By FPA member David Zuckerman, CFP®, CIMA®
Last Updated: September 19, 2011
Warren Buffet was recently in the headlines after agreeing to purchase Bank of America preferred stock. Buffet’s investment comes in the form of a special class of preferred stock that is held by his company, Berkshire Hathaway. While much attention has been focused on this investment and the “vote of confidence” that it represents, many investors remain unaware of the basic characteristics of preferred stock. Why does preferred stock appeal to investors like Warren Buffet? How much do you know about the factors that can influence the risk/reward profiles of preferred stock?
What is Preferred Stock?
Often referred to as a hybrid security, preferred stock has characteristics of both stocks and bonds.
Preferred stock dividends are much like bond payments, because preferred stocks typically pay fixed dividends that are required to be paid before dividend payments are made on common stock. Moreover, if a company is liquidated, preferred stock shareholders have priority over common stock shareholders. Bondholders, however, still retain the highest position in the capital structure and therefore have priority over preferred stock shareholders in the event of liquidation. As such, preferred stock has a position in the capital structure that is subordinate to bonds, but senior to common stock.
The senior position in the capital structure does come at a price, however, as preferred stock does not typically include the voting rights that come with common stock. The priority given to dividend payments on preferred stock may also translate to less potential for share price appreciation than common stock.
What are the Different Types of Preferred Stock?
There are many different types of preferred stock, and the characteristics of each issue are stated in a “Certificate of Designation.” One feature of Warren Buffet’s investment in Bank of America preferred stock that is considered advantageous is the cumulative nature of the preferred shares. Cumulative shares accrue a balance if a dividend is not paid. So if Bank of America were to miss a preferred dividend payment, then the company would be obligated to pay all past due dividends before paying any dividends to common stock shareholders. This stands in contrast to Bank of America’s common stock, which is non-cumulative. Non-cumulative common stock shareholders do not receive dividends if they are not authorized, and no balance accrues. Most, but not all, preferred stock is cumulative.1
Preferred stock can also be callable — meaning that the issuer has the right to “call” your preferred shares at a certain price and retire the issue. Call provisions are often one of the main reasons that preferred stock can offer less potential for share price appreciation than common stock. Preferred issues may also contain provisions for converting preferred shares into shares of common stock.
Is Preferred Stock a Good Fit for Your Portfolio?
Preferred stock can provide diversification benefits and unique risk/reward profiles when used properly. Keep in mind, however, that preferred stocks can be very complex securities. Preferred shares are often affected by factors that influence both the stock and bond markets. Your portfolio’s exposure to interest rate risk and credit risk could increase if you replace common stock holdings with preferred shares. Additionally, a large portion of all preferred stock is issued by financial companies. Adding exposure to preferred stock could result in overweight exposure to the financial sector. It is also important to understand that not all investors are equal when seeking favorable terms for preferred stock investments.
While you might be able to find some preferred shares that make sense for your portfolio, the odds of receiving terms as favorable as those provided to Warren Buffet are quite low unless you invest alongside him by owning shares of Berkshire Hathaway. If you need help evaluating whether preferred stock is right for you, consider consulting with a financial planner who is equipped with the tools and experience necessary to determine how much exposure your portfolio needs and the best way to achieve it.
1 Rotblut, Charles. “Why Warren Buffet Prefers Preferred Stock.” Forbes 2 September 2011
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, Calif. He serves as Director of Public Relations for the Los Angeles chapter of the Financial Planning Association.