The Rationale Behind Preferred Investing

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Includes: ABR, AMTG, ARCC, ARI, ARR, BKCC, CDOR, CLNY, CMO, CYS, FSC, LXP, MCC, MITT, MTGE, NCT, NRF, OAKS, PSEC, SLRC, TICC
by: Norman Roberts

Summary

To know and understand preferreds is to love them.

Why the average market investor should add preferreds to his portfolio.

Let's look at the pros and cons of both commons and preferreds.

I primarily invest in relatively high yield, fixed-income, cumulative preferred equities. To earn these yields, I am willing to accept additional risk, and because of this, a majority of my investments are in preferreds offered by enterprises involved in shipping; oil exploration, production, transport and storage; REITs, mortgage mostly; and some others, including pharmaceutical R&D and storage. However, because of the nature of preferreds, it is my belief that much of my risk is moderated, and by utilizing a sound investment strategy, my risk can be further reduced. To accomplish this, it's necessary to completely understand preferreds, the types, the advantages and disadvantages of each, and what they have to offer the investor. These are steps to learning how to successfully invest in preferreds, which is the basis of this article.

First, it's important to understand that investment safety viewed through the eyes of a preferred investor is, and should be, viewed differently from that of a common shareholder. Unfortunately, from my perspective, company, and consequently, investment safety is commonly reported from the perspective of the common shareholder, who is primarily concerned about the price fluctuations that are often influenced by quarterly financial reports and conference calls. Granted, they are important, but they should not be viewed as critically by the preferred shareholder, because his investment goals and objectives might not necessarily be aligned with those of the common shareholder.

Common shareholders invest with the idea of earning a profit in two distinct ways: stock price appreciation, and dividend distributions - if, in fact, the companies they invest in offer a dividend at all. Preferred shareholders, for the most part, invest with an eye toward a continuing stream of fixed income, not necessarily preferred price appreciation. This is apparent because most preferreds, unless seriously distressed, trade within a narrow range of par value and rarely exceed that value under normal circumstances. This is evident because if and when a preferred is called, it is called at that par value, not the value it might be trading at that time. If par value is $25.00 (the most common price) and it was purchased at $26.00, the holder will lose $1.00 when it is called, even if it were trading at $26.50 at the time. That's the reason for the unbreakable glass ceiling of preferred investment appreciation.

However, allow me to digress in order to explain how that glass ceiling might be shattered. Occasionally, during times of extreme volatility, a company might experience a severe existential threat, whereby to survive the company might find it necessary to suspend the preferred dividend as a way of preserving liquidity it might require to pay its creditors or simply to continue operating. How long the cumulative preferred distributions have been suspended will determine how high above par the preferred price will rise, if and when it becomes evident the company will survive and recover, or might be acquired by another stronger company. Because missed cumulative payments accumulate and are owed the holders, and must be repaid before the company can continue business as usual, the company will do everything in its power to make up those missed payments as quickly as possible.

This link will take you to an article detailing exactly how my carelessness led to a loss I should never have suffered, and a golden opportunity lost that clearly illustrates the above paragraph. It concerned my investment in Supertel Hospitality (SPPR), which ultimately was acquired by Condor Hospitality (NASDAQ:CDOR).

Ultimately, as a cumulative preferred investor, I am interested in only one thing: What are the future prospects of the company I want to invest in? And by future prospects, I want to know whether or not this company is built to survive. Because as far as I'm concerned, I can only lose in the event of a bankruptcy, or because I was forced to exit my position because of a margin call or some external event whereby I needed the cash to pay bills. In my reality, preferred price fluctuation means little unless it portends some serious company existential threat, or threat to my entire portfolio, as I mentioned above.

The following enterprises illustrates why the interests of the common and preferred shareholders are not necessarily aligned. I have provided the link to that article, which reported on the profits and/or losses of each of the following companies within the past five years. Arbor Realty Trust (NYSE:ABR), Colony Capital (NYSE:CLNY), NorthStar Realty Finance Corp. (NRF), Apollo Commercial Real Estate Finance (NYSE:ARI), Lexington Realty Trust (NYSE:LXP), Newcastle Investment Corp. (NYSE:NCT), American Capital Mortgage Investment (NASDAQ:MTGE), AG Mortgage Investment Trust (NYSE:MITT), Five Oaks Investment (NYSE:OAKS), Apollo Residential Mortgage (NYSE:AMTG), Capstead Mortgage Corp. (NYSE:CMO), ARMOUR Residential REIT (NYSE:ARR), and CYS Investments (NYSE:CYS).

Click to enlarge

Granted the above companies, mostly mREITs, might be considered high-risk because of the nature of their business and the high leverage they operate with, all are supported by both common and preferred shareholders. The big difference is that for the most part, the preferred shareholder profited while the common shareholder lost.

However, to protect my investment, I make sure 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 buying. I do this because common shares usually trade in volumes of millions, as opposed to their preferred counterparts trading in mere thousands. This alerts me as to how a larger number of investors feel about a particular company, rather than just a very few. Furthermore, because preferreds are normally so thinly traded, a majority of articles are written from the perspective of the common shareholder.

However, it would be unfair to present this article as entirely pro-preferred and biased against commons. Let's examine the pros and cons of both.

Commons

Pros:

  • The upside is unlimited. The common shares of a successful company can wildly enrich its investors.
  • Share appreciation is not recorded as income until sold, at which time, if held a sufficient time, profits are recorded as capital gains income with its attendant tax benefits.
  • Shares are usually priced lower than their preferred counterparts, which allows for better bang for the buck.
  • Because their dividends are not fixed, they can be raised if and when the company proves successful.

