally in this lesson a recap of 4 key points is given before buying a preferred share.
- Read the certificate of designation.
- Buy cumulative preferred.
- Avoid perpetual terms.
- Beware of callable securities.
NEW VOCABULARY
Preferred Shares
A hybrid security between stocks and bonds. The income potential comes from dividends just like the income potential from bonds comes from coupon payments. It has equity in the company which is similar to a common stock, but in practice it is seldom of any use. In terms of risk and ranking of payments, it is in less risky and paid before a common stock, but more risky and paid later than a bond.
Perpetual Term
There is no maturity for the preferred share, and in theory you could hold it forever just like a common stock. This is not advised for the investor as a fixed term gives you an exit strategy where you can receive the par value it was issued at.
Cumulative Preferred
While the dividend payment might be delayed you are required to receive that dividend later
Non-Cumulative Preferred
The issuer can choose to omit dividend payments to the investor. You should omit buying such a preferred share.
Callable
The issuer can call back the preferred share to benefit the common stock holders. This happens in situations where the preferred shares turn very profitable for the investor and less profitable for the issuer, and should therefore often be avoided to invest in.
Certificate of Designation
The contract between the company and the investor. It is very important to read this document before investing in preferred shares. The contract outlines the responsibilities to meet its financial obligations of the company.
LESSON TRANSCRIPT
This lesson will just go through the fundamentals. In order to understand these fundamentals, you must refer to the video as you read this post.
Seen at the chart is the lowest risk one can have on any investment – a bond. The preferred share is in the middle as far as owning some of the equity of the business. However, the preferred share performs like a bond.
The first risk to understand is that the preferred share is not as risky as owning common shares, but is definitely riskier than just owning the bond of a company. A lot of people think a preferred share would operate and have a lot of the same fundamentals as a common share, but it actually offers a lot more like a bond. Instead of having a coupon, it’s a dividend. A preferred share is a proportional piece of equity in a business.
Some think that piece of business will come about if the company would liquidate. That proportional owner really isn’t doing anything for you as far as the market price of that preferred share is changing. The money would go to the bond holders, and then to the preferred share holders, and then to the common share holders. In short, the bond holders are the only ones who’ll get what remains in the business. That share of equity that you’re getting with the preferred share isn’t worth anything, because 9 times out of 10 of a company would go bankrupt and liquidate. All the money would go to the holders and they’d lose everything at that point.
How does a preferred share work? On the left side is a bond. This is Company X. One bond of Company X. has a term of 30 years. The face value is $1000, the coupon is $50, and the figure is a 5% yield. Just like that, we have one preferred share of Company X. Now, pretend that the face value is only $25 instead of $1000, and it pays an annual dividend of $1.5 a year.
When take the dividend and divide it by the face value, you can get a 6% yield. This preferred share is very much like a bond, because it has a term, a face value, and instead of a coupon, it’s a dividend. Preferred share is a cheaper price than a $1000 on the face value of a bond, but it’s operating exactly through the same fundamentals.
However, a lot of preferred shares don’t have a term. They have perpetual terms, instead. The person responsible will issue it and the share stays out until he decides to terminate it by buying it back. You can’t find preferred shares with terms that are on them.
How does it work? First, you have to read the certificate of designation. It describes how that preferred share works and operates. Company X has a term of 30 years and the company buys that preferred share back from the holder, but that’s not always the case. As you look at one company’s preferred share to the next, it can be completely different. All of that information is found in this certificate of designation.
Preferred shares are not a real big market. There are a lot more bonds and common shares in the market. To understand how a preferred share works, you need to know why a company would even want to issue a preferred share.
Try to picture yourself as the CEO of a large business. Preferred shares are usually issued on new companies. They go public, because they need to raise money. The beauty of a preferred share from the CEO’s and the shareholder’s perspective is they currently own the company. They can raise money by issuing these proffered shares. They have the flexibility to set up that certificate of designation. They can delay their dividend payments even though they promise to make their 6th dividend payment at 6%. They let the dividend payments accumulate and pay them later.
Some certificates of designation don’t need the company to pay the dividend. If you were the company issuing these preferred shares, you now have the flexibility to not even make that dividend payment to the person holding it. The real reason is this – the company can retain its equity of the business for those common shareholders.
Think of it this way. If you’re a common shareholder of a business and you want to raise money, but you don’t want to give up that equity that you currently possessed, issue some preferred shares. Although that person thinks they’ve got some equity of the business, the only time that equity materializes is if the company would liquidate or fail. If you issued a 6% preferred share at your company to raise money and interest rates go down to 4%, you obviously want to pay off the holder of the preferred share, so you’re not paying such high interest rates. You have the flexibility to immediately pay off that preferred and all that equity disappears whenever you buy that back. Really, the equity you’re seeing, you’re not seeing any growth in the market price, because the market price is dependent on the interest rates alone just like the bond.
What are some of the things you might see in this certificate of designation? The first is the accumulative preferred versus non-accumulative preferred. For the accumulative preferred, you’ll eventually get your dividend, but you might not have the ability to compound a consistent dividend payment. At least you’re giving that payment. In this scene with $1.5 for Company X, if they skip that payment, they’ll have to pay you $3 instead of just $1.5. They’ll have to make that up.
Whenever you see terminology in this certificate of designation for non-accumulative preferred, that company doesn’t have to pay you the dividend. They’ll most likely pay you, but they don’t have to. Beware of that. I’d never ever buy preferred share with non-accumulative preferred dividend payment.
We briefly talked about the term and how many preferred shares are perpetual preferred share. It has no maturity date to it, so that company can issue that stay out for as long as they want. They can just keep making those payments to you. If you buy a preferred share and has very low interest rates, you might be holding on to that for really long time.
Unfortunately, For that person who’d buy low interest yielding preferred share, because it has no term to it, it’s not going back up to that face value of $25 for this generic share. It might just sit down there at $15. You might buy that preferred share for $25 and the interest rates start rising from where you bought it. It might sit down there in the market price at $15 forever.
There’s no exit strategy for this type of person that bought a preferred share without a term. There are learning points there. Either make sure you buy one that has a term or make sure you don’t buy a preferred share with the really low interest rate.
The next thing you got to be aware of is the callability of the preferred share. You’ll always find a preferred share with a callability cause and certificate of designation. If you buy a preferred share with a really high yield like 10% and it’s a fairly decent company that has an enormous amount of debt, you can pretty much expect that to get called. When you buy that, you just go into that with the anticipation to be called on that and they’ll pay you back their initial purchase price or that face value of the preferred share in order to stop hanging on that high interest rate. Be ready.
Most preferred shares have an adjustable dividend rate. It was affixed dividend rate at the beginning of the lesson, but depending on how that certificate of designation set up, you might purchase a preferred share that has an adjustable dividend rate. However, you must avoid this! Unless you’re buying it with low interest rates.
The name of the game is when you’re buying fixed income security or preferred share, you’re trying to fins something paying high dividend. You’re trying to get something that whenever those yield curves are pretty flat and above your 4% and 5% mark for your 10 year federal note, you want to find something that has a high yield in that is fixed. It gives you the leverage for whenever interest rates drop to sell that at a nice premium, you can sue that to buy your common shares.
What are we looking for when purchasing a preferred share?
- Read the certificate of designation.
- Buy accumulative preferred.
- Avoid perpetual terms.
- Beware of callable securities.