Preferred Vs. Shares of Common Stock: Risks and Rewards

Corporations issue debt to creditors and equity ownership stakes to shareholders to raise capital. Equity holdings may be categorized further into either preferred or common stock. Intelligent investors will study corporate finance to appraise risk versus rewards for both asset classes, before committing capital.

Hybrid Securities

Preferred shares are hybrid securities, due to their unique positioning within corporate finance, between stocks and bonds. In terms of asset claims, we rank these securities by seniority: bonds, preferred shares, common stock.

The corporation is legally bound to make good on principal and interest payments. Failure to do so throws the business into default, en route to bankruptcy litigation.

In the event of bankruptcy, bondholders and other creditors are to be paid first, out any asset liquidation proceeds. Next, preferred dividends accumulate, and all missed preferred dividends must be paid in full before common shareholders receive any dividends. Lastly, common shareholders are last in line, and relegated to be paid pennies on the dollar from whatever remains, if anything.

Shares of common stock do carry voting rights. Common shareholders elect a board of directors, who then hire management executives to run the business. Preferred shareholders are not authorized to vote, despite owning equity capital.

Fixed Assets, Interest Rates, and Returns

The gross majority of bond and preferred stock offerings are defined as fixed assets, which make level interest and dividend payments. As the name would imply, a perpetuity is a type of preferred stock that promises to pay the same, flat dividend per share amount through the end of time.

Conservative savers gravitate towards fixed assets, for investment income and stable value. Here, yield-to-maturity and dividend yield calculations are all important, to calculate investment income expectations per dollar invested. Expect for preferred shares to pay significantly higher dividends, relative to common.

Prevailing interest rates weigh heavily upon fixed asset valuations. Higher interest rates devalue preferred shares and bonds already in circulation, because newer, freshly minted offerings will generate more income. Alternatively, plunging rates will power capital gains in existing credit securities making relatively large payouts.

The Federal Reserve has aggressively driven its overnight lending rate from zero to 5.5% between Q1 2022 and 2024 to close out the COVID-19 cheap money era. From here, Wall Street expects The Fed to slash rates through looming recession. As a group, fixed asset returns will offer a small premium above the federal funds rate.

Shares of common stock, again, represent ownership stakes with junior asset claims. As such, shares of common stock prices closely track long-term corporate profits, which range from anywhere between zero and infinity.

The Standard and Poor’s 500 Index, as a stock market benchmark, averages 11% annual returns since its 1957 inception. All averages are not created equal, and S&P 500 historical returns do include 38% losses in 2008 amid the Great Recession alongside 27% returns for 2021. Common shareholders must be willing to accept volatility, in exchange for upside return potential.

Participating and Convertible Preferred Stock

If nothing else, the financial industry is creative, in pushing product out the door. Participating and convertible preferred stock add yet another wrinkle to the mix, by enabling conservative investors to also reap further benefits from business growth.

Financial managers promise dividend increases for participating preferred shares when the underlying corporation surpasses predetermined sales and profitability metrics. As the name would imply, convertible preferred stock may be exchanged for common at a set rate, at any time. Convertible preferred shares still pay hefty dividends relative to common.

Shareholders will make the conversion when common shares are trading significantly above parity. For example, Corporation X may offer preferred shares convertible to common at a two to one rate. Here, we would have parity, if the convertible preferred and common shares trade for $50 and $100, respectively.

Savvy managers also offer convertible preferred shares as built-in poison pills to ward off hostile takeovers. The poison pill is triggered after one shareholder acquires a set percentage of outstanding common stock. Convertible preferred shareholders then exchange positions for massive amounts of common shares, which would make any prospective takeover prohibitively expensive.

This controversial practice, of course, is dilutive for existing shareholders, and might even destroy long-term value by blocking new and more efficient management.

Financial Strategy

For many investors, a diversified portfolio featuring cash, bonds, real estate, and shares of common stock will be more than enough to build real wealth, while also mitigating downside risks. Onyx Investments would much rather manage money for long-term growth and assume stock market volatility.

Interestingly, corporations that make for good preferred stock investments, make for even better common stock investments through fundamental analysis.

Preferred shares are best reserved for sophisticated investors operating through special situations. In 2011, Warren Buffett struck a sweetheart deal to buy $5 billion in Bank of America preferred shares paying 5% dividends to Berkshire Hathaway. These preferred shares were also redeemable at a 5% premium and came with warrants granting rights to buy 700 million shares of Bank of America common stock at $7.14. In 2017, Buffett cashed out his $5 billion preferred shares and exercised all B of A warrants.

Bank of America stock now trades for $35.55 per share and is worth a cool $36.7 billion on the Berkshire Hathaway balance sheet.

Easy work if you can get it.