Preferred stock has always felt to me like the ugly stepchild of investments. Few people seem to understand what it is, and trying to explain it usually just makes their eyes glaze over.

Fear not, fellow Fools -- preferred stock is easy to understand. Although there are many different kinds, I'm going to explain the most common type, and probably the only type the average investor should consider.

I think of preferred stock as a stock-bond hybrid, because it shares characteristics of both. A company offers preferreds as a method of financing. For example, Mr. Cluck's Chicken (Ticker: HUGOR) may issue 5,000,000 Series A preferred shares at $20 per share to raise $100 million.

The price at which the stock is offered is called the fixed liquidation value, or par value (just like a bond). If Mr. Cluck's gets liquidated because of bankruptcy or a similar event, holders of preferred stock should ostensibly get $20 per share. However, bondholders always get first bite at the apple in a liquidation.

Still, the advantage of preferred stock is that its holders get paid out before holders of common stock. As we know, when a company goes bankrupt, common shares often get wiped out. At least with preferred stock, you have a chance of getting something -- and quite possibly the full value of your investment.

For me, the most attractive feature of preferred stock is that it comes with a fixed dividend amount, usually stated as a percentage of the par value. Using our example, Mr. Cluck's would issue 5,000,000 shares of 8% Series A preferred Stock at $20 per share.

This means the preferred shares pay 8% of $20 per year, or $1.60 per share.

Can the company cut or suspend that dividend? Yes -- but there are two things going for you, even if it does. First of all, the company must first suspend the dividend on common stock before it attacks the preferred. Often, if a company foresees a cash crunch, it will suspend the common dividend and wait to see just how bad things are. If things are really bad, then it'll cut or suspend the preferred stock.

The other advantage of preferred is that the company can miss a payment but not go into default, thereby risking the whole enchilada, as happens with bonds.

The trading price of preferred tends to be in a relatively tight range, because preferreds trade more like bonds than stocks; their price reflects the market's confidence in the company's overall health. I buy preferreds less for capital gain potential than for the dividends, although a preferred trading below par means potential capital gains down the line.

There are four things I look for when choosing a preferred stock:

  1. Is the company in reasonably good shape?
    Unlike common stock purchases, I'm not necessarily looking for the company to grow here. It just needs to break even and stay afloat. As long as it meets debt service, that's enough for me to look at the preferred.
  2. Is the preferred cumulative?
    If the company does cut or suspend the preferred dividend, will the unpaid sum accumulate for future payment? This never happens with dividends on common stock, another advantage of preferred.
  3. Is the preferred Series you buy senior to other series?
    A company may issue several different series of preferred stock. Make sure your series is the most senior -- so its dividend gets cut last, and is closer to the top in the event of liquidation.
  4. Where is it trading relative to par?
    If a preferred is within 5%-10% of par, I chalk it up to an inefficient market, since preferreds tend to have low volume. However, a significant discount to par may offer value, if you believe the market is being too pessimistic about the company's health. Like a bond, its price may increase if the market's confidence improves.

Here's an example of a company I would consider. JPMorgan Chase (NYSE:JPM) 5.72% Series F preferred Stock. This cumulative preferred ranks equally with all its other preferreds. The Series E stock par value is $50, and pays $2.86 per share each year, or $0.715 quarterly. It trades at $48.27, just under par. JPMorgan is a solid company, so it works for me.

My screen turned up preferred stock at some other companies that fit my specific risk profile. Here are three: Ashford Hospitality Trust (NYSE:AHT) 8.45% Cumulative Series D, Sunstone Hotel (NYSE:SHO) Cumulative 8% Series A Preferred, and NorthStar Realty (NYSE:NRF) Cumulative 8.75% Series A Preferred.

When should a Fool go for preferreds over bonds? First, bonds almost always have a smaller yield, because they present less risk; bondholders always get first bite in a bankruptcy. If your personal risk profile suggests that the preferred stock's yield is higher enough to take the risk, consider it over the bonds. Second, if you believe a company is being unfairly undervalued, then for the same risk-assessment reason, the preferred will trade at a greater discount to par. If you are confident in the company's survival, that may translate into a larger capital gain than with a bond.

In sum, while this gentleman may prefer blondes, he also prefers preferreds.

If you prefer to read more about preferred stock: