The Role Of Preferred Equity In A DGI World

Dec. 5.13 | About: JPMorgan Chase (JPM)

If you're vaguely familiar with my writings, you know that I usually proclaim to be a dividend growth investor or DGI. The idea is to partner with wonderful companies that have not only the ability but also the propensity to continuously increase their dividend payouts by a rate quicker than inflation. In turn, a number of great things could happen with this strategy.

First, if you partner with what you perceive to be a collection of excellent businesses - the Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ) and Colgate-Palmolive (NYSE:CL) types - over the long-term you will likely be quite pleased with the results. Next, because of the expected dividend raises each year your income and purchasing power will probably increase whether you do anything or not. Finally, given that the market is unlikely to price say Exxon Mobil (NYSE:XOM) or PepsiCo (NYSE:PEP) with 8% current yields, it just so happens that capital appreciation is apt to come along for the ride whether you focus on it or not.

Yet none of this is to suggest that is the only or best investment strategy - there are many worthwhile endeavors out there. Instead, it's simply an approach that appeals to my lasting goals.

Today, I would like to take a step away from DGI - however slightly - and explore a potential supplement to an otherwise pure DGI plan of attack. The enhancement to which I am referring is preferred equity.

Preferred equity has long been the third leg of a company's cost of capital. As investors, we know that "preferred" means it takes preference in the capital stack above common equity and below debentures. But other than that, there really isn't all that much information out there about this investing subclass. In fact, I don't believe Seeking Alpha has the preferred tickers I'm about to talk about in its database.

There's hundreds of preferred issues out there, but for simplicity let's narrow it down to a few well-known names, say Wells Fargo (NYSE:WFC) and JPMorgan (NYSE:JPM). Wells has a handful of outstanding issues like WFC-O, WFC-N and WFC-P. Likewise, JPM has similar issues like JPM-A and JPM-D. We'll settle on JPM-A - otherwise known as "JPM, 5.45% Dep Shares Non-Cum Preferred Stock, Series P" - to continue with this example.

Now I think it's important to underscore the idea that I view potential investments as business deals and not speculations or otherwise hopeful events. That is, when I partner with say McDonald's (NYSE:MCD) or General Mills (NYSE:GIS) I am doing so with the understanding that I expect certain business and payout results over the long-term. The same holds true for preferred equity. Tell me the deal and then I'll decide whether or not it has a place in my underlying strategy.

The deal with JPM-A is as follows:

Liquidation preference of $25 (per depositary share), redeemable at the issuer's option on or after 3/1/2018

Non-cumulative, perpetual

$1.3625 annual dividend paid quarterly in March, June, September and December

Subject to early call possibility as result of a capital treatment event

Current price ~$20.60 = current yield ~6.6%

Obviously there's a touch more to it than that, but basically that's the arrangement that the market is offering on JPM's behalf. Your job as an investor is to determine whether or not this might fit within your personal strategy; if so, great. If not, then it's on to the next possibility. As alluded to in my title, I'm about to suggest that even in a DGI world preferred equity might have a place in your portfolio.

Immediately those concerned about a rising interest rate environment will be clamoring about the inherent red flags of owning a fixed paying position. After-all, just a small uptick in rates resulted in the recent dramatic downward price push that we see today. However, if your focus is on replacing an income stream over time I would contend that this is less of a worry and more of a slight distraction. After-all a major benefit of DGI and like minded strategies is the ability to ignore market fluctuations. With that being said, the way I see it there are 5 basic outcomes with a security like JPM-A.

1. Bankruptcy. Ok, so that's not the most compelling thought when considering an investment, but it should be in the back of your mind nonetheless. Your returns are certainly not guaranteed and whether you're talking about owning your local pizzeria or Clorox (NYSE:CLX) there's natural risks associated with ownership claims. In the case of JPM I would suggest that this probability is quite small, but it is something to recognize.

2. Missed Dividend Payment. 0 for 2 as far as a workable investment rational I would imagine, but again I feel that it's paramount to demonstrate that certain downsides always exist. In the case of JPM-A, if the company doesn't want to pay a dividend it doesn't have to. However, this possibility is largely mitigated given the fact that preferred dividends must be paid before common dividends. Although nothing is certain, if JPM could still pay a dividend during the throws of the Great Recession it seems especially likely that it could continue to do so in more "normal" times.

3. Capital Event. This sounds like another bad news situation, but in reality it's not that terrible. JPM has the right to call the security early if the funds originating from this issue are no longer allowed to be classified as Tier 1 capital. However, according to the prospectus this event would take place in whole, but not in part, at a redemption price equivalent to $25 per depositary share. In other words, if this capital event occurred - and if JPM wanted to call the shares - they would have to pay an investor over 20% of what they paid today. Granted you would have to find a new income replacement, but you would've received the dividends along the way as well.

