My investment club's theme in 2019 is “Incorporate Safety.”
When the market sold off and corrected in the fall of 2018, the value of our portfolio slipped more than we would prefer. So, we're venturing into preferred investing - preferred stocks that is.
Initially, our investing strategy was growth at a reasonable price (GARP). In 2016, we adopted a focus on income and began migrating toward a DGI (dividend growth investing) model. Common to both strategies, the word we find appealing is “growth.” Even in the short term, it's going to be a challenge to choose safety over growth.
Preferred shares are assured a minimal value (the call price) at a specific future date (the call date). Thus, preferred shares tend to trade in a fairly tight range. The dividend rate on preferred shares is fixed at the offering and, at least initially, does not have the potential to grow like the dividend rate for a common share. Obviously, stability trumps growth when investing in preferred shares as neither the share price nor the dividend rate will be growing. Then again, the yield on preferred shares is typically greater than the yield on common share.
Admittedly, we don't yet have everything figured out regarding expectations and targets. Dividend reinvestment has been a key contributor to growth in our strategy. But this won't be an option for preferred dividend payments. Thus, it may be a worthwhile effort to track how we use those payments to determine a true return. Also, we have not yet set a target proportion for our portfolio for preferred stock investments. In late March, SA contributor, Rida Morwa, recommended investors take a defensive position against the threat of an upcoming recession.
“However our target is to reach a 50% allocation by year end 2019. The more allocation to fixed income the better as we head into a period of higher economic uncertainty.”
Deciding which preferred shares to research and consider does add another layer to our haze. But, we are determined to not allow the still-to-be answered questions to stifle progress. So far, we've opted to invest in two preferred stocks. The first was JPMorgan Chase's (JPM) most recent, Series EE (OTC:JPM.PC). It yields 6%, has a call date of March 1, 2024, has no maturity date and is non-cumulative. The second was Air Lease's (AL) first preferred, Series A (NYSE:AL.PA). It will initially yield 6.15%, has a call date of March 15, 2024, has no maturity date and is non-cumulative. After the call date, the yield will adjust to a floating rate - “equal to three-month LIBOR plus a spread of 3.650% per annum, reset quarterly, payable quarterly in arrears.”
Both companies, at some point, had been on our watch list. Next, we followed the advice to consider companies we are invested in already. And, a third caught our attention.
People's United Financial's Preferred
In March 2017, People's United Financial (PBCT) hit our radar due to its above-average yield and because of its M&A appetite. Its dividend growth history spanned 25 years. Its dividend rate increases, though not staggering, had become predictable. So, we invested in the regional bank growing rapidly in the northeastern United States.
As a rule, we are buy-and-monitor investors. We give investments at least three years to validate our investment thesis. Obviously, three years have not yet passed on our People's investment. But, it is already lagging. So, considering our focus and the advice mentioned above, we were prompted to entertain the option of converting our common shares to People's Series A (PBCTP) preferred shares.
The preferred offering commenced in late 2016. Ten dividend payments have already been made. But, unlike many preferred stocks with call dates five years out, People's Series A will yield 5.625% for ten years, up to December 15, 2026. At that point, the yield will convert to a floating rate “equal to three-month LIBOR plus a spread of 4.02% per annum, payable quarterly in arrears.”
At first glance, it did not appear the difference in dividend payments between the common stock and preferred stock would warrant the effort of conversion. The current annual rate for the common stock is $0.70 per share. However, People's has been increasing its dividend rate by $0.01 annually in mid-April for the past ten years. For the purpose of comparison, I assumed a similar bump will come in the next week to $0.71 per share. Comparatively, the preferred rate is $1.4064 per share annually.
Certainly, this appears to be an approximate doubling of the payment. But, it has to be remembered a static dollar investment in both would not purchase the same number of shares. For example, purchasing 100 shares of the common stock in March 2017 would have cost minimally $1,749 if one caught the low of the month and as much as $1,980 if one caught the high. With dividends of approximately $144 reinvested, the current share count would be just over 107 shares. However, those 107 shares would be worth only approximately $1,800 at recent prices.
The annual dividend payment on those shares will be minimally $75.97 (without dividend reinvestment). On the other hand, converting the $1,800 investment to preferred shares would allow a purchase of only 72 shares if purchased at the par value of $25. The annual dividend payment would be $101.26, approximately 33% greater than the common.
But, the common dividend rate will, most likely, continue to grow and, as the dividend continues to be reinvested, so will the number of shares. It is impossible to predict the exact share price on the date of reinvestment. Yet, for the sake of modeling, we assumed a gradual price improvement.
