What is preferred stock and how does it work?

Tendersetter

3:30 pm

24 June 2020

Who hasn’t heard of Warren Buffett, the billionaire CEO of Berkshire Hathaway? The famous American businessman is well known for buying and holding stock — and not giving in to the volatility of the market. He’s also well known for taking big stakes in companies, such as the $900 million worth of shares he has in Amazon.

Last year his $10 billion investment to back Occidental Petroleum’s bid for Anadarko Petroleum was big news. Berkshire Hathaway purchased 100,000 shares of preferred stock, which pays out an 8% annual dividend.

Why did Buffett buy preferred stock?

Preferred stock, also known as preference shares, is different from common stock, or ordinary shares: both are equity in a company, but preferred stock typically pays a higher dividend.

So when is it a good idea to follow in Buffett’s footsteps and invest in preferred stock? The characteristics of preferred stock investments are summarised below.

Higher earnings

If you want higher and more consistent dividends, then a preferred stock investment may be a good addition to your portfolio. Preferred stock tends to pay a higher dividend rate than the bond market and common stocks and it is also a lower risk instrument.

For example, Wells Fargo’s dividend yield on its common stock is 3.92% and it offers several preferred stock options that range from a 7.5% yield to a 5.125% yield.

Sempra Energy’s common stock has a dividend yield of 2.96%. It also issues a mandatory convertible preferred stock with a current yield of 6.19%. The convertible feature is an option for the shareholder to exchange their shares for common stock at a predetermined conversion rate.

It’s also important to know that dividends aren’t guaranteed: they are paid out of company earnings, just like a common stock dividend.

However, there are several different kinds of preferred stocks, and that could matter when it comes to collecting any dividends the company missed.

Interest rate sensitivity

The main risk of investing in preferred stock is that the assets are, like bonds, sensitive to changes in interest rates. There’s an inverse relationship between interest rates and the price of not only fixed income securities but also of hybrids, such as preferred stocks.

The company can also call back the preferred stock whenever it chooses to, based on the provisions in the prospectus. That means that if interest rates are falling, the issuer has the right to call the stock back and then issue new shares with a lower dividend.

Voting rights

In general, preferred stockholders have limited voting rights depending on the rules in the company’s deed of incorporation. It may, for example, establish that preferred stockholders may vote only at extraordinary general meetings, although they have the right to challenge ordinary resolutions pursuant to article 2351 of the Italian Civil Code.  

Other risks

Investors also should take a close look at the market of preferred stocks, because it is a lot smaller than that of common stocks and therefore not as liquid.

It also has a higher concentration of financial companies, which took a big hit during the 2008 financial crisis.

Conclusions

Diversification is probably the most important thing when considering this asset class. To achieve diversification, it is a good idea to look at exchange-traded funds or at mutual funds, which will give you a basket of preferred stocks.

Investors should keep in mind what their general objectives are and seek the advice of professionals when building their portfolio.

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