Why Don't More People Invest in Preferred Stock?
By Preston G Pysh
When I talk about preferred stock with most people, they look at me like I've got crabs crawling out my ears. Numerous reasons contribute to the lack of understanding in this particular type of security. This article will identify those reasons and also provide guidance for your investing approach.
Most don't understand what it is
For starters, most people don't understand what preferred Stock is. The best way to describe preferred stock is that it's a little bit like a bond and a little bit like a common share. When an investor owns common shares of a company, they own equity. Just like a house, when you have equity, it's considered your ownership. So if you say you have 20% equity of a home, that means you own 20% of it. As for the other 80%, that belongs to the bank. When we discuss the characteristics of preferred stock, we can definitively say that it's equity in a business. In fact the equity holds a higher priority over the equity of a common shareholder. To demonstrate this idea, let's say we have a small coffee shop and the business possess $100,000 of net tangible assets. If the company has $100,000 of preferred stock issued, we can confidently say that the common shareholder possesses zero equity of the business. This is because preferred shares out prioritizes common shares.
So how can preferred stock have a definitive dollar amount when the price of common shares are determined by the market price? Well, preferred shares are issued like bonds. You see preferred shares change in value based on the companies ability to make the dividend payments associated with the shares. Since the dividend and book value of the preferred shares are the only payments an investor will receive on the security, they trade exactly like bonds. As you can see, this is somewhat difficult to understand. As a result, I believe most investors avoid this type of investment due to confusion.
There's a whole let less of if on the market
When a person looks at the number of common shares on the market and they compare it to the number of preferred shares, they'll be quickly surprised to see the lack of the later. Although the number of shares on the market are constantly changing, one things for sure, you have to dig around to find decent preferred shares that meet all your investment criteria. Let's face it, if there isn't much to be found, few will own it.
The returns can be risky
One of the most important reasons I don't own preferred stock at the present time is because it's very difficult to find decent buys. The more you study this obscure form of investment, the more you'll realize it's inherent risks. Here's a few to consider:
1. Call-ability: One of the things I like about bonds is I can buy a long term bond at a high interest rate and the market price will drastically increase if and when interest rates drop. This is very difficult to find with preferred stock because most shares are callable within 5 years of their issue. By the way, right now (2012) is a absolutely horrible time to be in bonds and preferred shares - due to all-time-low interest rates.
2. Non-Cummulative: One of the tricks that many companies play with preferred shares is that they're listed as non-cummulative. This means the company isn't obligated to pay your dividend if they don't want to. Now the company isn't able to pay dividends to common shareholders if they elect to stop payment, but regardless, this is a very risky decision for any non-cummulative stock holder. Remember, the value of the preferred stock is completely dependent on the dividend - unlike common shares.
3. Liquidation: During a corporate liquidation, companies sell their tangible items and pay the debts of their loans and bonds - what's left goes to the shareholders. For any investor that thinks assets will remain for preferred and common stock holders are simply kidding themselves. For the extra 1 - 2% gain of the same businesses bonds, I'll take the bonds every day of the week.
There seems to be more variables
Finally, the last reason people might not invest in Preferred Stock is the numerous variables they need to understand. If you've been in the investing world for a few years, you'll quickly find that most people are stock or bond people. Usually they don't mix. It's my opinion that the best investors on the market use both securities to their advantage and at the right timing. In order to invest in preferred stock properly you really need to thorough understand the inner workings of both securities. This is very overwhelming for most people and something that involves a lot of time.
Although this article provides a lot of negative information for investing in preferred stock, if you'd like to learn more about what preferred stock is, be sure to follow this link. If you're interested in a comprehensive site that has almost an hour of video content that teaches investors how to value preferred stock like Warren Buffett, be sure to follow this link.
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