Sleep At Night Investments: Utility Preferred Shares

Five Plus Investor has been active on the Seeking Alpha boards for several years. In my time of reading and contributing comments under dividend-related articles, I've noticed four kinds of dividend / income investors:

Dividend Growth - This method is considered is the surest path to a secure and growing dividend stream. Dividend growth stocks are primarily common stocks with a "sweet spot" yield between 2% to 4% and a dividend payout that increases at least once per year. This method is addressed often on Seeking Alpha and has many faithful adherents. For retirement purposes, this method works best when starting young and investing much, or when starting later with a large capital base. The motto of the Dividend Growth Investor is: "slow and steady wins the race."

High Yield with High Risk - From my experience - both on the boards and in my own life - High Yield with High Risk investors fall into three camps: traders, newbies and desperate retirees. The motto of the High Yield with High Risk investor is: "it's my dividend and I want it NOW!"

While experienced traders may be able to navigate this dangerous highway, all others need to heed this warning: unless you understand what kind of stock you are considering, high yield is not a "green light" for a buy. If the stock is not created specifically for high yield (i.e., MLPs, REITs, BDCs), you are risking a loss. High yield in common stocks is usually a "yellow" or "red" light, cautioning you that the market has priced in, or believes in, bad news for the company.

Income Investors - These investors value capital preservation and a steady income. They may categorize themselves as high yield (above 5%) or median yield (3 to 5%). They look primary to bonds, mutual funds and preferred shares for their dividends. The motto of the Income Investor is: "I will create a stable dividend stream while not sacrificing my capital."

Blended Approach - This comes closest to the Five Plus Investor's method of investing. This kind of investor canvasses the investing universe and holds anything that meets their personal investing goals: common shares, preferred shares, bonds and bond funds, CEFs, mutual funds, even CDs and annuities. The motto of the Blended Approach investor is: "Whatever works".

There are many wonderful contributors on Seeking Alpha writing on dividend growth investing, and several very solid contributors who write solely on fixed income investing. Where there could be more input is in regards to a blended approach, with a focus on higher yield.

This will be the approach of the Five Plus Investor - to provide information on investing with a blended approach, higher yield and a potential margin of safety. "Potential" is an important designation, as there is no such thing in the investing world as "safe". However, achieving high yield in a "safer" manner that just investing in high yield common stocks is possible.

The motto of Five Plus Investor is: "I will only invest in high yield issues that offer a potential margin of safety and/or capital appreciation."

To accomplish this goal the Five Plus Investor will focus on high yield stocks, bonds, preferred shares, funds and international issues that meet most of the following criteria:

• Have a dividend yield of 5% or higher
• Have a stable or growing dividend
• Are from companies that are stable or growing
• Are considered lower beta, undervalued or with little historical price variance
• Are currently priced well for an entry point
• Have potential for capital appreciation
• May be tax-advantaged

In short - I want the high yield investor to invest in such a way that allows us all to sleep at night.

High Yield and a Good Night's Sleep

So how does one create a portfolio that not only provides higher yield but also a measure of safety that allows for a good night's sleep? As stated above, you do not want to create a portfolio consisting primarily of high yield common stocks. This leaves you with MLPs, REITs (many flavors including real estate, mortgage and agency), BDCs, bonds, open- and closed-end funds, Canadian and other international trusts, and preferred shares to choose from.

The focus today will be on preferred shares. More articles will follow in a series focusing on other types of "sleep at night" investments.

But which class of preferred shares? A cursory browse of the excellent website quantumonline.com will quickly show you there is a whole universe of choices that can be a bit overwhelming.

The world of preferred shares is dominated by issuers from financial and mortgage companies. These might appear easy choices, but if we are looking for an increased margin of safety, financial and mortgage preferred shares may not currently be the best choices. Using history as a guide, we know that during the financial crisis of 2008 many preferred shares from financial and mortgage companies became equal victims as the corresponding common shares. They suffered dividend eliminations, crashing share prices, and even suspension altogether. During this time period, preferred shares ended up being no "safer" than the common shares. Sadly, the latest news regarding a potential downgrade of U.S. debt shows we are still unwinding from our credit and financial crisis, and there may still be more pain to come.

Therefore we are looking outside of financial and mortgage issuers to other classifications of preferred shares for our "safer" choices. Further research by Five Plus Investor shows preferred shares from utility companies are amongst the better performing preferred shares in terms of yield, price variance and stability.

"Utility Preferred Shares" - The name says it all

Utility preferred shares are exactly that - preferred shares issued by utility companies. Right from the start you have a strong combination for a potentially steady performer:

Utilities - Utilities are companies that provide the stuff of everyday life: water, gas, telephone and electricity. Because these companies provide a service that is required in good times and bad, they are considered recession-proof. In addition, utilities profit in a low interest rate environment.

Preferred Shares - Preferred shares provide several benefits for the high yield investor, including: "first in line" payment of dividend before common share holders; fixed dividend payments; ratings by credit agencies; and in many cases, lower volatility and price variance.

The "Sleep at Night" Difference - Price Variance

"Price variance" is a term that this author is using to describe a stock's historical price action. Price variance measures in percentage terms the difference between a high closing price and a low closing price within a given measure of time. The percentage can be measured from high-low or low-high. For simplicity's sake, this article will focus on a high to low percentage.

By measuring the variance between a high to low point, you can extrapolate that a higher percentage price variance means the stock has been historically more volatile, with higher highs and lower lows. Stock issues with a higher price variance are not the "sleep at night" stocks we are looking for.

