When our business careers ended and my wife and I moved to Maine several years ago, I decided that I would try to accomplish three things in retirement: I would improve my golf game, learn to play the guitar, and become proficient in Spanish.
Well, here we are eight years later. My golf game is terrible, I haven't opened my guitar case in two years, and my Spanish-English dictionary is gathering dust on the shelf.
So much for my "best laid plans".
Instead, I learned to cook, I became a gardener, and most important, I became an ardent self-directed investor.
During my banking career I relied on professional investment advisors to manage my portfolio, but in retirement I finally decided to "go it alone". Having been disappointed time and again by poor results, high fees, inconsistent communication, and mediocre customer service, I decided that I was going to have to learn to do investing by myself. And so I did.
My investment approach has evolved over the past six years into what I would now describe as "half Dividend Growth and half High Yield". Josh Peters of Morningstar (he has since left) got me started with his excellent book "The Ultimate Dividend Playbook", and I subsequently absorbed critical knowledge and advice from various investment publications and from dozens of authors on Seeking Alpha and other websites. I started out cautiously by sticking to large cap dividend growth stocks and as I gained knowledge and confidence I gradually expanded into other asset classes.
My wife and I now diversify our investment assets among 72 positions as follows:
30% Common Stocks
20% Preferred Stocks
20% Closed End Funds
10% Business Development Companies
10% Master Limited Partnerships
Our weighted yield at cost is 6.67% and our market yield is 6.05%. The organic income from our portfolio, when added to social security, a pension, and one annuity, covers all our living expenses and taxes. I conservatively estimate that our income should grow by about 2-3% per year, which I hope will cover inflation.
To me this is the pinnacle of investing. As long as we stay on budget and assuming that inflation remains under control, we should never have to sell securities to pay the bills. We will sell because we want to, not because we have to. Sure, there may be unpredictable emergencies, but we are at the very least in the best possible defensive financial position.
What I want to write about in this article is the screen I have developed to select preferred stocks. While there are a few authors on Seeking Alpha who provide excellent data and advice for this asset class, I think that more can be said about the specific financial metrics one can use to evaluate these securities, enhance income, and reduce risk.
One of my favorite SA authors who writes regularly about preferred stocks is Norman Roberts. Norm is refreshingly open about his lack of interest in analyzing financial statements. His basic approach to selecting preferred stocks is to look at the price history of the common stock and give some thought as to what if any "existential threat" may exist for that company. There is no effort made to analyze the income, cash flow, or balance sheet strength of the issuer.
Doug Le Du is another excellent source for preferreds. In his book "Preferred Stock Investing" (fifth edition) Doug sets out 10 criteria for screening preferred stocks (page 117). Most of these criteria deal with the preferred issue itself, such as rate, call date, par value, and convertibility. Only three conditions relate to the issuing company, which are: 1) Should be a US company; 2) Must have no previous preferred dividend defaults; and 3) Must have an investment grade rating. So again, there is no effort made to analyze the financial statements of the company. The only "protection" the investor has is the investment grade rating. But as Doug shows us on page 169, this requirement will eliminate the great majority of issues with a yield over 6.0%.
Another very helpful author on preferreds is Colorado Wealth Management. CWM has developed a 1-5 rating system to assess the risk of a preferred issue, and also offers detailed buy/hold/sell recommendations. The author opines directly as to whether an issue is suitable for the buy-and-hold investor or better suited for trading (I have declined to buy certain preferreds that CWM rates as unsuitable for B-A-H investors such as myself). However, his rating system is proprietary and so we do not know the metrics involved and cannot determine these risk ratings ourselves.
I should also mention Arbitrage Trader as a very helpful source for the preferred investor. AT maintains an incredible data base of hundreds of preferred issues which are sorted by every possible variable, such as rate, yield, yield-to-call, call date, price vs. par, yield curve, and so forth. Also, for the more active investor, AT looks for opportunities for pair trades and dividend capture. AT also reviews every new preferred offering in detail, although no opinion is usually expressed.
So despite these (and other) very helpful sources, I have yet to find an author who actually gets involved in the analysis of financial statements to screen preferred stocks and tells us in his articles what these metrics are and how to calculate them.
Perhaps this is because of the very nature of preferred stocks, which are fixed rate instruments with call provisions that may limit or constrain total return. This would turn off any equity analyst, who seeks common stocks with unlimited growth and total return potential.
However, to an old commercial lender like me, the bond-like nature of preferred stocks is very similar to the character of the business loans I used to analyze. In my opinion, screening preferred stocks is an exercise is credit analysis, which is different from equity analysis.
And that means that I want to focus on income coverage of all preferred and funded debt obligations and on balance sheet strength in selecting a preferred stock. I can only do this through direct analysis of the financial statements.
So let's take a look at my approach, which involves:
1) A review of the characteristics of the preferred issue, and
2) An analysis of the issuing company's financial strength.
