It’s A Bond! It’s A Stock! It’s… Preferred Stock (Part 2)

preferred stock

bonds-and-stocksLast time, I discussed preferred stock, and how they are really a stock-bond hybrid with many aspects of bonds.  I think you should have some in your long-term diversified income portfolio.

What are the criteria to screen for possible preferred stocks?

1) Is the company financially healthy?

I don’t want to buy a company that is on the brink of bankruptcy, that is experiencing sequential quarters of losses, or sequential quarters of negative cash flow. That means the company may be facing a cash crunch and suspend the preferred dividend.

However, and this is a key point, the company does not even need to be growing.  See, the beauty of both preferred stock and bonds is that all investors really care about is cash flow.  Is the company generating enough cash flow to pay the preferred stock? You are in this for the yield, not capital appreciation.

2) Is the preferred dividend cumulative?

This isn’t really a factor if you’ve chosen a company with gobs of cash flow.  However, I like to be certain I’m covered in case of disaster.  “Cumulative” means that if the company suspends or cuts the preferred dividend, it will accumulate whatever wasn’t paid, to be paid out in the future.

3) Is the preferred stock senior to other series?

This can cut either way as far as importance. Just as bonds have senior and subordinate notes, preferred stock can have multiple tiers.   The more senior the series, the later a dividend will be cut and the more chance you will receive your investment back in a bankruptcy or liquidation.

Junior series may offer a higher yield, so again, it comes down to company solvency.

4) Where is it trading relative to par?

Preferred stock generally doesn’t yield capital gains, but that’s not always true. As I mentioned last time, during the financial crisis, many preferred stocks fell alongside their common stock counterparts. We saw this happen quite a bit with hotel companies.

These companies were in real danger of going under because their cash flow was badly impacted by the reduction in travel. Investors started to worry that preferred dividends would be cut or suspended (many were), and even worse, that bond interest payments would be defaulted upon. With so much pessimism pervading the market, many companies saw their preferred stock get sold off.

Astute investors were able to pick up some preferred stocks at a discount of as much as 70% off par. Indeed, a significant discount like that may offer value if the market is being too pessimistic about the company’s health. Like a bond, its price can recover if the market’s confidence improves. In many cases it did, and preferred holders not only saw massive capital gains from the price of their preferreds, but enjoyed dividends along the way.

A few months ago,

What are some examples of preferred stock I might consider?

Unquestionably, my top choice is Ashford Hospitality Trust (NYSE: AHT) 8.45% Cumulative Series D.  I have held this stock for a long time The company maintained its payments on this preferred stock even at the worst point of the financial crisis. The market had even discounted the shares down to $7, although they’ve since rebounded to over $25.  It trades over par because Ashford has a solid balance sheet and management has shown expertise in managing its liquidity.

There is also a 9% Cumulative Series E.  However, it tradest at $26.82, or 7% over par.

Goldman Sachs (NYSE:GS) Cumulative preferred 6.0% Series is tied to the legendary investment bank, and trades at about 2% over par.

NorthStar Realty (NYSE: NRF) Cumulative 8.75% Series A might also be worth a look. The company continues to run positive cash flow, the dividend is generous, the stock trades at a 3% premium to par, and the balance sheet appears strong.

One last note: at some point, interest rates are going to rise. That means that U.S. Treasury bonds, which are essentially guaranteed by the government, will become attractive alternatives for those seeking fixed-income investments. While those yields have quite some distance to go before presenting any real competition to preferred stocks, be aware that holders of preferred stock will likely sell out of those positions and drive preferred stock prices down when yields rise significantly.

Also, if you want to trade preferred stocks, the symbol for each differs based on brokerage house.  Ask your broker for the correct symbol.

About Lawrence Meyers – Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected]


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