Cons:

  • Dividend-paying companies, when facing adversity, can cut or suspend a dividend at any time without the necessity of having to repay those missed payments as they would be with cumulative preferreds, if the company survives.
  • Share price is more affected by the momentary performance of the company or the vagaries of the market, and there is no guarantee that they will ever recover to the price the investor originally paid.
  • Shareholders are diluted each time more shares are issued, and this appears to happen as a normal order of business.
  • In the event of bankruptcy, the common shareholder stands last and is virtually assured to lose his entire investment.

Preferreds (Cumulative)

Pros:

  • Dividends are fixed and cannot be reduced. However, in the event that they are suspended, should the company survive, it is obligated to repay all those missed dividend payments.
  • No matter how the share prices perform over the short term, ultimately, when called, they are called at par value.
  • The only way the investor can ultimately lose is if the issuing company goes bankrupt or the investor is forced to sell, for whatever reason, when the share price is below the investor's average cost per share.
  • In case of bankruptcy, should any money remain - which is doubtful - the preferred shareholder stands ahead of the common shareholder.

Cons:

  • Share appreciation is limited by the glass ceiling as described above.
  • Because shares lack liquidity and are thinly traded, in the event of company stress and existential threat, positions are difficult and costly to exit.
  • Dividends are taxed - at varying rates - the year they are received. Commons' profits are taxed the year they are sold, and if long-term, are treated as capital gains, and thereby, taxed at a maximum of 15% or 20% depending on the recipient's tax bracket for that year. Consequently, with commons, your gains are unrealized until you sell, and therefore, the tax is effectively deferred.

Why I am virtually an exclusive preferred investor

The best answer is that I really don't like investing in commons, especially those that offer a healthy dividend. I've found that when a particular company's stock price suffers a significant fall, the company's board of directors will often cut or reduce the amount of the dividend paid to their shareholders. Furthermore, in too many instances, these crafty individuals reduce the dividend payment proportionate to the recent share price fall, which, in effect, results in the illusion of 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, the new and often unsuspecting 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, which accelerated in early 2009. Sadly, I have more recently experienced it with my investment in Prospect Capital Corp. (NASDAQ:PSEC), one of several BDCs in which I had invested in 2013 and sold for a tax loss the following year. Some of the others were Medley Capital (NYSE:MCC), Solar Capital (NASDAQ:SLRC), TICC Capital Corp. (NASDAQ:TICC), BlackRock Kelso Capital (NASDAQ:BKCC), Ares Capital (NASDAQ:ARCC), and Fifth Street Finance (NYSE:FSC). Several reasons I am not overly impressed by the recommendations of admittedly knowledgeable number crunchers.

I also invest primarily in preferreds because I fully understand them and the nature of the average preferred investor. More accurately, the preferred investor who not only lives off fixed-income dividends, but those who, like I, are yield-hungry opportunists. I'm sure you're familiar with the term water seeking its own level - well it's the same with preferreds. Their natural price level hovers around their issue or call price, which, for our example, is $25.00. This happens to be the most common issue and subsequent call price of most preferreds. Consequently, under normal circumstances, each company's preferreds will hover around that price. However, that price normally fluctuates higher or lower, depending on the following:

Lower (The most common occurrence)

  • The company is perceived as being weak.
  • It reports some bad news.
  • The company's sector suffers negative press or a general downturn.
  • Interest rates might rise, especially in the case of mREITs.
  • A general market sell-off during a contraction, which happens, more or less, on a regular basis.

Higher (priced above par)

  • The IPO coupon rate offers a healthy yield, somewhat above what is available by similar products at a particular time.
  • The company appears strong, yet offers a respectable dividend yield, and it's preferred is not callable for several years.
  • When the shares are cumulative and have been suspended for whatever reason, yet the company survives and appears to be prospering again, how many dividend payments were missed will determine how high above par the shares will rise - which I detailed above as regards Supertel Hospitality.

During times of extreme volatility in a particular sector or the entire market, when the prices of preferreds of companies most affected drops into the low single digits, opportunists become seriously interested and begin snapping up low-dollar risk, very high-reward deals. A 1000-share preferred buy at the depressed price of $2.50 risks the investor $2,500, plus the 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, making those preferreds more valuable, ironically. The moment when savvy investors, or investors with inside knowledge realize this is when that those preferred prices skyrocket, reaching dollars amounts well above the $25.00 call price, on occasion - 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 a $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!

The following reason is why I prefer preferreds: unlike commons, with preferreds one is able to make a bid based on a reasoned price and yield one is willing to pay for. One is not buying in the hopes that the stock price will appreciate enough for one to sell and earn a profit. One 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 and, consequently, raise additional capital. Lots of bad things they want to get out from under as soon as possible.

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

Finally, when, to my chagrin, I discovered I was not the world's greatest trader and was certainly no financial expert, I decided to exit the market or find a way that I could profit within it. That's when I discovered preferreds and realized they would work for an investor such as I. They have, and I prospered. It doesn't mean I haven't made costly mistakes along the way, but on balance, I am far ahead since I began investing in preferreds in early 2009. Will I continue to prosper? Hopefully so. But as the saying goes, the market makes geniuses and idiots of us all.

Disclosure: I am/we are long ARR-A, ARR-B, CYS-B, MITT-B, NCT-B, NCT-D, NRF-B, NRF-C, NRF-D, NRF-E.

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.