I'd Preferred Not To

| About: Navios Maritime (NM)

Summary

Addressing a recent event with Navios Holdings.

Why it doesn't make a lot of sense to own distressed preferred shares.

Some discussion about how the mREIT sector has similar risk factors.

Company CEO Angeliki Frangou pushing buttons.

A business does what is best for the business.

I have observed, mostly through my readers' comments, that there is a widespread belief that the management of a company has a responsibility to do what is in the best interest of shareholders. There is an important caveat with that rule: not every business has the ability to do what pleases shareholders.

Likewise, we also tend to believe that what has gone down must come up. I will be the first to tell you that I love it when my favorite stock is on sale. However, when something sells at a deep discount, understand that does not necessarily mean there is a large upside to it. Case in point: Preferred stock.

There are no unsinkable ships.

I've got a really great example to talk about today, which are the preferred shares of Navios Maritime Holdings (NM). Two issues of its in particular, the Series G (NM-PG), and Series H (NM.PH) preferred stock.

If you were to ask me what the single most important thing to have a handle on with regards to the stock market, I would actually answer that saying it is how the bond and other debt markets work. That said, even experts in these areas occasionally have difficulty seeing problems.

These two issues are what are called "Cumulative", and "Perpetual" preferred shares. That means that they never expire unless they are called, and that they can owe dividend payments indefinitely.

What has happened is that dividends on these preferred issues were completely cut, and Navios has made an offer to the holders to buy them back now that they have fallen in price by nearly 75%. The offer has brought the price support to take that drop to only about half, but doesn't make these a suddenly good value.

Required reading for professionals. Most don't.

The difficult thing about working in the industry as an investment analyst, and this is true all the way up to the ranks of the top fund managers, is that we aren't attorneys. To become a registered advisor, you don't typically require an education in law. However, at the same time, we are served our information in legal documents like this one. It's not hard to understand how information can be overlooked.

You have to dig a little bit, but buried in the fine print of the preferred share prospectus, in the "Voting Rights" section is the following, somewhat inconspicuous phrase:

Unless we have received the affirmative vote or consent of the holders of at least two-thirds of the outstanding Series G Preferred Stock, voting as a single class, we may not adopt any amendment to our articles of incorporation that would materially and adversely alter the preferences, powers or rights of the Series G Preferred Stock.

I had a heck of a time locating that, and I only found the series G prospectus at the official site. You can find the document in the "SEC Filings" section in the investor relations area of the company's homepage. Look for a document dated 1/23/2014, form 424B5.

Other sites carry the series H prospectus, but require registration. I was able to obtain the full document at Preferredstockchannel.com. The wording is similar.

So who actually "prefers" this kind of stock?

You sort of want to view this from the perspective of the business management, who, as I said above, is doing things that serve the interests of the business. The terms of the preferred shares offer some flexibility with what a business can do in financing, and the risk is mainly shouldered by the people who buy the issues.

The major selling point for the investor is that when dividends are paid, the company must be paying them on preferred shares first. The secondary promise is that if dividends are withheld, the company has to pay all those dividends back before it can get the rights to redeem the shares.

Unless, according to that paragraph above, the holders of at least two-thirds of the outstanding shares voted for changes. Navios always had the right to buy out the preferred share owners at full price, but that tiny bit of legal speak meant that Navios could do virtually anything it wanted to the terms of this offer as long as it could get a majority of holders to go along with it.

Yes, of course it realized that.

Now, I don't think that Angeliki Frangou, the company CEO just got up one day and decided that it was a good idea to try to deceive people. Undoubtedly, it was realized that nobody really knew just how bad things could get with shipping rates, and issuing preferred shares instead of bonds was a way to be prepared if things got rough.

For investors, an 8.75% coupon seemed like a pretty easy way to get a free lunch in a market full of low interest rate choices. But the company also knew that the secondary market existed, and once shares were issued, it could always come back for them later at a cheaper price.

It won't be the last to try this, either.

At this point, what I want to try to do is open your eyes to the possibility of other parts of the stock market where these problems could happen in. Around March of 2015, I started seeing questions coming in from my readers asking about a type of investment commonly referred to as an mREIT, a type of real estate trust that holds, for the most part, mortgages.

The appeal of the mREIT is that it typically sports an above-average dividend yield. In many cases, exceeding double-digit percentages. Moreover, there was this perception of safety because the companies were trading below their book value. Well, I put a lock on that perception, and 16 months of nearly continuous book value erosion later, it seems to have been a prudent call.

REITs love to issue preferred shares.

AGNC Investment Corp. (AGNC), formerly known as "American Capital Agency", has two series of cumulative, perpetual preferred shares too. It trades under the symbols for Series A (AGNCP) and Series B (AGNCB), and you will find similar language in the voting rights areas of its prospectus stating that if two thirds of the holders act, it can change the terms.

By contrast, those two preferred issues are actually selling at premiums at market close today, meaning the holders are pretty confident the future will be just fine. But ratchet up interest rates a point or two, and everybody will start sweating when the margins on the bonds they're buying suddenly get very small.

Of all of the mREITs that I am aware of, AGNC probably has the reputation of being the safest. Annaly Capital (NLY), previously described by analysts as being in a "lose-lose" situation has four issues of preferreds! And yes, the very same clause.

Paradoxically, I rate all of the common stock mentioned here a buy.

I'm actually long the common shares of Navios Holdings, as well as AGNC and Annaly. That is because I think there is an excellent chance that all of these businesses will survive. I believe that the people who bought those preferred shares are actually helping to make that possible.

The preferred issues have eased the possibility of any of these companies facing bankruptcy in the face of rising interest rates. I'm not saying that risk is completely off the table, just that it gives flexibility, and management knew that too. Just be willing to cost average, because there is probably going to continue to be substantial price volatility.

The bottom line.

If you're searching for income investments, and are considering the purchase of preferred shares on a distressed investment, consider something else. Especially if the dividends on the common stock have been dropped. There are only two possibilities with preferred shares here.

Either:

  1. The situation will improve, or
  2. It will not.

If the situation improves, and both start paying dividends again, you have a better chance of getting a greater return on the common shares, because the dividend rate on preferred shares is set, but common shares have the possibility of increases later on.

If things do not improve, nobody would want them anyway. Why accept that risk?

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Thanks for reading. Fed activity looks like it might finally start to pick up, and I've got plans to start tearing into the balance sheets of many of your favorite high-yield investments. There is potential out there, and there is also risk that has never been seen in our lifetimes before. You are going to want a guide. Go click on that follow button.

Disclosure: I am/we are long NM, NLY, AGNC.

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.