Since Wall Street has thrown us such an unexpected curve ball and subsequently slammed the S&P 500 down ~35% (2008 YTD), most of us are justifiably thinking about readjusting our portfolios, reviewing our asset allocations, or even reducing our 401k / IRA contributions until this financial crisis is resolved. For my own portfolio, I’ve been reviewing the damage and while I’m still buying up as much equities as I can afford, I’m considering using a lesser known strategy that has quietly moved its way into the forefront. It’s called Preferred Stocks, and has become quite the hot item on Wall Street.
What are Preferred Stocks?
Preferred stock (also called preferred shares), is basically a hybrid between the common stock that we generally think of when we buy stock in the stock market, and a corporate bond which are generally for more conservative fixed income investors.
By owning preferred stock, you get the benefits of a stock appreciating in value, while more often than not, receiving a much higher dividend yield for your investment than common stock. Which basically boils down to a company paying you 2 to 3 times that of an average savings account will pay for simply owning their stock.
Yet, to avoid sounding like this is too good to be true, preferred stock also has several negative aspects. It can decrease in value just like common stock, it doesn’t always appreciate as significantly as common stock, and most of the time, you have no voting rights when it comes to company decisions.
Who’s buying preferred shares?
Oh, a few people you might have heard of.
The U.S. Government has purchased $250 Billion worth of preferred stock in U.S. financial companies like Bank of America, J.P. Morgan Chase & Co, and several others.
Long time guru Warren Buffett recently bought $5 billion in Goldman Sachs preferred stock, and another $3 billion in General Electric preferred stock via his Berkshire Hathaway holding company. He’s getting a 10% interest rate (i.e. dividend yield) on his investment, so you can see why he decided to take the plunge.
Even Meredith Whitney, the superstar financial analyst who went on record numerous times with her highly controversial and ultra bearish forecast on the financial sector nearly 1 year ago, has just recently recommended going long on a few of her favorite financial preferred stocks. That’s a pretty big endorsement considering she made the correct call to sell financial stocks, or even giving aggressive traders the green light to short the financial sector by in large.
Additionally, when you consider the magnitude of such endorsements, coupled with the tendency of other investors to “follow the pros”, it’s a reasonable assertion that others will be following along these lines. I’m not suggesting that now is the time to invest, but these examples illustrate that large entities are finding value at these levels.
Why are preferred shares becoming so popular?
Primary reason – High Dividend Yields! And die hard dividend investors love them.
It works fairly simply: for each share you own, you receive a cash payout on a regular basis. For example, if you own a $10 stock and it pays you $1 every year for owning it, you have a 10% dividend yield.
Each company will set individual dividend payouts, but generally, preferred stock dividend yields are larger than common stock.
What is the best way to buy preferred stocks?
Generally, I would discourage anyone from buying individual stocks, common or preferred, unless they have experience investing on their own.
That said, for those still interested in buying preferred stocks, the iShares S&P U.S. Preferred Stock Index Fund (Stock Quote: PFF) is probably the best means available thanks to it’s diversification. It currently holds 64 different S&P listed companies in it’s portfolio, and most of preferred stocks from financial institutions like Well Fargo Chase & Co, Goldman Saches and Bank of America.
At present, the iShares Preferred Stock ETF has a dividend yield ~ 11.5% and is trading at roughly half what it was a year ago. With dividends as high as this, one can certainly understand why Meredith Whitney is making the buy recommendation.
Again, investing in this environment is risky, but if you have the constitution for above average risk and you’re a long term investor, this Preferred Stock Index Fund is certainly worth a look.
Disclaimer: I hold no position in PFF when this article was published.