Preferred Stock Is A Fine Way To Go

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Includes: FFC, HYG, PFF, VFH, VTI
by: Left Banker

Summary

A recent article advised against investing in preferred shares.

The data bolstering that advice was deeply flawed.

Investing in preferred stock, especially via closed-end funds, has been a safe, productive choice with the exception of the period affected by the financial crash of 2008.

There was an article on Seeking Alpha today, in which the author, Louis Kokernak, CFA, argued Preferred Stock Isn't the Way to Go. His points were preferred stocks represent a tiny fraction of the domestic markets, preferred stocks are overwhelmingly drawn from the financial sector, and preferred stocks can be replaced in a portfolio by "conventional" stock and bond holdings. He supported his argument with data showing a preferred stock and a financial sector ETF have performed poorly since 2007 relative to his "conventional" choices.

It's my view that preferred stocks can, even should, be a core component in an income investor's allocation strategy. That's ok, it's different opinions that make a market, and there can be little real question that one can build a solid portfolio without any exposure to preferred stocks. But to dismiss the category out of hand is, in my view, a mistake.

My primary objections to the article are twofold. First, the author cites only a single set of performance data. He takes the iShares U.S. Preferred Stock Index ETF (NYSEARCA:PFF) to represent preferred stocks and compares its performance with ETFs standing in for stocks (NYSEARCA:VTI), junk bond aggregate (NYSEARCA:HYG) and the financial sector (NYSEARCA:VFH). The author neglects what has been the most productive investment choice for preferred shares, closed-end funds. This omission appears to be purposeful as the author did include several of the preferred stock CEFs in his focus ticker list at the start of the article. This is not unusual, many advisors tend to dismiss closed-end funds, even for the two asset classes where they excel, preferred shares and municipal bonds.

The second point is also a common flaw in such arguments. The author chose as a start point for his single data table June 2007, a market high point that immediately preceded the worst market drop since the 1929 crash. And to compound that bias, he uses that date to follow financial sector stocks, the sector that was most devastated by the 2008 crash. Of course, the other asset classes would outperform by comparison, because over the next 20 months, VFH lost 72.8% of its value and PFF lost 52.6%. So it should come as no surprise that VFH and PFF are the two worst performers of the lot from June 2007 through July 2016. Start that analysis at later dates and one can draw quite different conclusions as I'll show.

But what's perhaps most interesting is that, had the author chosen much better-performing CEFs instead of ETFs, a very different picture would have emerged, even from that biased start point. Let's add Flaherty & Crumrine/Claymore Preferred Securities Income Fund (NYSE:FFC) to the list and see how the results stack up. I have been writing about FFC for several years now and have repeatedly called it out as the single best choice for preferred stock. The author lists as one of his focus tickers. FFC is not some obscure fund.

Even starting from the worst possible timing point for any financial sector investment, FFC soundly beats each of Mr. Kokernak's other selections.

Now, let's look at what happens if we chose later starting dates:

With this wider selection of time frame, we see that preferreds, when represented by PFF - the ETF chosen to illustrate why the investment class should be avoided - has modest returns accompanied by the lowest volatility from 2011 on. The closed-end fund, FFC, continues to be a leader, with returns beating or coming in second to the other funds for every time frame.

One way to have a quick comparison of different investments without having the inevitable biases that come with choosing a start date and looking at returns through the present is to look at rolling returns over time. This next chart shows the funds' rolling 12-month returns for the period since June 2007. It illustrates why the author's choice so severely skewed the results and why the start date matters.

Click to enlarge

Note that in under three years' time from the start chosen by the author, the preferred stock funds swung from a <-50% to a >100% rolling one-year return.

An important aspect of closed-end funds came into play in facilitating FFC's strong recovery (a 200-point swing). Closed-end funds are closed. Management can neither add nor subtract from the asset base. When investors panic, as they did in 2008, the fund's price will drop and its discount will grow (at its extreme point, FFC's discount fell to -40%). But regardless of how bad it becomes, the fund's managers are not forced to liquidate assets at panic-level valuations as an open-end fund or an ETF manager will be. Thus, the asset base is intact when the inevitable recovery gets underway.

To sum up, I hope readers who are invested in preferred stocks or are considering them will take Mr. Kokernak's recommendation to avoid the category with a healthy degree of skepticism. His omitting from consideration the whole category of closed-end funds ignores the strength that CEFs have in the preferred stock category. Then, he compounds that omission by selecting an exceptionally flawed and biased data set to bolster his recommendation. The term is horribly overused these days, but the fate of the financial sector in the 2008 crash is the definitive black swan event. Unless you expect a repeat of that cataclysm, analyses and arguments that depend on it can be readily dismissed.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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: I have no ties to the financial or security industries in any form. My interests are strictly personal. The banker part of the nym has absolutely no relationship to the profession of the same name. Readers should be aware that I am an investing novice. I do not give advice; what I publish is an annotated version of my research notebook for topics that I think will be of interest to readers at a similar level of investing knowledge. Anyone who finds any securities or strategies to be of interest will necessarily want to do his or her complete research and due diligence before acting on that interest. It would be foolish to rely on my conclusions without having done so.