Are Preferred Stocks a Smart Investment Choice?

Even the most novice investor understands what a share of stock is: one small piece of a company. When the company rises in value, so does your piece. Likewise, corporate bonds are fairly straightforward: They represent money the company is borrowing, which gets paid back to the holder, with interest.

But then there are slightly more arcane assets, like preferred stock. The name alone makes it sound like you should want some in your portfolio, and Rule Breaker Investing listener P.T. Lathrop is interested. In this segment of the mailbag podcast, host and Motley Fool co-founder David Gardner, Motley Fool Chief Investment Officer Andy Cross, and senior analyst Jim Mueller cover the basics of what preferred stocks are, their pros and cons relative to regular shares, who buys them, and what role they can play in a portfolio.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on July 31, 2019.

David Gardner: Rule Breaker mailbag item No. 5. And now for something completely different. Yeah, we like to mix it up here. Anything goes at Rule Breaker Investing, especially our mailbags. This one goes to an area of the investment world, Andy, that we don't often talk about on this podcast, which is maybe why P.T. Lathrop wrote, "Hey, Fools, anyone want to help us understand preferred stocks? What role might they play? What pitfalls should anyone look for? Are they worth diversifying into at all?"

Andy, let's first define our term. Can you just, as our chief investment officer, knowledgeable about everything, encyclopedically aware of everything in the investment world...

Andy Cross: [laughs] Well, that's very kind of you to say! There's a lot to this question, but the definition of preferred shares, they're kind of like a hybrid between the common stock, the stock that we typically know, and a bond. They are shares that are issued by a company as part of an allocation strategy that offer a dividend payment, a consistent dividend payment. They tend to be shorter-term than bonds. And they have preference to the claim on the assets, both the income ahead of the common as well as if something happens to the company, the company files bankruptcy, they have a claim on the assets.

Gardner: So, that's the preferred part of this, Andy. If things get really rough, and we sure hope this doesn't happen with stock recommendations we make, and we usually look at the balance sheets to make sure this wouldn't happen, but if things got really rough, preferred stockholders get paid off first in a bankruptcy situation ahead of the rest of us poor lunks listening to Rule Breaker Investing and buying common stock.

Cross: That's right. Another key difference is that the preferred stock, the shareholders tend not to have voting rights. Most of them do not have voting rights like you do as a common shareholder, have a voting say in the company's board directors and their decisions. The preferred doesn't have voting stock, but they have that claim on the assets. But the key thing is, they pay the dividend, hence they're considered more like a bond. They're offering by banks, real estate investment trusts, utility, shipping companies, those kinds of companies that tend to issue a lot more debt.

Gardner: Andy, have you ever owned a preferred stock?

Cross: I have not.

Gardner: Nor have I. For whom are preferred stocks appropriate?

Cross: A lot of institutions will buy them to help them get exposure to dividend payments, but without the long terms like they're doing typical for a bond. I would say, they are very popular with yield-seeking, dividend-seeking people who want to have the potential for a little bit of growth in the security like a stock, a little bit of upside in the stock, but they really want, and they really rely on those dividend payments. So, really, if you're an income-seeker, a yield hunter, preferred shares are potentially one investment vehicle for you.

Gardner: So, some of the higher dividend yields that are paid are these preferred stocks. Usually we're looking at higher yield, lower returning kinds of devices.

Cross: That's right, David. I was just looking at some of the yields. We're talking, some are 5%, 6%, 7%, 8%.

Gardner: Yeah. I'm not getting that with my Ford stock, for example.

Cross: That's correct. Yeah. They tend to yield much more than common. And, obviously, as we said, they have the right to the earnings stream before the common as well, too.

Gardner: Alright. This is probably the only preferred stock talk we're going to have on this podcast in 2019. It's not really how we roll. But Andy, for P.T. Lathrop and others of his or her ilk, what's a good resource to find out more about preferred stock?

Cross: David, I'll just go to The Fool. So if you just search on Google, "site:fool.com preferred shares," you will find a number of articles written about preferred shares, what they are, how to think of them, with other links to other sites. So I would just go there.