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After the latest decline in rare earth miner Molycorp (NYSE:MCP) due to the company drastically missing earnings, bargain hunting investors might be tempted to take a look at the preferred shares (MCPPRA), as they now yield an eye-popping 12%, paying out $5.50 a year in dividends.

However, investors should realize that they would have to pay a prohibitively expensive premium to garner these payouts, considering that the preferred shares have a mandatory conversion feature where they automatically convert to common shares on March 1, 2014. Each preferred share will convert to two common shares if the stock price is below $50, which now seems like a virtual certainty, and slightly fewer shares if the price is higher.

Given this fact, it is fairly straightforward to calculate whether the preferred shares trade at a discount or premium to the common. You simply multiply the price of the common by two and add the total dividends you will receive before conversion. This should give you an idea of the price you should be willing to pay for the preferred.

I was initially attracted to the preferred shares last December, when they traded at a discount to the common shares. With the common trading around $24, I bought the preferred at $58 when it was yielding about 9.5% and had nine dividend payments of about $1.38 remaining, since its intrinsic value was above $60 ($24*2 + $1.375*9 = $60.375).

However, since the preferred share price has held up much better than the common lately, the situation is now reversed and each preferred share trades at a huge premium to the common. At yesterday's closing stock price of only $12.50 and with only seven dividend payments remaining, the value of the preferred should be around $35 ($12.50*2 + $1.375*7 = $34.625).

This huge premium was the reason I sold my preferred shares today for around $44.50, and will look to reenter the common instead on any weakness. For those who were in the preferred for the dividend income, another strategy could be to take advantage of the large options premiums that now exist after the recent volatility in Molycorp stock.

You could sell a cash secured put at the December 2012 $12 strike price for a premium of $2, collecting $200 for the 100 shares it represents. If the stock continues its recent decline and closes under the strike price and you are forced to buy the stock it would be for the equivalent of $10 a share, 20% lower than you could currently buy the common. And if the stock finishes above $12 you would keep the premium and earn over 15% on the money you would have set aside to buy the stock.

Either way you get exposure to it, I think the common is now clearly superior to the preferred, since the preferred now trades at a premium that cannot be justified even though the dividend yield is tempting. I believe this premium may evaporate after the next dividend payment on September 1, as investors may have driven the price up to an unsustainable level by piling into the preferred ahead of the August 15 ex-dividend date.

Source: Molycorp Preferred Shares: High Yield But A Huge Premium