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TRADER'S NOTEBOOK


Preferred Stocks

04/09/09 01:52:28 PM PST
by John Devcic

What's the difference between preferred stock and common stock? Which is better for your portfolio?

When you ask the average investor about stocks, virtually all of them will tell you about common stock. These are stocks that everyone is familiar with. These are the stocks with the ticker symbols everyone sees quoted and scrolling on a ticker. Mention preferred stocks, though, and you will probably get a blank stare. Most investors, if they have heard of them, have no real idea what these stocks are or how they differ from common stocks, nor can they tell you where to find them. This article is all about preferred stocks, to clear up any and all misconceptions that surround them.

WHAT ARE PREFERRED STOCKS?
What are they, anyway? Simply put, preferred stocks are shares of a company, but unlike common stocks, they offer no voting rights. However, they do pay a dividend, and in case a company is liquidated, they are next in line after bonds to be paid off. A lot of investors like to think of preferred stocks as a cross between common stocks and bonds. Like a bond, preferred shares have a yield, usually listed in the name of the preferred stock so the buyer knows what the yield will be. Preferreds trade more like a bond than a common stock. Preferred stocks technically have an unlimited life span, but the company can call them at a future date. Preferred stocks are also sensitive to interest rate changes. They can also be rated by credit rating agencies. Of course, their ratings will always be a few notches below the company's bond ratings because they do not offer the same security.

The best part? Like common stocks, preferreds receive a dividend payment. Usually, that dividend will be paid. A company can suspend payment of a dividend to common stock holders, but preferred stock holders will get paid. That is not to say that a company cannot suspend the dividend payment on a preferred stock; it's just not as easy. Some preferred stocks require that any unpaid dividends have to be paid to the preferred stock holders before the company can begin paying out to common stock holders. It is important to note that not all companies issue preferred shares. Preferred shares usually come about when a company has the cash flow to pay the dividends but does not want to issue bonds. Since preferred shares have no voting rights, a company can issue preferred stock without diluting the current voting rights. Like common stock holders, preferred stock holders own a piece of the company. Nor are all preferred stocks the same. There are different types of preferred stocks that a company can issue: Callable: This is preferred stock issued with the right for the company to call the preferred some time in the future. The call date is listed in the prospectus.

Cumulative: Most preferred stocks issued will be cumulative. This means that if a company stops paying dividends or holds back part of the dividend, then these dividends must be paid before any other dividends. Preferred stocks without this feature are referred to as noncumulative.

Convertible: The ability to convert the preferred stocks. The time and price at which these stocks are converted are listed in the prospectus.

Participating: The dividend rate can be more than the stated dividend. The formula is listed on the prospectus. It is important to note that most preferred stocks are nonparticipating.

Adjustable-rate preferred stock: These are newer types of preferreds, and the dividend payments are based upon a number of different factors stated beforehand in the prospectus. These preferred stocks attempt to shield the holder of the preferred stock from interest rate fluctuations.

THE GOOD & THE BAD
Advantages of preferred stocks:
1 Preferred stocks have priority over common stocks for dividend payments as well as company liquidation.
2 Prices do not fluctuate as much as they would with common stocks.
3 They pay a steady and consistent dividend.
4 They are more liquid than the same corporate bonds.

Disadvantages of preferred stocks:

1 Preferreds do not have voting rights.
2 Some are callable.
3 They are sensitive to interest rate moves.
4 Prices are usually stable, so if the value of a share of common stock moves up, that move will usually not be shared by the preferred. If it is shared, the magnitude of the move for the preferred will be far less than the move of the common.

When it comes to investing in preferred stock, investors will need to dig deeper. Finding these preferred stocks is not as easy as you might think. The ticker symbols for preferred stocks differ slightly from those of common stock. Some sites will list the preferred shares with a dash.

JPMorgan Chase preferred is a perfect example. On Yahoo!, "JPM-PF" is what the symbol would look like; the "pf" is short for preferred and will follow the ticker symbol. Yahoo! will also have another letter following that tells you the series. CNBC, on the other hand, will list preferred stocks on its ticker with "PR" after the ticker symbol. When looking for preferred stocks, you will also come across what are known as "series," like "Series A or B." Companies can have different series of preferred stocks that pay different yields. Look for company SEC filings like 423B and the like.

The biggest purchaser of a company's preferred stock is usually another company. The dividends received by a company are not taxed the same way as an individual investor is taxed when he receives dividends. US corporations that pay corporate income taxes are allowed to exclude 70% to 80% of the dividend income they receive.

IT'S THE STEADY DIVIDENDS
Preferred stocks are often described as a cross between a bond and a common stock. While they have no voting rights, the share price of preferreds usually remains stable and will not fluctuate wildly like shares of common stock. This can be good and bad; on the good side, if the company is down, the preferred stock will usually only drop a few points. On the other hand, a jump up in the price of the common stock will also not be reflected by the share price of the preferred stocks.

A higher-than-average dividend yield is one of the biggest factors that grab the interest of investors. Investors looking for a steady dividend without the price fluctuations often will choose preferred stocks for their portfolio.



John Devcic

John Devcic is a market historian and freelance writer. He may be reached at drmorgus@gmail.com

E-mail address: drmorgus@gmail.com


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