What You Need To Know About Preferred Stock

In many respects, publicly held corporations are the ultimate democratization of wealth. Both the Sultan of Brunei and your neighborhood plumber can buy however many shares they want of, say, Cisco Systems, Inc. (CSCO), the only barrier to entry being the outlay of a few bucks to create an E*Trade Financial Corp. (ETFC) account.

Sometimes, a corporation wants to lure a certain class of investor; the kind who wants fixed, scheduled payments. To do that the company can issue bonds, which come with their own disadvantages. When a company authorizes a bond issue it could be declaring that it’s desperate for cash, which can scare stock investors off. How to offer equity while simultaneously guaranteeing investors a certain regular payment? Through the magic of preferred stock, which is sort of an amalgam of bonds and common stock. (For more, see: A Primer on Preferred Stock.)

The differences between preferred stock and common stock are few but crucial. Preferred shareholders indeed receive dividend payments: the dividends are a selling feature, intrinsic to the security. Whereas with common stock, corporations are under no obligation to offer dividends. (For more, see: What is the Difference Between Preferred Stock and Common Stock?)

Becoming Rare

In practice, the blue-chip companies that offer dividends on their common stock don’t issue preferred stock, at all. Seldom do the companies that don’t offer dividends on their common stock, either. Preferred stock is a dying class of share. According to some estimates, there’s $80 of common stock circulating in the United States for every dollar of preferred stock. None of the heavyweights – Apple Inc. (AAPL), Exxon Mobil Corp. (XOM), Microsoft Corp. (MSFT), etc., offer preferred stock. Among the 30 largest corporations in America by market capitalization, the only ones that do offer preferred stocks are the Big Four banks – Wells Fargo & Co. (WFC), Bank of America Corp. (BAC), Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM). In fact, about 88% of preferred stock is issued by banks. As to why, it’s the continuation of the aftermath of the financial crisis and corresponding bailouts of 2008-09. Preferred stock becomes an additional asset on the balance sheet, something that banks need more than oil companies and semiconductor manufacturers do.

No Voting Rights

Most things in life involve a tradeoff, and preferred stock is among them. From an investor’s perspective, the one primary disadvantage to preferred stock is that its holders don't have voting rights. Just from the name, you’d figure preferred stockholders would receive, well, preferential treatment. But when a company elects board members, it’s the common stockholders who do the electing while the preferred stockholders sit on the sidelines, disenfranchised. (For more, see: Know Your Rights as a Shareholder.)

Better During Bankruptcy

On the other hand, say the publicly traded company goes bankrupt. When the company liquidates, the bondholders get paid first. Which makes sense; they’re the creditors, the ones who lent their money to the company to help it stay afloat. Should there be anything left once the bondholders get made whole, the preferred shareholders get paid next. Only then do the common stockholders get paid, if at all. Thus the “preferred” in preferred stock.

There are some other differences between preferred and common shares, too. The latter can be called by the company at its discretion. “We reserve the right to buy these shares back from you on May 17, 2016.” In most cases, you can convert the preferred shares to common shares at a predetermined rate. Do that, and you’re sacrificing surety for volatility and the possibility of capital appreciation.

Alright, enough theory. Say you wanted to buy preferred stock. Assuming you indeed opened a brokerage account like the plumber in our example, how would you even start?

Finding Preferred Stock

First, how to read a preferred stock listing. They differ from common stock listings, which are easy to read. International Business Machines Corp. (IBM) common stock (the only kind the company offers) is listed on the ticker under a 3-letter code: IBM. Boom, give me a hard one.

Preferred stocks are more complicated. Because the dividend payments are so important, preferred stocks are defined by their dividends (expressed as a percentage):

Pretty straightforward, no? The ticker symbol includes a one-letter suffix indicating that the stock is preferred. It’s a good thing the Roman alphabet has 26 letters, because a company can issue various classes of preferred share, which is why we included three different Southern California Edison preferred issues in our example.

Treated Like Bonds

Nor is it coincidence that all the issues are at about the same price. With very few exceptions, preferred shares go on the market at $25. That they don’t stray much from that price tells you how the market treats them almost like bonds. No one’s going to offer much more than $25 for a share that could be called, and no one’s going to sell so valuable a revenue-producing asset for much less than $25. By the way, that issue price is also the price that the company will call the share at, should it choose to. (For more, see: Why do Some Preferred Stocks Have Higher Yield than Common Stocks?)

Understandably, the higher the dividend rate, the more expensive the stock. Buy a share of Southern California Edison 4.08%, and you’ll receive quarterly dividend payments that would each amount to 25.5¢. The quantity the dividend is expressed as a percentage of is the issue price (again, $25).

A couple more points. “Cumulative,” as in Seaspan 8.25% Cumulative preferred stock, means that if the company hadn’t paid out a particular dividend in the past, that dividend accumulates until it is paid out. And it’ll be paid out before the common stockholders get any dividend. In Seaspan’s case, the company does pay a quarterly — if erratic — dividend to its common shareholders and has for years. “Floating rate” means the dividend payout changes according to criteria determined by the issuer. In Zion Bancorporation’s case, the rate is tied to the London Interbank Offered Rate. (For more, see: Preferred Stock Valuation.)

The Bottom Line

Among intermediate and advanced securities, preferred stocks carry a relatively small learning curve and less chance of risk. You’re less likely to go bankrupt with preferred shares than with common shares. So should you invest in them? Understand that most preferred shareholders are institutional: organizations that have little to gain and much to lose by putting their funds in anything less stable than a bond or bond equivalent. For the everyday investor, buying preferred shares is usually something done once you’ve already established a decent-sized portfolio. One that was probably, at least in part, the result of buying undervalued common stocks. If you're still interested, though, consider a preferred stock exchange-traded fund (ETF). (For more, see: Preferred Stock ETFs With Huge Dividends.)