Instead, we are seeking out lower price variance, meaning there is less difference between the given high and low. A lower price variance means the stock may not appreciate much in a bull market, but conversely it may not depreciate much during market downturns.

It's that last factor - the lack of depreciation during the bear markets - that makes utility preferred shares appropriate for the "I can sleep at night" portfolio.

In this respect, the recent financial crisis has given us a tremendous gift - the ability to measure how stocks will price themselves during a financial meltdown. The market reached a high point on October 9, 2007 then plunged to the lowest point in twelve years on February 23, 2009. Therefore we will use a five-year measurement for our price variance which includes both of these timeframes.

Utility Preferred Shopping List

The utility preferred stocks that meet the criteria of the article have the following characteristics:

• Price variance high to low of 25% or less in the past five years
• Current yield of 5% or higher
• Under call price
• Past call, anytime call or non-callable

The last factor is important, as having a call date provides a certain amount of inherent trading volatility for the preferred share. A call date provides a target wherein investors try to capitalize by purchasing or selling according to the call. Issues that are past call but are still trading on the secondary market (and paying dividends); that don't have a call imminent (anytime); or may not be callable at all (non-callable) don't have that target and therefore are typically less volatile.

The prices used for variance are the closing prices. The issue may have traded higher or lower in its overall history. In addition, for comparison sake, where there is a common stock issue from the same company, it is given in italics to demonstrate the real difference in price variance between the two classes of issues.

Energy Co.	Symbol	High	Low	Variance	Yield Now	Call Time	Call $	Price Now
Excel Energy	XEL-G XEL	$89.99 $24.99	$71.90 $16.29	20% 35%	5.14%	any	$100.00	under
Georgia Power	GPE-A	$26.50	$22.50	15%	6.00%	past	$25.00	over
Westar Energy	WREGP WR	$84.50 $28.34	$65.15 $14.95	23% 47%	5.88%	any	$100.00	under
Pacific Enterprises / Sempra Energy	PET-B SRE	$87.25 $66.29	$67.50 $37.99	23% 43%	5.37%	any	$100.00	under
PECO	PE-D	$92.00	$71.75	22%	5.21%	any	$100.00	under
Pacific Gas & Electric Co.	PCG-A	$28.60	$23.60	17%	5.60%	non	$25.00	over
Connecticut Power	CNLHO CNLPL.OB	$40.25 $54.27	$31.00 $42.25	23% 22%	5.77% 6.19%	any any	$50.00 $50.00	under over
Baltimore Gas / Constellation Energy	BGLEH CEG	$115.00 $104.49	$90.25 $16.03	22% 77%	6.97%	past	$102.09	under
Dayton Power	DAYTL	$76.00	$57.50	24%	5.10%	any	$102.50	under
Consumers Energy	CMS-A	$85.25	$64.00	25%	5.10%	any	$103.25	under
Great Plains Energy	GXP-A GXP	$78.50 $33.36	$62.40 $11.01	21% 67%	5.50%	any	$103.70	under
San Diego Gas & Power	SDOGI SDOpB SDOpC	$28.00 $18.85 $18.50	$22.00 $14.75 $14.45	21% 22% 22%	6.67% 5.29% 5.13%	any any any	$25.80 $21.20 $21.00	under under under
Southern CA Edison	SCEpB SCEpE	$22.00 $23.00	$16.46 $18.20	25% 21%	5.65% 5.60%	any any	$25.00 $25.80	under under
Southwestern	SWSEO	$94.50	$74.50	21%	5.81%	any	$109.00	under
Wisconsin Pwr	WELPP	$75.00	$57.00	24%	5.33%	any	101.00	under

Click to enlarge

Priced Right Now

A common stop-loss rule is to sell if the price dips below 10% of the original purchase price or cost/basis price. To "sleep at night", it would be advisable then to purchase these issues within 10% of the given five-year low price on the table above. The following issues meet this criteria as per trading price for April 21st, the last trading day on record for the article:

• BGLEH - at $100.00 a share on April 21st, this share barely qualifies at just under 10% from the given low. Baltimore Gas is a subsidiary of Constellation Energy (CEG), which trades under a
  common share.
• GXP-A - is trading within 7% of its historic low. Because the preferred issuer also lists a common stock, the underlying fundamentals of the company are more accessible.
• SCE-E - is trading within 9% of its historic low.

Runners-Up: Both GPE-A and PCG-A are priced as of close on April 21st within 11% of their historic low.

Before you jump in…

Preferred shares can be complicated instruments that share some characteristics with bonds. If you have never researched or purchased a preferred share before, I highly recommend you read the following primers and articles:

• Investopedia: A Primer on Preferred Stocks
• Seeking Alpha: Preferred vs. Common Stocks: What's the Difference?
• Quanumonline.com: Income Investing Basics

Some preferred shares have low liquidity which makes them more difficult to purchase, and some brokerages are not adept at trading these types of shares. You may need to contact your broker before attempting a trade.

There is also interest rate risk with any utility stock. Here's a very basic explanation: when interest rates go up, profitability of utilities goes down. While this presents a risk, the chart above shows that the preferred shares are less of a general proxy on a company's profitability than are the common shares. It should also be noted that high five-year price points on utility preferred shares were achieved in 2007-2008, when interest rates were higher than today.

Disclosure: Long GPE-A.

Disclaimer: Five Plus Investor is written for the retail investor, from a retail investor's experience and point of view. The articles presented by the author are for informational purposes only. Five Plus Investor is not a professional investment counselor. Before investing one should conduct their own due diligence or seek the advice of a professional as needed.

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.