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The Power of Preferred Stocks

Preferred stock issues often read like the ingredients on a bag of potato chips. Yet terms like "monosodium glutamate" don't keep you from eating chips, so don't let "non-participating" and "redeemable" keep you away from preferreds. Preferred issues can be complicated, but may be worth your attention.

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By Todd N. Lebor
April 24, 2001

Even though preferred stocks are listed as equity on the balance sheet, they should be viewed more like bonds than common stocks. Preferred stocks usually have a fixed dividend and carry no voting rights. They have priority over common stocks in the case of bankruptcy and with regard to dividends, but usually do not share in a company's success. They technically have an unlimited life but often are redeemable. As with any investment, before diving in, you should understand the company. With preferreds, you must understand the lingo as well.

Terms to know

Cumulative --
Most preferred issues are cumulative, meaning that dividends will accrue even if they are not actually paid. The Board of Directors (BOD) has to approve (declare) the payment of preferred and common stock dividends each quarter. In a cash crunch, preferred dividends may be suspended. Once the dividends are resumed -- and before common dividends can be paid -- cumulative preferred shareholders must be paid their accrued dividends.

Redeemable -- Most preferreds are also redeemable, or "callable," meaning the issuer has the right to call (redeem) the shares after a stated date.

Participating/Non-participating -- Participating preferred shares may receive additional dividends based on a predetermined formula using the issuer's profits, the BOD's generosity, or a combination of all three. The participation dividend will be less than the amount paid to common shareholders, but this feature can add to the value of preferred shares. Most preferreds are non-participating.

Convertible -- Convertible preferreds can be exchanged for common stock at a set price after a certain date. For example, in 1996, Microsoft (Nasdaq: MSFT) issued 12.5 million shares of 2.75% convertible, exchangeable, principal-protected preferred stock that was converted in 1999 for 1.1273 common shares.

Who issues preferred stock?
Most companies shy away from issuing preferred stock because it is an expensive form of capitalization. Preferreds pay dividends, which are paid from after-tax profits, while bonds pay interest, which is paid from pre-tax dollars. Therefore, preferreds are more costly to corporations because they get no tax break, but owning preferred stocks of other companies is another issue. Corporations are exempt from taxes on up to 80% of preferred dividend income. The IRS calls it a "dividend received" deduction and, unfortunately, individuals are not eligible for this tax relief. That's why preferreds are mostly held by corporations, but that should not prevent individuals from owning preferreds.

There are a few benefits to issuing preferred stock. First, there's flexibility. Preferred stocks pay dividends, and if the issuer needs cash, dividends can be suspended -- at the discretion of the BOD -- unlike bond interest payments, which must be paid for fear of default. Second, preferred shares are often used in mergers and acquisitions because they can be structured as a "guaranty" to the seller. This is most common when closely held or family companies are purchased and these preferred shares are frequently not traded publicly.

Where to find them
Finding preferreds is easy -- just look on the balance sheet between debt and common stock. Once you've spotted preferred stock, pull up a comfy chair, crack a cold one, and read the preferred stock prospectus (it's probably a 423B prospectus filing). Are the dividends cumulative? Are the shares redeemable and, if so, when? What is the likelihood of redemption? Has the BOD ever suspended dividends? (If so, it's a bad sign -- management usually only cuts dividends as a last resort. Suspending dividends is a sign of cash flow trouble.)

Preferreds can be bought and sold just like common stocks. Companies that issue them often have more than one series, using letters of the alphabet to distinguish them (e.g. Series A, Series B, etc.). On Yahoo! (Nasdaq: YHOO) Finance, preferreds are listed by the ticker of the issuing company followed by an underscore, the letter P, and then the series letter. On CNBC, tickers are indicated by the company ticker symbol followed by a vertical "PR" and a letter indicating the specific issue.

How to evaluate them
As you'd expect, preferred investing is a combination of equity investing and fixed income investing. It's important to understand what the company does and how it makes cash, but as with investing in corporate bonds, it's more of a risk analysis than a company analysis. The main issue is how likely is it that this company will be unable to pay its preferred dividends. Enter coverage ratios.

The most common coverage ratio is EBIT or EBITDA coverage. EBITDA is earnings before interest, taxes, depreciation, and amortization. It is a measure of a company's ability to handle debt service (interest payments) but can and should be adapted to include preferred stock dividends. The ratio is EBITDA divided by interest expense plus preferred dividends. The higher the coverage ratio, the better.

Chances are a company with preferred stock also has unsecured debt. (Unsecured debt has no collateral. It is "secured" by the company's income rather than tangible assets like real estate or equipment.) Like corporate bonds, most preferred stocks are rated by Standard & Poor's or Moody's. If preferreds are only rated by one of the second-tier rating agencies like Duff & Phelps or Fitch, chances are good that management couldn't get a favorable rating from S&P or Moody's, which could be a warning sign.

Even though the rating agencies above use slightly different grading scales, the general rule of thumb is the following (and bears some resemblance to high school): Anything below a "B" is junk, a "B" or above is considered investment grade, the closer to "A" the better, and the more letters the better. For example, "AAA" is better than "A." Most corporate investor relations websites should provide the ratings. If not, queries can be made on the S&P and Moody's websites.

Preferred shares should have a higher yield than comparable debt. (Yield is the annual dividend divided by the price.) The hard part is matching preferred shares with debt because preferreds can have so many caveats. It is a bit of trial and error. There are so many variations that decisions have to be made on a case-by-case basis. Sorry, no rule of thumb here.

So if you're looking for less volatility and a higher cash return with more liquidity than bonds for your retirement portfolio, preferreds are worth a look. Need more help in choosing the right path to retirement? Try our self-paced Roadmap to Retirement seminar and get ready to pick out different colors for your elastic-waist pants.

Todd Lebor owns shares of Microsoft and looks forward to wearing multi-colored elastic-waist pants. Todd's other holdings can be found online along with the Fool's complete disclosure policy. The Motley Fool is investors writing for investors.