Preferred Shares: The Answer To Inconsistent Dividends

| About: Annaly Capital (NLY)


Seeking Alpha contributor Tim McAleenan Jr. has written two first-rate articles on the prospects of holding Annaly Capital over a business cycle.

His theses are sound; however, some investors might not have the stomach or inclination to be surprised by their yearly investment income.

As a result, an alternative option might include considering preferred shares in both this security and others.

Over the last month fellow Seeking Alpha contributor Tim McAleenan Jr. has penned two articles on the potential of holding Annaly Capital (NYSE:NLY). These articles -- which can be found here and here -- evaluate the prospects of holding NLY through a full business cycle, and in my opinion are certainly worth a read. The basic premise of each commentary was that NLY's dividend payouts have been volatile in the past, and are likely to be unpredictable in the future, but for a long-term investor this equity has the potential to supply a healthy stream of income.

This can be better demonstrated by using history as an illustration. For instance, the period ranging from 2004 to 2013 is particularly telling. At the beginning of 2004, shares of NLY were trading at $18.40 with a trailing yearly dividend payment of $1.95 for a yield of 10.6% (which, incidentally, is quite near today's current yield). Over this timeframe a hypothetical $10,000 investment would have returned roughly $9,700 in dividend payments. Expressed differently, an investor would have collected 97% of their initial investment just from those quarterly checks; not bad.

However, during that same time period, the investor of 2004 would have also seen the share price drop from $18.40 to just under $10 -- a 46% decline. Plus, it's not as if the dividend payments were steady. By 2006 the dividend cratered to $0.57 a share -- representing a yield of just 3.1% on cost -- before rocketing up to a peak of $2.65 in 2010 and dropping back to $1.50 in 2013. It was truly a roller coaster of dividend emotions: in 7 different instances the payment changed by a double-digit percentage with 4 such occurrences being negative.

So if you have a long enough time horizon and aggregate the payouts, all appears well. But otherwise, you must understand what you're getting into. The fear would be: "I buy today at a 10% yield, next year that might be a 3% yield." If you can avoid the "sell low" trap then the common shares could be worthy of further research. However, if you have neither the stomach nor inclination to be surprised come investment income time, preferred shares could become a prime consideration.

As an example, you might look into something like Annaly Capital Management Series D Preferred (NLY-PD). It presently yields 7.8% and is trading at a roughly 4% discount. Subsequently, the thought of whether or not the common stock NLY will yield 15% or 5% next year might keep you up at night; but the preferred shares don't share this same restlessness. In fact, there are two calming factors.

First, being preference shares, the dividends get paid prior to the common shares. The company must pay the preferred dividends prior to any payments being declared for the common stock. So whether the dividend payment is $0.57 or $2.65, you don't care as a preferred owner -- as long as the common dividend is above $0.00 you get paid. Second, it's a cumulative issue such that even in the unlikely scenario whereby NLY doesn't pay a common or preferred dividend, if it resumed payments the company would have to make up for it.

Of course due to the REIT status the income is not eligible for preferential tax treatment; yet in a tax-advantaged account that wouldn't matter anyway. Likely the biggest deterrent would be the idea that you aren't exactly swinging for the fences with effectively capped 7.8% yearly returns. Then again, if your primary focus is a sustained high income stream -- thus the foray into considering NLY instead of the Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ) and Procter & Gamble's (NYSE:PG) of the world -- then it doesn't appear to be the worst place to look.

I used the Series D shares in this example, but it follows that Annaly's Series A and Series C share common characteristics. In all instances you're likely trading any potential for equity upside and perhaps even a percent or two in income over a business cycle. Yet what you get is a more balanced income stream. If one is so inclined to be swayed by the inherent income volatility, there is a high yield alternative.

Naturally this does not just apply to the common and preferred equity issues of Annaly. For instance, I have previously detailed why preferred shares could have a role in a dividend growth portfolio. As an illustration, consider the examples of some well known banks: JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB). As most financials do, each come equipped with their very own preference shares.

Prior to recession, all three had stellar dividend records -- with solid payout ratios and a history of consistently rewarding shareholders through constant or increased payments. Then, as we know, the major banks were forced slashed their dividends; leaving an income scar in an otherwise unblemished record. Since that time, each company has rebounded nicely. In fact, it could be argued that these depositories are one of the better places to look for dividend growth today as their payout ratios readjust upwards.

Presently, these three banks yield 2.8%, 2.6% and 2.2% respectively -- we'll call it 2.5% as a group. The corresponding preferred shares yield somewhere in the 5.7% range. The difference of course is that the common shares come with the implied opportunity for both equity and income growth. On the other hand, the preferred shares are limited in both. Still, it's always important to do the math; especially if one is primarily concerned with the income component.

As a comparison, it would take a 2.5% yield growing at 8% annually 12 years to create a higher yearly payout than the 5.7% constant rate. On a nominal payout basis, the lower yield would require 20 years to provide more total income. Add in the idea of reinvesting a higher initial yield and it's easy to see that it might take 20+ years for the lower yield decision to win out on an income basis. It is true that a lower yield with any growth must eventually provide more income, yet be conscious of the timeframe required. Today you might think that the major banks offer a strong and growing dividend, but certainly it's possible to see another collapse in the next 25 years.

Even beyond preferred versus common shares, the same type of comparison applies when thinking about say AT&T (NYSE:T) versus PepsiCo (NYSE:PEP) -- you always want to do the applicable math.

In short, the comparison between preferred and common equity all comes down to trade-offs. With the preferred securities you're likely giving away your equity upside in exchange for higher initial payouts or a steadier income stream. If you're chiefly concerned with the income component -- and simultaneously uncertain about the company's underlying dividend prospects -- then this comfort for consistency trade-off might be of interest.

Disclosure: The author is long JNJ, PG, T, KO, PEP, WFC. 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.

Additional disclosure: NLY-PD