What You Need To Know About Preferred Stock

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What You Need To Know About Preferred Stock

In many ways, publicly traded firms represent the ultimate in wealth democratization. The Sultan of Brunei and your local plumber may both purchase as many shares of Cisco Systems, Inc. (CSCO) as they wish, with the only barrier to entry being a few dollars to open an E*Trade Financial Corp. (ETFC) account.

A company may want to attract a certain kind of investor; one who prefers stable, predictable payments. To do this, the corporation may issue bonds, which have their own set of drawbacks. When a corporation allows a bond offering, it may be proclaiming that it is in severe need of funds, which might turn off stock investors. How can equity be offered while still assuring investors a monthly payment? Through the use of preferred stock, which is a hybrid of bonds and common stock. (For further information, read A Primer on Preferred Stock.)

The distinctions between preferred stock and ordinary stock are subtle but significant. Dividend payments are made to preferred shareholders because dividends are a selling element of the investment. Corporations are under no duty to pay dividends on common shares. (For further information, read What Is the Difference Between Preferred and Common Stock?)

Becoming Rare

In reality, blue-chip businesses that pay dividends on common stock do not issue preferred shares. Companies that do not pay dividends on their common shares are much rarer. Preferred stock is a fading share class. According to some estimates, there is $80 of common stock for every $1 of preferred stock in circulation in the United States. None of the industry’s giants, such as Apple Inc. (AAPL), Exxon Mobil Corp. (XOM), Microsoft Corp. (MSFT), and others, provide preferred stock. The Big Four banks – Wells Fargo & Co. (WFC), Bank of America Corp. (BAC), Citigroup Inc. (C), and JPMorgan Chase & Co. (JPM) – are the only ones that sell preferred stock among the 30 biggest firms in America by market capitalization (JPM).In reality, banks issue over 88% of preferred shares. The reason for this is the continuing of the aftermath of the 2008-09 financial crisis and bailouts. Preferred stock is added to the balance sheet as an asset, which banks need more than oil firms or semiconductor manufacturers. (For further information, see Preferred Stock Features.)

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No Voting Rights

The majority of things in life entail a compromise, and preferred stock is one of them. The fundamental drawback of preferred stock from the standpoint of an investor is that its holders do not have voting rights. From the name alone, you’d think preferred investors would get, well, preferential treatment. When a corporation elects board members, however, it is the common shareholders that vote, while preferred owners remain on the sidelines, disenfranchised. (For further information, read Know Your Rights as a Shareholder.)

Better During Bankruptcy

Assume, however, that the publicly listed corporation falls bankrupt. Bondholders are paid first when the firm is liquidated. That makes logical; they’re the creditors, the ones who provided the firm money to keep it viable. If there is anything remaining after the bondholders are paid, the preferred shareholders are paid first. Only then, if at all, are common shareholders compensated. As a result, the “preferred” in preferred stock.

There are also further distinctions between preferred and ordinary stock. The latter may be summoned at the discretion of the corporation. “On May 17, 2016, we retain the right to purchase these shares from you.” In most circumstances, preferred shares may be converted to common shares at a set rate. If you do this, you are trading certainty for volatility and the prospect of financial appreciation.

Okay, enough theory. Assume you wished to purchase preferred stock. Assuming you did create a brokerage account, as the plumber in our case did, where would you begin?

Finding Preferred Stock

First, let’s look at how to interpret a preferred stock listing. They are distinct from ordinary stock listings, which are straightforward to read. The ticker symbol for International Business Machines Corp. (IBM) common stock (the only sort the business issues) is IBM. Give me a hard one, please.

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Preferred stocks are more difficult to understand. Preferred stocks are characterized by their dividends (stated as a percentage) since dividend payments are so important:


Symbol



Name



Price on 10/11/14



SSW-E


Seaspan Corp. (SSW) 8.25% Cumulative



$24.95



SCE-B



Southern California Edison 4.08%




$21.04



SCE-C



Southern California Edison 4.24%




$21.25



SCE-D



Southern California Edison 4.32%




$22.80



ZB-A


Zions Bancorp (ZION) Floating Rate (minimum 4%)



$24.60

None

Isn’t it rather simple? A one-letter suffix indicates that the stock is favored in the ticker symbol. Because a firm may issue numerous classes of preferred shares, the Roman alphabet includes 26 letters, which is why we included three separate Southern California Edison preferred issues in our example.

Treated Like Bonds

It’s also no accident that all of the publications are priced similarly. Preferred stock trades at $25 with very few exceptions. The fact that they don’t deviate much from that price demonstrates how the market sees them virtually like bonds. No one will pay much more than $25 for a callable share, and no one will sell such a valuable revenue-generating asset for much less than $25. By the way, the issue price is also the price at which the business will call the share if it so desires. (For additional information, read Why Do Some Preferred Stocks Yield More Than Common Stocks?)

Understandably, the larger the dividend rate, the higher the stock price. If you purchase 4.08% of Southern California Edison, you will get quarterly dividend payments totaling 25.5. The amount indicated as a percentage of the issue price (again, $25) is the dividend amount.

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A few additional points. The term “cumulative,” as in Seaspan 8.25% Cumulative preferred stock, signifies that if the corporation hasn’t paid out a certain dividend in the past, it accumulates until it is paid out. And it will be paid out before any dividend is paid to ordinary investors. In the instance of Seaspan, the corporation has been paying a quarterly — though inconsistent — dividend to its ordinary stockholders for many years. The phrase “floating rate” refers to dividend payouts that vary based on parameters set by the issuer. In the instance of Zion Bancorporation, the rate is linked to the London Interbank Offered Rate. (For further information, see Preferred Stock Valuation.)

The Bottom Line

Preferred equities have a lower learning curve and less risk than intermediate and advanced securities. With preferred shares, you are less likely to go bankrupt than with regular shares. So, should you put money into them? Understand that the majority of preferred shareholders are institutional: organizations with little to gain and much to lose by investing in anything less stable than a bond or bond equivalent. Buying preferred shares is often done by the average investor after they have built up a sizable portfolio. One that was most likely the outcome of purchasing inexpensive common stocks. If you’re still intrigued, try investing in a preferred stock exchange-traded fund (ETF).(For further information, read Preferred Stock ETFs With Massive Dividends.)

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