Preferred stock offers an investor a comparatively attractive yield with reasonable quality and security. Preferred shares should be part of your portfolio to reduce risk. Preferred stock is a hybrid instrument with the combination of characteristics of common stock and debt instrument. They have higher ranking to common stock, but subordinate to bonds in terms of claim in the payment of dividends and upon liquidation.
The advantages of preferred are also their disadvantages: Like a bond, a straight preferred does not participate in future earnings and dividend growth of the company, or growth in the price of the common stock. However, a bond has greater security than the preferred and has a maturity date at which the principal is to be repaid. The current yield of a preferred stock tends to move in sync with the bond yield, its variability is higher.
While 4% to 8% dividend yield is not bad for many investors, it is often insufficient for the aggressive investors. However, there is a way to boost the return from investing in preferred stocks. This article describes a simple strategy, which can consistently improve the return of preferred stocks without increasing the risk.
Rationale of the Strategy
Investment return consists of dividend and capital gain. Preferred stocks have limited gain, because they do not participate in future earnings and dividend growth of the company. The price of preferred stocks can rarely go beyond their coupon price, which is $25 for most of the preferred stocks. However, when the preferred stocks' price is well below their coupon price, they represent a very attractive opportunity. The attraction arises because of the increase in potential of capital appreciation (from purchase price to coupon price) and higher effective yield (dividend divided by the purchase price). Such a combination provides a strong support for the preferred share price, if the company itself does not have serious financial troubles.
Let's look at an example: Annaly Capital Management Inc. (NYSE:NLY) Preferred Stock series D (NLY.PRD) from 11/4/2013 to 6/19/2014. The low price is $21.51 on 12/13/2013 and high is $24.76 on 5/2/2014, roughly six months apart. It is paying $0.469 per share of dividend every quarter. Its coupon price is $25 and the coupon yield is 7.5%. In our strategy, we want to quantify the relative potential gain when the NLY.PRD price is at $21.51 as compared to $24.76.
To do so, we use a benchmark of effective yield plus the potential capital appreciation to coupon price as the yardstick. The effective yield is the dividend amount in a year divided by the current price. The potential capital gain is (coupon price/ current price -1). That is the gain when the stock is purchased at current price and sold at coupon price. We have the table below:
Source: Created by the author.
The first row in the table shows that if we buy the shares on 12/13/2013 for $21.51, we have an effective yield of 8.72% and a potential capital appreciation of 16.23%, our yardstick is 24.94%. This condition will be achieved if we hold the shares for one year and the share price reaches coupon price by the end of one year.
If the share price reaches coupon price earlier and we sell earlier, we would be getting fewer dividend payments but higher annualized capital appreciation. Let us assume that we sold the stock on 5/2/2014 at $24.76, and we got two dividend payments, and the shares appreciated 15.1%. The total return is $4.19 per share, or 19%, translating into the annualized gain is 37.39%. Not so bad.
At first glance, it seems that I am trying to identify the lows and highs. But I am not. The preferred shares are different from common shares, because they pay a fixed dividend and they have a reference price - the coupon price. When the share price is below the coupon price, the share has a discount. The discount plus effective yield can be quite significant.
Let's look at four different prices of NLY.PRD, in which we show how the yardstick changes with its share price.
Source: Created by the author.
You can see that the yardstick goes up dramatically when the share price goes down. The combination of dividend and discount is acting like an elastic band to prevent the share price to go much lower. This cannot be said for common shares, since they have no coupon prices as references. Of course, there is no way for us to predict the lows and highs. Therefore, we have to use a strategy.
Description of the Strategy
The strategy is best explained by using PSA.PRT as an example. PSA is Public Storage, a Maryland real estate investment trust. The company's principal business activities include the acquisition, development, ownership and operation of self-storage facilities which provides storage spaces for lease, generally on a month-to-month basis, for personal and business use, and it also has equity interests in commercial facilities. It has 2,078 facilities located in the US alone, plus substantial facilities located in Europe. In short, it is a respectable company that we can sleep well if we invest in it. I have to emphasize once again that this is the precondition in investing the preferred shares.
PSA has issued a total of 15 series of preferred stocks to finance its expansion. Let us look at one of them - the Series T preferred shares (PSA.PRT). It has a yearly dividend of $1.4375 and par value of $25. Therefore, it has coupon rate of 5.75%. The table below lists the effective yield, potential capital gain and our yardstick for different PSA.PRT prices.
Source: Created by the author.
Our strategy is to use the yardstick to determine whether we will buy the preferred shares. If we select 25% for our yardstick as our buy trigger, we will have to wait for its price to hit 21.5 or below. Indeed, it provides us with a window of opportunity from 12/12/2013 to 1/3/2014.
Once we bought it, it is a question when to sell. We will determine the sell point by its realized annualized return. You can also use the yardstick, but it will be less effective. Examine the table below:
Source: Created by the author.
We purchased PSA at 21.09 on 1/2/2014 and received dividend once on 3/31/2014. On that date, the total gain per share is 2.37, or 11.2% over our investment, but the annualized return is 35.3%. On 6/20, the PSA.PRT price is 24.05, % gain becomes 21.9% and annualized % gain is 24.1%. The % gain is higher but the annualized gain is lower, because longer time has elapsed. The shaded area represents the unknown future. So far, by 6/20, we have realized 35.3% real gain or 24.1% annualized.
As PSA.PRT prices approach the coupon price, the potential capital gain diminishes, while the effective dividend yield remains constant. Therefore, the yardstick reduces dramatically. Eventually, it will saturate at the 5.75% dividend yield. Or worse, the gain can be wiped out if the price drops.
The strategy calls for exiting the position when the annualized gain reduces to 20%. At that point, you know that you have already extracted maximum gain out of this stock, you should use that money for some other investment, which can yield better.
This strategy shows us a simple yet low risk way of investment in preferred shares to get high return. The risk in preferred shares is in the interest rate and company performance. You should be aware that some very high discount and high effective yield preferred shares reflect fundamental problems of the companies. Therefore, they carry a very high risk. One such company is Hovnanian Enterprises (NYSE:HOV). Its Series A Preferred Stocks (HOVNP) has a discount of 49% and an effective yield of 15%. Using this strategy, it is important to stick to the companies that you know well. Do not chase blindly for the preferred shares with huge discount.
When the interest rate rises, the share price will have to go lower to provide matching effective yield for the investors. The chart below shows the correlation between NLY.PRD share price and ProShares UltraShort 7-10 Year Treasury (NYSEARCA:PST) from 9/10/2012 to 6/19/2014. It shows an inverse correlation. All the major tops and bottoms in NLY.PRD match corresponding bottoms and tops in PST. During this period, we can say that NLY.PRD price is prominently determined by the interest rate.
For the preferred share price performance that cannot be explained by the interest rate, it can be explained by the company's performance. Here are the charts showing the comparison of Citicorp H series of preferred shares C.PRH with both Citicorp common share C and PST.
We should add preferred shares in our portfolio to reduce the overall risk of our portfolio. However, if we buy and hold the preferred shares, our overall portfolio return will be reduced (as compared to the market return). By using the strategy outlined in this article, we will be able to ride the up cycle of the preferred shares, harvesting the benefits of both dividend and capital appreciation at the same time. The buy timing is determined by the yardstick as described above and the sell timing is determined by the annualized yield.
As with any other investment, we need to do due diligence in the company we invest in, as well as observe the direction of interest rates before making an investment decision.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.