4. Called. On or after 3/1/2018 JPM has the option of calling the shares at a price of $25. Using the current discount price and a 6.6% dividend yield, this roughly approximates to a 10% annualized yield to call. Beyond that date the yearly rate decreases, but the call upside is higher than dividend payouts alone.

5. Never Called. Finally, given that interest rates are near historical lows, this particular security is perpetual and never has to be called. In this way, as interest rates increase it is overwhelmingly likely that the security's price would decrease. Further, there's no mechanism that prevents this security from being worth substantially less in a couple years. However, if one is chiefly concerned with a specified income stream then the underlying share price is likely of little concern. The focus is on a steady income, not the possibility for great gains. An income investor could treat this preferred issue like a CD rarely glancing at principal while continuously collecting a perpetual 6.6% yield.

Once again, it should be underscored that capital appreciation potential appears slight with regard to this particular security. However, the 5 possibilities outlined should be somewhat appealing for the income focused investor. The first two are low probability events that should be kept in the back of one's mind. Which one of the last three is most likely to happen is anyone's guess. Yet it should be clear that they all provide reasonable return prospects. For the income investor, this might offer an additional arena in which to invest.

To press on with this example, let's make the assumption that the 5th possibility is the most likely. That is, JPM-A offers a 6.6% perpetual yield and you have no plans on selling the issue.

How does this specifically relate to a DGI strategy? That's a good question and I'm glad you asked.

First, let's look at JPM-A vs. JPM. In reality you could select any DGI company instead, but it seems that the relative dividend prospects are roughly similar. JPM currently yields 2.7% - an amount that would be assumed to grow - while JPM-A yields 6.6% without any growth whatsoever. Now it is true that any grow at all for JPM would necessitate that the common equity position would eventually oust the income provided by the preferred equity issue. However, it's always good to keep these realizations in perspective.

I have no idea how fast JPM's dividend might grow in the future, but let's assume it's 8% moving forward. Growing at 8% a year, it would take JPMorgan's 2.7% yield nearly 12 years in order to reach a yield on cost over 6.6%. In addition, it would require 22 years of aggregate payouts for the lower initial yield to provide a greater nominal payout - and this is without considering the effects of reinvesting the higher yield. While it is apparent that the lower yield must eventually win out, it's not a clear income runaway. If you plan on retiring in 10 years or 20 years with the sole goal of income replacement, the role of preferred equity is especially paramount. Even if you have a 30+ year time horizon, JPM's growing yield is not guaranteed while many preferred issues give you immediate income to redeploy.

Additionally, for those fast approaching financial independence, preferred equity also has the advantage of allowing you to reach your number (I'm talking annual passive income rather than a portfolio balance) more quickly. For instance, consider an investor who presently has a DGI portfolio that is expected to generate $18,000 in annual income within the upcoming year - a number he expects to grow by 6%. Further, this investor anticipates that he will need $25,000 per year to fund his retirement and supposes that he will have not have additional monies (excluding received dividends) to invest. (Glazing over inflation if only slightly) If that investor simply sits on his hands, doesn't buy anything and doesn't sell any of his partnerships, then he would reach that $25k number in 7 years time.

A second option would be to take the dividends at the end of the year and invest in a collection of DGI companies yielding somewhere in the neighborhood of 3%. This choice would allow the investor to reach the $25k number in 5 years. A third opportunity would be to take the collected dividends and reinvest in a 6.6% yielding preferred - knocking the $25k annual income number down to just 4 years. By simply considering a higher yield, it might be possible to reach financial independence years sooner. Granted a variety of simplifying assumptions were made, but it's plain to see that a higher initial yield in a short time period will allow for greater immediate income stream. Of course one would have to account for the idea that the higher yield doesn't grow - but the benefit is still tangible.

Finally, the difference between preferred equity and common equity should be once more emphasized. Using the Estimated Earnings and Return Calculator provided by F.A.S.T. Graphs this is what a potential investor might be giving up:

Click to enlarge

More specifically, if you accept the preferred equity deal you're trading income in lieu of the underlying business upside potential of the company - there's no question that the total return possibility tilts towards the common equity side. In addition, it might even be true that the common stake eventually pays more income as well. However, for those with intermediate timeframes (decades not months) the preferred equity side offers a deal worth contemplating. If you're primarily focused with income replacement, then the comparison between a security like JPM-A and Lowe's (NYSE:LOW) - for instance - becomes especially paramount. What LOW does for you on an income basis in a year, JPM-A can presently do in less than a quarter. In turn, these high initial payouts allow you the flexibility to strategically redeploy a greater amount of funds. It's important to define exactly how long-term your time horizon is while simultaneously doing the appropriate math. If you haven't considered it already, preferred equity could provide a potential supplement to your underlying income replacement strategy.

Disclosure: I am long KO, PG, WFC, MCD, JNJ, PEP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long JPM-A.