Preferred Vs. Common: The Pros And Cons Of Each

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Includes: AHT, ARP, BBEPQ, BEE, CMRE, CPE, FCH, GDPM, GRH, GSL, GST, HPT, LGCY, MHRCQ, NM, NMM, PPHM, PSEC, SB, SHO, TEU
by: Norman Roberts

Summary

How and why I became a virtually exclusive preferred equity investor.

With volatility comes angst and opportunity. Not for the squeamish.

It's a constant refrain, math doesn't lie, but you have to pay attention.

The pros and cons of investing in either commons or preferreds.

The best way to protect your portfolio.

Over time, as I became more involved in trading and gained a greater knowledge of the inner workings of the market, I decided to heavily populate my portfolio with a broad spectrum of relatively high yield fixed income, cumulative preferred equities. During that time I made an extensive study of, what I term, preferreds. The skill and expertise I gained, what I pride myself on, allows me the confidence to function as a SA contributor. More importantly, I have utilized that knowledge to successfully and lucratively invest in a broad variety of preferred, fixed income, equities, allowing me a very comfortable retirement.

In early March 2009, disgusted with my losses suffered as a result of 2008 Wall Street meltdown, I sold the majority of my common positions and replaced them with similarly battered preferreds I had recently been introduced to. After doing a rushed, but in depth study, I took the plunge, determined to recapture all I had recently lost, or lose it all and quit the market forever. Consequently, I began a buying spree with whatever funds remained in my account plus whatever I could borrow on margin. Because I had invested in the commons of hotel REIT's and was familiar with the companies and their basic business model, I believed, most if not all, would survive the current market dislocation. Consequently, I replaced the commons of the following with their preferreds: BEE, FCH, AHT, HPT, SHO. Bottom line: I made a killing. I had purchased several whose prices had been severely depressed as a result of the general market dislocation and the recent suspension of their preferred dividends. Within a year I had reversed horrendous losses, which I had transformed into tremendous gains.

Today, with the meteoric drop of oil prices and the historically low rates of drybulk and container shipping, we are seeing preferreds in these sectors facing prices equaling the lows reached during the market collapse of 2008 - 2009. Oil patch frackers, the hardest hit, were the first to fall, some to bankruptcy; the absolute bane of the preferred trader, from which there is no coming back, and the loss total. Magnum Hunter Resources (OTCPK:MHRCQ), Miller Resources(NYSE:MILL), Green Hunter (NYSEMKT:GRH), and Goodrich Petroleum (NYSE:GDP), are some of the worst, either in bankruptcy or banging on its door.

Others in that sector are struggling to hold on and make it through these terrible times of incredibly low priced oil, natural gas, and natural gas liquids. Atlas Resource Partners (NYSE:ARP), Gastar (NYSEMKT:GST), Brightburn Energy Partners (NASDAQ:BBEP), Legacy Reserves (NASDAQ:LGCY), and Callon Petroleum (NYSE:CPE), are among this latter group. There are others, too numerous to name. As a natural optimist I have hopes that these will survive, but at this time it's simply too soon to say, much depending upon the Saudi Arabia dominated OPEC, Russia, Iran and a host of other players not known for their rational actions, and certainly not the greatest of friends.

Additionally, there are the hard hit sectors of drybulk and container shipping: Navios Maritime Holdings (NYSE:NM), Navios Maritime Partners (NYSE:NMM), Box Ships (NYSE:TEU), Safe Bulkers (NYSE:SB), Costamare (NYSE:CMRE), Global Ship Lease (NYSE:GSL), and International Shipholding (ISH). Call it intuition or just blind faith, I believe that many of these companies will make it through this volatility and eventually recover. In fact, I've recently written several articles about them as potential high risk/high reward preferred plays along with one of the above-mentioned oils. I've provided the links below, and it might be in your interest to give them a second look. As far a I'm concerned, considering the risk/reward ratio, it might be a look well worth taking: Navios Maritime Post, Costamare Post, Lucrative Opportunities Part I, Lucrative Opportunities Part II, and from the oil patch, Gastar.

I also contributed two articles concerning Peregrine Pharmaceuticals (NASDAQ:PPHM), which might be of interest. Its stock was hit by a failed Phase III Sunrise Trial and a threatened legal action, which I wrote about.