Characteristics of the Preferred Issue
- Yield at Cost: Minimum 6.5%
I want a minimum yield of 6.5% when I purchase a preferred stock. This is the minimum yield I will accept for this asset class, which compensates for the lower yield I receive on my dividend growth common stocks. My common stocks provide the growth of my income (along with REITs and MLPs) so I need a higher starting fixed return from my preferred stocks and CEFs.
I realize that this yield requirement means that I will in most cases be buying preferred stocks that have no credit rating, or a below investment grade rating. I can accept this because I believe that the protocol I have established to screen these stocks will provide a level of safety/risk control that a conservative investor would find acceptable.
- Yield to Call: Minimum 6.0%
I am willing to pay a slight premium for a preferred that yields 6.5% or higher. However, I want a minimum yield-to-call of 6.0%. I am willing to take a slightly lower yield to call because the call may never happen or because I might want to sell the security before the call date for a number of reasons.
- Call Date: Two Year Call Protection
As mentioned above, I am a buy-and-hold investor. So I want a certain level of call protection when I buy a preferred issue. I generally want to see at least two years of call protection, since I don't want to go through the exercise of analyzing, buying, and monitoring a security if it can be called away within a brief period of time.
However, if the issue is selling at a significant discount (let's say $.50 or more), I could accept a shorter call date, since the issue, if called, would yield a capital gain.
- Cumulative: Not Required
Obviously, this is good protection but certain issuers (banks, for example) do not offer this feature. I believe that regular periodic review of the company's financials should alert the investor to a declining situation well before a dividend suspension might occur, at which time the issue could be sold.
Analysis of the Company's Financial Position
Here we are going to determine the extent to which the historic earnings of the company will cover the interest and dividend costs of the company's funded debt and preferred stock. We will also look at the strength of the balance sheet. Finally, we will look at the "cushion" which the common dividends represent for preferred shareholders.
Basic Corporate Characteristics:
- Company must be at least ten years old
Commercial lenders like me want to see that a company has established a track record of successful operations which include both strong and weak periods of economic activity. Since the last recession ended about eight years ago, I want to see how the company in question performed in 2008, 2009, and 2010. So I want the company to have been in operation for at least a decade.
- No losses for the past three years
We are going to calculate the safety of preferred dividends by analyzing the company's net income for the past three years. To be conservative we require that there be no net loss experienced in FYE 2015, 2016, or 2017.
- No more than three losses during the past ten fiscal periods
Another conservative screen for added protection
- Company must have paid common dividends for the past 7 years
This provides a cushion for preferred investors since no common dividend can be paid until the preferred dividend is paid in full.
Note that there are occasions when a company might cancel both common and preferred dividends at the same time. The existence of a common dividend does not necessarily guaranty that the preferred dividend is safe. Nevertheless, the common dividend does represent an additional cash "reserve" that could be available if needed to continue funding the preferred dividend.
Net Income Coverage of the Preferred Dividend
- Defining the Numerator: Net Income
We are going to take a conservative approach to calculating preferred dividend coverage by dividing net income by that dividend. It is important to make clear that we are not adding back depreciation, interest, or taxes. We are not using EBITDA, Funds from Operation, or Distributable Cash Flow. We are using basic net income as defined by Generally Accepted Accounting Standards, the most conservative measurement of cash flow.
The advantage of using net income is that interest expense has already been taken out. This means that all interest owed on all debt, long and short term, has been paid in full, and the remainder is fully available to pay preferred dividends. This is why you will see preferred dividends shown as a deduction immediately after the net income figure on most income statements.
I recognize that net income can vary greatly from one year to the next and for that reason I calculate a weighted average of net income over the past three years. I use weights of 3, 2, 1 and apply these weights to the net income figures for 2017, 2016, 2015. That figure becomes the numerator of the ratio.
- Defining the Denominator: Preferred Dividends
Here it is important to make sure that you have included all preferred dividends, not just the particular issue that you are reviewing. This can be tricky with companies that issue preferred stock on a regular basis. So you need to go to the most recent quarterly report (10Q or 10K) and look at the balance sheet to find all the outstanding preferred issues.
For each issue, you should list the shares outstanding, the liquidity preference (which is the number of shares multiplied by the par value - usually $25), the coupon rate, and the dividend (coupon rate multiplied by the liquidity preference). Then add up all the dividends to determine the denominator of the ratio.
Note that this number may be significantly higher than the most recent annual preferred dividend. This will certainly be the case if new preferred issues have been added during the year. This is why simply using the most recent preferred dividend figure may understate the dividend requirements going forward.
- Required Ratio: Net Income / Preferred Dividends. Minimum 4.0
This is a completely subjective ratio that I have established to give me a significant margin of safety should earnings fall. I am basically saying that net income as averaged over a three-year period could fall by 75% and the preferred dividend would still be covered. And again this is strictly net income coverage which does not rely on non-cash sources of funds such as depreciation.