Through August 15, 2026, the dividend rate would likely grow to $0.195 quarterly. By reinvesting dividends, the common stock share count would likely grow from 107 shares to a range of 144 to 148 shares. Reinvested dividends would likely total approximately $700 to $710. In the same time frame, dividend payments on 72 preferred shares at a rate of $0.3516 quarterly yields $759.45.
Quite simply, the $50 to $60 difference did not, initially, seem enough to warrant action. But, the investment values could not be overlooked. By August 15, 2026, the cost of the investment in the common stock will have grown to, at least, approximately $2,600. To have a positive return, the 140+ shares will have to be trading at greater than $17.78. Comparatively, the cost of the investment in the preferred stock would still be only $1,800.
For long-term investors, the dividend rate on the preferred stock will adjust December 15, 2026 to, minimally (if the three-month LIBOR rate were to be 0), $1.005 annually. On the other hand, the annual rate on the common stock will, most likely, be $0.78. Again, the number of shares owned becomes the difference.
For 72 shares of preferred stock, the annual payment would be, minimally, $72. But, for approximately 146 shares of common stock, the annual payment would be closer to $114. Actually, in August 2024, due to both share count and dividend rate growth, the quarterly payment on the common stock should surpass the quarterly payment on the preferred - even at the higher fixed rate.
Based on this scenario, it did appear our best course of action would be to, for approximately five years, convert our common shares to preferred shares. The scenario does not account for a probable recession and assumes only gradual share price improvement in the common stock. Thus, the decision cannot go untended. We'll have to continue to monitor the share price of the common.
Potential Share Price Appreciation
As already mentioned, my investment club invested in People's United Financial based on its above-average yield and steady dividend growth rate. The yield tops 4%.
The other motivating factor was the bank's M&A activity. Acquisitions continued with the addition of half a dozen companies from 2017. Deposits grew 21% from $29.9 billion at year-end 2016 to $36.2 billion at year-end 2018. Likewise, the loan portfolio has grown 18.5% from $29.7 billion at year-end 2016 to $35.2 billion at year-end 2018. Net interest income improved 30% from $933 million at year-end 2016 to $1.2 billion at year-end 2018. Tangible book value (TBV) improved 3.5% from $8.92 at year-end 2016 to $9.23 at year-end 2018. Operating earnings per share increased for the ninth consecutive year.
Despite the growth, the share price continued to trade between $16 and $20. Then, in the reset of 2018, it fell to as low as $13.66. Though it rebounded to nearly $18 in early 2019, it has again stalled. Even if an investor had managed to purchase People's United Financial common shares at the low mark in March 2017, they would still be showing a paper loss – even with dividends reinvested.
Decent share price appreciation is key.
In January 2019, SA contributor, Stephen Simpson, CFA, was less than positive about the bank's past performance.
“The problem, I believe, is an ongoing conservatism on the part of management, which depresses yields and profits, and an ongoing willingness to make TBV-dilutive transactions.”
He acknowledges the bull thesis.
“The bull argument is that all of these acquisitions will eventually produce value through scale and improved growth opportunities across a bigger footprint, not to mention the idea that the company’s conservatism will show its merits when the cycle turns sour.”
Mr. Simpson does see some potential for upside.
“I think the performance should start improving from here.”
People's United Financial projects both deposits and its loan portfolio will grow 3% to 5% in 2019. Net interest income is projected to grow 10% to 12%. The net interest margin is expected to fall in a range of 3.15% to 3.25%.
Yet, in its 2018 fourth quarter earnings call, the company warned there are unknowns.
“Looking ahead to 2019, we expect the year to be similar to 2018 in terms of economic and political uncertainty.”
Of course, the bank assured it is positioned to manage through uncertainty.
Rightfully, such uncertainty continues to weigh on investors' minds. Many believe recession is just around the corner – though no one knows exactly where that corner is. Therefore, my investment club decided to err on the side of safety.
At this juncture, it appears the safest course of action regarding People's United Financial would be to convert our common shares to preferred shares. We intend to collect the dividend on the common in late April. Then, we'll sell the common and reallocate the proceeds to the preferred in time to collect its next dividend in late May.
When we reach a break-even point on the total investment, we'll reassess whether to stay invested in the company at all. By that point, hopefully, some of the unknowns will have been answered. But, if not – if we are still anticipating recession and preserving capital or if People's United Financial's scale and larger footprint are not yet driving decent share price appreciation, we can always continue to collect the 5.625% yield at a profit into 2026.
Disclosure: I am/we are long PBCT, JPM.PC, AL.PA. 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: I belong to an investment club that owns common shares in PBCT and will convert to preferred shares in PBCTP in May. We also own preferred stocks JPM.PC and AL.PA.