Your Guide to Understanding Preferred Stocks

When it comes to investing in the stock market, understanding preferred stocks is a must.

As you start dealing with stocks and bonds, you will run across the term “preferred stocks.” Knowing the difference between them and common stocks is important.

I first learned about preferred stocks back in the day from my Uncle Bill.

At the time, he was heavily invested in preferreds paying 8% and he thought his holdings were better and safer than common stock.

And as he found out the hard way, that wasn't necessarily the case.

How Preferred Stocks and Common Stocks Are Similar

Shares of corporate stocks represent a percentage of ownership of the business. Most shares come in the form of common stock and many companies only issue that one class of stock.

Some companies issue two classes of stock: common and preferred.

Each type of stock trades at its own price range and prices will rise and fall independent of each other.

Also, each type of stock may pay dividends.

If both types of stock pay dividends to its shareholders, the amount paid to each type will differ.

Both stocks are a form of ownership of the corporation which issued the shares.

But understanding preferred stocks, and how they differ from common stocks is super important for investors.

So, here we go.

The Differences Between Preferred Stocks and Common Stocks

While both types of shares prove ownership in a company, the rights of each owner usually vary. You may think the term “preferred” implies favorable treatment and better rights. But that is not always the case.

Voting Rights

Holders of common stock in a company can vote for board members. For each share they own, they have one vote.

On the other side, preferred stock shareholders have no voting rights.

Common stockholders have a say in the management and operations of the business. They can vote for members they believe will perform best for the company.

If you are holding preferred stock, you have no influence in that matter.

On voting rights, common stockholders definitely have more power than preferred stockholders, which seems counter-intuitive.

Convertibility

Sometimes preferred stock has an option to convert to a fixed number of common stock shares.

Common stockholders never get an option to convert to preferred stock shares. Preferred stocks that have this feature are convertible preferred stocks.

Convertible preferred stock has a set price for conversion. Dividends are lower because of the upside potential for converting shares.

Prices of convertible preferred shares are affected more by the price volatility of the common stock than non-convertible preferred stock.

Price Performance

Common stocks generally outperform bonds and preferred stocks.

But they can also drop more dramatically during troubled times.

For investors seeking greater price stability, preferred stocks are a better choice.

However, in a bullish market with rising prices, the growth potential with preferred stocks is limited. This is because of the other benefits attached to preferred stocks.

Businesspeople discussing stocks and looking over candlestick charts

Preferred Dividend Position

Both preferred and common stocks can pay dividends. It can happen that a preferred stock will pay dividends and a common stock won't. Each case is unique and should be analyzed separately.

Preferred stockholders are treated to a preferred position for dividend payments. Meaning their dividends must be paid before common stock dividend payments.

This does not mean preferred dividend payments are guaranteed. But companies must first eliminate all common stock dividends before reducing or stopping preferred dividend payments.

Fixed Dividend Payments

Preferred stocks usually set a dividend payment that remains fixed into the future.

Long term investors often find their returns diminishing on preferred stock dividends through inflation, making it less attractive in the long run.

Worse is seeing common stock dividends increase while your preferred stock stays the same.

On the flip side, some investors like the certainty of fixed payments. They know exactly what to expect each time. Unless that is, the company hits hard times and cuts or stops dividend payments to all classes.

Even with preferred stocks, investors still face risks, just hopefully lower than with common stocks. (That's not always a guarantee though!)

Call Feature

Many preferred stocks include a call feature. This is a benefit for the issuing company, not the investor. They are known as callable preferred stock. Keep that in mind when evaluating a preferred stock.

A call feature allows the issuer to purchase back the preferred shares at a set price after a certain date. Often the repurchase price is the par value, the original share price when it was issued.

If a company does very well and sees its common stock rise, very likely they will call the preferred stock as soon as they can.

If, on the other hand, the company is struggling and stock prices fall, they are not at all motivated to repurchased preferred shares.

The call feature appears to give the company all the advantages and reduces their risks. The preferred stock investor can almost be assured of no upside potential through their success.

The investor must analyze the preferred stock as if it will be called at its earliest possible date. If the dividend yield is better than average and the risk lower than average, it may be worth considering.

But that is a rare instance!

Risk of Principal

Owning preferred stock does not make you invulnerable to risk. It's a stock and its price will rise and fall.

A preferred stockholder is in a better position than a common stockholder in the event the company goes bankrupt, but just slightly better.

The distribution, after paying all other business debts, of remaining funds goes to the three classes of investors, in the following priority:

  1. Bondholders are first paid off, like every other debt (but after paying other business liabilities), and if anything is left,
  2. Preferred stockholders are then paid par value (issuing share price) for their stock, and if there is still something remaining,
  3. Common stockholders get what is left.

So not only are preferred stock prices subject to price fluctuations, they can lose their entire value through bad business practices.

Interest Rate Sensitive

Preferred dividends pay a fixed rate, so they act like bonds in volatile interest rate situations.

If interest rates rise, watch your preferred stock price drop accordingly.

The logic behind that is pretty simple. People buying bonds want a good yield. Let's say you have a bond paying 5% on its par value. If the market is demanding 5.5% yields for the same bonds, the 5% bond price drops to also yield 5.5%.

Preferred stocks are also yield driven, which is why they don't do well when interest rates go up.

The Recap on Preferred Stocks

With this guide to understanding preferred stocks, you now know the main differences between common and preferred stocks.

While some people find preferred stocks intriguing, I'll tell you now that I'm not a big fan of them. There is a difference between liking and understanding preferred stocks.

It seems to combine the worst features of stocks (minimal principal growth prospects) with the worst features of bonds (interest rate impact). Also, you have no voting rights, your shares might be subject to calls, and that fixed dividend loses purchasing power as the years pass.

Much better is finding quality stocks paying dividends like we do here at the Income Investors.

This way you can benefit from a bull market but more importantly, have income-generating assets that you can reinvest and benefit from its compounding power.

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