I've provided all the above links because I believe they all present potentially profitable opportunities you might avail yourself to after you read and fully digest the information I have provided in this article.

First, it's important you understand what my definition of safety really means. As a preferred investor, I am notusually concerned about the price gyrations of the common stocks of the companies whose preferreds Iintend to invest in. However, during times of extreme volatility, suffered by an individual company, its sector, or the general market, I make certain to carefully monitor the price movement and volume of their common shares. In fact, on my trading platform, I have opened a page dedicated exclusively to the commons of those companies whose preferreds I am interested in investing in. I do this because the volume of their common shares usually trades in million as opposed to mere thousands of their preferred counterparts. This tells me how a larger number of investors feel about a particular company rather than a view of just a very few. I've, on occasion, radically moved the price of a particular preferred position with the sale or purchase of just a few hundred or thousand shares. Consequently, I believe, this is a terrible way to get a feel for the general sentiment of a particular company.

Now allow me to explain how and why I came to be virtually an exclusive preferred investor:

For whatever reason, let's assume that an individual company, its sector, or the entire market is hit by volatility as a result of a general contraction or negative event specific to the company. Should this happen, whereby, said company's common share price suffers a dramatic hit, in my experience, the company's board of directors, more often than not, will cut or reduce the amount of the dividend paid their shareholders. In too many instances, these crafty individuals reduce the dividend payment proportionate to the recent share price fall, which in effect, results in maintaining the ongoing dividend yield. To illustrate:

Price Paid Per Common Share Pre-Volatility
Price Paid Yearly Dividend Dividend/Price Effective Yield
$20.00 $2.50 2.50/20 12.5%
Click to enlarge

Price Paid Per Common Share Post-Volatility

Price Paid Yearly Dividend Dividend/Price Effective Yield
$10.00 $1.25 1.25/10 12.5%
Click to enlarge

In reality, new and often ill-informed investors, are lured to invest, attracted by the handsome dividend yield. Unfortunately, the investor who bought in at $20.00 has suffered a 50% effective dividend yield drop to what is now 6.25%, plus the additional loss of half his original investment. I suffered this experience, more often than I care to remember, in late 2008 and accelerated in early 2009. Sadly, I have more recently experienced it with my investment in PSEC, one of several BDC's I had invested in 2014 and sold for a loss the following year. Another reason I am primarily a preferred income investor.

Another reason I invest primarily in preferreds is that I fully understand them and the nature of preferred investors. More accurately, the preferred investor who is not only interested in living off fixed income dividends, but is also a yield hungry opportunist. Someone just like me. To explain: You've heard of water seeking it's own level, well it's the same for preferreds. Their natural price level hovers around their issue price, for our example, of around $25.00; which happens to be the most common issue and subsequent call price of those preferreds. Consequently, under normal circumstances, each company's preferreds will hover around that price. There are additional tiny variables, which move the price fractionally, but it would take too much time to explore them all at this time, and take us too far a field to make it worthwhile. However, there is one particular instance (although there are others) that will drive the price higher than $25.00, which I will discuss presently because for this article it's relevant and worth exploring in greater detail.

During times of extreme volatility in a particular sector or the entire market when the price of preferreds of companies most affected, on occasion, drops into the low single digits. That's when the opportunists become seriously interested, and begin snapping up low dollar risk very high reward deals. A thousand share preferred buy at the depressed price of $2.50 risks the investor $2,500, plus to insignificant cost of the purchase. This low price is only hit when a company is on the verge of bankruptcy and/or when it has elected to suspend the preferred dividend; principally to save cash, which might save the company from going bankrupt. Yes, the risk of loss is high, but the dollar amount at risk is pathetically low. And if you have adequately researched the company, you might find that it's not as weak as it appears to be.

Furthermore, if the preferreds are cumulative, (the only ones I invest in), the suspended dividend payments are still owed and must be repaid at some later time if, and when, the company survives and things go back to normal. This usually takes several years, but those unpaid dividends keep piling up and, ironically, making those preferreds more valuable. The moment the savvy investors, or the investors with inside knowledge, realize this, is the moment that those preferred prices skyrocket, reaching dollars amounts, on occasion, well above the $25.00 call price; which might be several years, or more, in the future. Bonanza! All for risking a paltry $2,500+.