Measuring the Common Dividend Cushion
- Common Dividend
Among the most recent quarterly financial statements, look for "Changes in Stockholder Equity". Here you will find a breakdown of dividends paid for common stock and dividends paid for preferred stock. Make a note of common dividends. You can ignore the preferred dividend figure, as you will be using the preferred dividend figure calculated above.
- Ratio Common Dividend / Preferred Dividend: Minimum 4.0
This is another purely subjective ratio that I use to measure the safety or "cushion" that the common dividend provides for the preferred dividend. If you add this ratio (here the ratio is 4.0) to the number 1, the total amount of common and preferred dividends equals 5. This means that the total amount allocated to all dividends could be cut by 80% and the preferred dividend would still be covered. I frequently find this percentage to be well over 90%, offering another level of protection for the preferred investor.
- Market Capitalization / Preferred Liquidation
Another interesting metric is Market Capitalization / Preferred Liquidation value. In essence, this ratio shows the market value of the common equity capital that "backs up" the amount of the preferred equity capital. I don't have a set minimum value for this ratio buy I have read one author who mentioned that he likes to see a value of 4/1 or higher.
A sudden drop in this value (caused by a significant drop in common stock price) might be an early warning sign to the preferred investor to recheck the level of coverage in the ratios described above and below.
Debt Service Coverage
- Debt / EBITDA: Less than 6.0
This ratio is a standard calculation which measures a company's ability to service its debt. Some analysts use "net debt" to calculate this ratio, reducing debt by cash on hand. This seems artificial to me since one can never know what level of cash may be available in the future and it seems totally unrealistic to assume that the entire amount of cash now on the books would somehow be available to pay down debt. So I use the total amount of the debt liability - long and short term - to calculate this ratio.
EBITDA stands for "Earnings before Interest, Taxes, Depreciation, and Amortization" It is therefore a much broader measurement of cash flow than Net Income per se. It can be calculated from the income statement, but it is also available on web sites such as Morningstar under the "Financials" tab for a particular company.
Again realizing that EBITDA may change markedly from one year to the next, I use a three year weighted average with weights of 3-2-1, as with net income above.
- Debt / Total Capital: Less than .70
OK I may get into trouble on this one.
I am constantly amazed to see major blue-chip companies that have no net worth. When I look at the balance sheets of McDonalds, Boeing, Clorox, UPS, and other companies I could name and see that liabilities are nearly as large - or even larger - than total assets, I just shake my head. Those companies are technically insolvent, but I guess that doesn't bother their shareholders - or even their bankers for that matter.
So old fashioned me still requires at least some level of equity, even if total debt is more than twice the equity amount. That's what I need to Sleep Well At Night. But I know I am out of step on this point, so the reader may choose to ignore this ratio.
- Mortgage REITs
Mortgage REITS (MReits) are prolific issuers of preferred stocks and they deserve special mention concerning the nature of their debt.
MReits invest in mortgage securities - both residential and commercial - which are financed with considerable leverage through repurchase agreements or similar borrowing arrangements. This debt is "self-liquidating", meaning that it is repaid by the sale of the underlying mortgage asset rather than repaid through earnings over time. Since there is usually very little funded debt involved, the ratios discussed in this section do not normally apply to MReits.
Preferred Stocks that I now own
The following preferred stocks pass all of the above requirements. I am presenting them for your consideration with the understanding that you will perform your own due diligence before making an investment:
AGNC Investment Corporation Preferred (AGNCN)
Call Date: 10/15/22
Net Income / Preferred Dividends: 17.4
Common Dividends / Preferred Dividends: 21.1
Chimera Investment Corporation Preferred A (NYSE:CIM.PA)
Call Date: 10/30/21
Net Income / Preferred Dividends: 13.0
Common Dividends / Preferred Dividends: 10.0
Energy Transfer Partners Preferred C (NYSE:ETP.PC)
Call Date: 5/15/23
Net Income / Preferred Dividends: 10.6
Common Dividends / Preferred Dividends: 26.9
Golar LNG Partners Preferred (GMLPP)
Call Date: 10/31/22
Net Income / Preferred Dividends: 13.5
Common Dividends / Preferred Dividends: 13.1
Annaly Capital Management Preferred F (NYSE:NLY.PF)
Call Date: 9/30/22
Net Income / Preferred Dividends: 10.4
Common Dividends / Preferred Dividends: 9.4
Sunstone Hotel Investments Preferred E (NYSE:SHO.PE)
Call Date: 3/11/21
Net Income / Preferred Dividend: 13.7
Common Dividends / Preferred Dividends: 11.7
I look forward to the readers' comments and will do my best to answer your questions. I would greatly appreciate learning how other investors approach this asset class.
I first began to acquire preferred stocks two years ago. Prior to that time I had developed alternative screening techniques for common stock, REITs, MLPs, and Closed End Funds. If the reader would like to review my screens for those asset classes, they are presented in my book "The Organic Dividend Portfolio" available on Amazon.
Disclosure: I am/we are long AGNCN CIM-A ETP-C GMLPP NLY-F SHO-E. 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.