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Preferred Stock: A Smarter Investment Alternative?

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Once a widely used part of many companies' capital structures, preferred stock has become little more than an afterthought in most investors' minds. Yet recently, the search for higher yields has led to renewed interest in preferred stock, and with companies having found novel uses for it in recent years, the old-fashioned investment could well be on the upswing for quite a while.

The latest preference
Most recently, preferred stock has hit the headlines as part of David Einhorn's battle with Apple (NASDAQ: AAPL  ) . Apple proposed in its annual proxy materials to eliminate provisions allowing for the creation of preferred stock in Apple's capital structure. Einhorn responded with a lawsuit seeking to separate the preferred-stock provision from the remainder of the proposal, and at the same time suggested a strategy involving the issuance of perpetual preferred stock that he argued would unlock shareholder value in a way that would effectively use the company's big cash hoard without causing repatriation tax liability.

The success of the Apple preferred depends on investors valuing the preferred stock more highly than the common. While Apple common stock trades at an earnings multiple of just 10, Einhorn believes that Apple preferred would trade at a 4% yield, producing a value of 25 times the earnings dedicated toward paying the preferred dividend. The increase of 15 between the multiples translates to what Einhorn argues is $30 billion of unlocked value for every $50 billion of preferred shares Apple issues.

Not the first preferred
Einhorn's arguments are open to debate, but he isn't the first person to suggest using preferred stock in a somewhat novel way. During the financial crisis, when the government gave financial companies bailouts under TARP, it received preferred shares that entitled it to preferred dividends and a liquidation preference. AIG (NYSE: AIG  ) , for instance, had to pay 10% dividends on $40 billion in senior preferred stock, while Citigroup ended up paying 8% dividends until the preferred was converted into common shares.

The Treasury's stakes under TARP closely mirrored deals that Warren Buffett made with hard-hit companies during the financial crisis. Buffett arranged to receive preferred stock and warrants, guaranteeing both income and potential capital appreciation.

A safer alternative?
But going beyond unusual ways of using preferred stock, you'll more commonly see preferred stock in its traditional role of providing income and security against loss, while common shares retain more upside potential.

For good examples of this traditional use, mortgage REITs Annaly Capital (NYSE: NLY  ) and American Capital Agency (NASDAQ: AGNC  ) both have preferred issues. Because of the REIT structure of the issuing companies, the common shares actually yield more than their respective preferreds. But with some investors worrying about the potential impact on dividends that events like the Federal Reserve's purchase of mortgage-backed securities under its quantitative easing program could have, the preferred stock would be required to pay dividends in full before common shareholders could get a single penny of income. For investors who really need income and are willing to leave a few percentage points on the table in exchange for more secure payouts, preferred stock in mortgage REITs has definite advantages over the common shares.

Get preferred investments
If you don't want to focus in on a single security, iShares S&P US Preferred (NYSEMKT: PFF  ) and other ETFs focusing on preferred stock offer broad diversification. Be careful, though, as ETFs tend to reflect the concentration of preferred shares issued by companies in the financial industry, so they may not be as diversified as you'd think.

Preferred stock isn't the perfect investment for everyone, but the creative ways that companies are using it opens up some lucrative opportunities for investors. When a company you're interested in offers a preferred stock issue, look at its characteristics and see whether it might be a better fit for you.

The Einhorn debate over preferred stock is just the latest controversy about Apple. Investors are wondering whether Apple remains a buy after its recent plunge. Let top tech analyst and deputy managing editor Eric Bleeker give you his take on Apple, with an up-close look at the opportunities are left for the company (and more important, your portfolio) going forward. To get instant access to his latest thinking on Apple, simply click here now.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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