But there's more, especially for an investor such as I. If at the issue price of $25.00 the yield was 8%, what do you think the yield is at the $2.50 purchase price. Simple math, 80%. For every $2.50 invested you would receive a yearly dividend of $2.00, which might be paid for years, because rarely are preferreds called when their call date arrives, many not for years after. And if and when they are called, it's for $25.00 plus all unpaid accrued interest. Ka-ching.

Next reason I prefer preferreds: Unlike commons, with preferreds one is able to make a bid based on a reasoned price and yield he is willing to pay for. He is not buying in the hopes that the stock price will appreciate enough for him to sell and earn a profit. He wants the steady stream of income that is fixed and can't be altered by the whim of the directors. That's the last thing they will do. Their only option with preferreds is to suspend payments, they can't cut them as I illustrated above, and the missed payments are still owed, so no long-term benefit. And when they do suspend, they face sanctions determined by rules set out when the preferred shares were first issued. Not the least of them is that they cannot distribute one red cent to the common shareholder until all the unpaid dividends are completely repaid to the preferred shareholders. They probably won't be able to issue new shares, consequently, raise additional capital. Lot's of bad things they want to get out from under as soon as possible.

Additionally, many directors are preferred shareholders too, and miss their payments as much as we do.

There are downsides to holding preferreds:

  • Preferreds have a glass ceiling, which hovers around that $25.00 mark. Commons can run up indefinitely and make the lucky holders fortunes. Apple is a prime example, one of many.
  • Those dividends are taxed, at varying rates the year they are received. Common's profits are taxed the year they are sold, and if long-term are treated as capital gains, thereby, taxed at a maximum of 15 or 20% depending on he recipient's tax bracket for that year. Consequently, with commons, your gains are unrealized until you sell, therefore the tax is effectively deferred.
  • Common shares are normally less expensive than their preferred brothers. We pay for preference.
  • Preferred shares are considerably less liquid, and when their price is falling, it's difficult to exit. Believe me I know. Especially when the bid-ask spread is humongous. It's a mind-numbing experience capable of shattering the steeliest nerves.

Finally, except in the case of bankruptcy, long-term, there is little chance of losing with preferreds unless, for a variety of reasons, you decide to, or are forced sell your positions. I believe this last statement need further explaining. When I speak of long-term, the horizon might be years, and during that time period, the dividends might remain suspended and the preferred's market price might remain well below the price you bought it. However, during that time the unpaid dividends have been accruing, which in reality is the same as if they had actually been paid. At the end of the day, only if the company goes bankrupt will you lose. But if it doesn't, as often happens, when the headwinds it was facing, slackens or turns in a favorable direction, the company will survive and eventually return to profitability. That's when your patience will be handsomely rewarded. However, that's if you were not forced to sell for a variety of reasons as outlined below:

  • Investors who are heavily leveraged and margin-called, thereby forced to sell, or have their positions liquidated; most probably at the worst time when prices are severely depressed.
  • Panic selling when the contracting market seems as if will never end or the individual preferred's share price continues to fall, giving rise to the fear of a potential bankruptcy.
  • The investor finds himself if need of ready funds to pay unexpected or upcoming bills and is forced to liquidate a portion in his portfolio to cover those expenses.
  • When the investor finally sells, accepting the loss when he's exhausted by the continued and agonizing share price drop, and/or after a time, he's decided the issuing company recovery still remains uncertain, and he is simply no longer prepared to wait for something that might never occur.

However, their are ways to protect yourself from any of the above-mentioned events. Make certain to maintain a sufficient cushion or balance of excess liquidity, enough to sustain you in the event of even the most serious contraction. Also, aside from the market, your financial resources are more than sufficient to maintain your lifestyle even if circumstances should suddenly change. A tall order, but a necessary one. Although this might not always be possible, it's best you give the best shot you are capable of.

In conclusion, with a little more study and experience, you now have the basic knowledge to successfully invest and prosper with preferreds. It's your decision and your money.

Disclosure: I am/we are long AHT-E, AHT-D, CMRE-C, CMRE-D, GSL-B, GST-A, LGCYO, NM-G, NM-H, PPHMP, SB-D, TEUCF.

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.

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