Most investors avoid preferred stocks. They do this for a number of reasons. Most don't know about them, some don't understand them and many are afraid of them. Investors dislike the lack of growth potential. the duration risk from long maturities, the negative convexity from call options, their medium grade credit ratings. The list goes on.
A smaller number of investors feel they are compensated for these risk by strong predictable dividends, cushion from rising rates, yield spread over similarly rated corporate bonds, price transparency and the convenience of trading on major exchanges.
Good or Bad, there is a place for some preferreds in almost all portfolios. Preferred stocks are a conservative addition to common stock portfolios, and an aggressive addition to bond portfolios.
There are many ways to understand preferred stocks but a simply method is to view your common stocks as bonds and view preferred stocks as equities.
Seeing Common Stocks as Perpetual Bonds
In many ways a stock is just a perpetual security. A security paying an adjustable dividend, having a variable maturity value and a reinvestment feature. The security matures when you sell it to another buyer. The only difference between a stock and a bond is bonds have a fixed dividend or coupon, and a fixed maturity. A date when your money is returned at par value.
Common stock investors hope over time the earnings and market price will increase with company growth. The good news is stocks do this. Unfortunately it is with great variance, around 20 percent.
To crudely value the S&P 500 as a bond we can take the inverse of the current 26.69 P/E ratio. This gives us a yield of 3.75 percent. So owning the S&P 500 is like owning a variable coupon perpetual bond that currently earns 3.75 percent per year. The bond pays at a 1.92 percent dividend rate and reinvests the remaining 1.83 percent back into the company.
When you buy a stock, you are speculating on two variables, the dividend payout and the final selling price. Voting rights aside, that's all you get from owning a stock - a dividend and a selling price. All buyers purchase stocks on the speculation that one or both of these values will increase.
Common Stocks Offer Little Growth Over Inflation
Historically, it is well told and well sold that the maturity value or final selling price of a common stock will increase as the economy is always growing. And, on average, that's true. But, to make a real gain on an investment, the capital gains must grow faster than the rate of inflation.
Unfortunately, that usually doesn't happen. Since 1871 adjusted for inflation stocks have been flat almost 90 percent of the time. There have been 21 up years and 125 flat years. Over that same time the long-term real growth has been about 2.27% compounded.
Today with the markets making new highs, everyone is throwing a party. But stocks are only two percent above their 2000 inflation-adjusted high. Over the last 17 years real growth in stock prices is about 14 basis points per year. That's a hard way to get rich.
(courtesy of www.multipl.com)
Dividend Yields Keep Falling
Capital gains are only half of the equation. Investors also get dividends. Over time the dividend gains from common stock have steadily declined. During the last 137 years common stock dividends have fallen from 5.5 percent in 1870 to 1.92 percent currently, along a bumpy long-term trend line.
(courtesy of www.multipl.com)
Flat Real Growth Plus Declining Dividends
If you're buying stocks for dividend growth and inflation-adjusted gains, you would have been disappointed on both accounts. The market has been flat 90 percent of the time and dividends have fallen. The common wisdom that your portfolio should have at least 60 percent of common stocks begs a follow up question. Why?
In short, would you buy an inflation-adjusted security paying a 1.92 percent and a inflation-adjusted market price growing at 2.27 percent? I guess the answer is "Maybe?". What if it had a 22 percent price volatility? Would load up on them?
Inflation is now 2.5 percent, depending on how you calculate it, adding a 1.92 percent dividend, 2.27 percent growth, and 2.5 percent inflation gives the investor 6.69 percent expected total return.
That's not bad, but is there an easier way?
Seeing a Preferred Stock as an Equity
A preferred stock is an equity that gives the investor a stated dividend entitlement, and usually a fixed maturity date. Like the common equity the investor gets the dividend, and unlike the common stock they get a guaranteed selling price at maturity. The investor gives up potential dividend growth and capital gains in exchange for a higher fixed dividend. Unlike the common the investor is entitled to the dividend. The security has no implicit inflation-adjustment. Some preferreds are perpetual, like a common stock.
A Tale of Two Birds
In short, the preferred is a bird in the hand, and the common is a bird in the bush.
Imagine a good company that has common stock that pays a two percent dividend, the company is expected to grow at 4.5 percent nominal. The market price has 20 percent volatility.
The company also offers preferred stock that is entitles the share holder to a 6.5 percent dividend. The preferred tends to trade near its par value with very little volatility.
Which one would you want to own? Do you trade a low volatility stock with a 6.5 percent dividend entitlement for a chance to participate in market growth?
The Decision is Easy
The answer, of course, is easy…. "It depends".
It depends on what you know. Do you know what the interest rate will be next year? Do you know where the stock market will be next year?
If you know the long-term interest rate will increase significantly or you know the stock market will be higher by more that 4.5 percent-you should buy the common stock.
If you know the long-term interest rate will be flat or lower, and you know stock market will be lower or grow less than 4.5 percent-you should buy the preferred stock.
If you don't know what will happen in the future, you may want to own some of each. You may want to weight each based on how confident yo are of the outcome.
If you had to buy one forever and you could never look up the market price, which one would you own?
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: This article is for informational and discussion purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. All investment and speculations have risk. I am not your investment advisor, please consult your financial and tax advisers before investing.