Once a widely used part of many companies’ capital structures, preferred stock has become little more than an afterthought in most investors’ minds. Yet recently, the search for higher yields has led to renewed interest in preferred stock, and with companies having found novel uses for it in recent years, the old-fashioned investment could well be on the upswing for quite a while.
The latest preference
Most recently, preferred stock has hit the headlines as part of David Einhorn’s battle with Apple Inc. (NASDAQ:AAPL). Apple proposed in its annual proxy materials to eliminate provisions allowing for the creation of preferred stock in Apple’s capital structure. Einhorn responded with a lawsuit seeking to separate the preferred-stock provision from the remainder of the proposal, and at the same time suggested a strategy involving the issuance of perpetual preferred stock that he argued would unlock shareholder value in a way that would effectively use the company’s big cash hoard without causing repatriation tax liability.
Not the first preferred
Einhorn’s arguments are open to debate, but he isn’t the first person to suggest using preferred stock in a somewhat novel way. During the financial crisis, when the government gave financial companies bailouts under TARP, it received preferred shares that entitled it to preferred dividends and a liquidation preference. American International Group, Inc. (NYSE:AIG), for instance, had to pay 10% dividends on $40 billion in senior preferred stock, while Citigroup Inc. (NYSE:C) ended up paying 8% dividends until the preferred was converted into common shares.
The Treasury’s stakes under TARP closely mirrored deals that Warren Buffett made with hard-hit companies during the financial crisis. Buffett arranged to receive preferred stock and warrants, guaranteeing both income and potential capital appreciation.
A safer alternative?
But going beyond unusual ways of using preferred stock, you’ll more commonly see preferred stock in its traditional role of providing income and security against loss, while common shares retain more upside potential.
For good examples of this traditional use, mortgage REITs Annaly Capital Management, Inc. (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) both have preferred issues. Because of the REIT structure of the issuing companies, the common shares actually yield more than their respective preferreds. But with some investors worrying about the potential impact on dividends that events like the Federal Reserve’s purchase of mortgage-backed securities under its quantitative easing program could have, the preferred stock would be required to pay dividends in full before common shareholders could get a single penny of income. For investors who really need income and are willing to leave a few percentage points on the table in exchange for more secure payouts, preferred stock in mortgage REITs has definite advantages over the common shares.
Get preferred investments
If you don’t want to focus in on a single security, iShares S&P US Preferred and other ETFs focusing on preferred stock offer broad diversification. Be careful, though, as ETFs tend to reflect the concentration of preferred shares issued by companies in the financial industry, so they may not be as diversified as you’d think.
Preferred stock isn’t the perfect investment for everyone, but the creative ways that companies are using it opens up some lucrative opportunities for investors. When a company you’re interested in offers a preferred stock issue, look at its characteristics and see whether it might be a better fit for you.
The article Preferred Stock: A Smarter Investment Alternative? originally appeared on Fool.com and is written by Dan Caplinger.
Fool contributor Dan Caplinger owns shares of Apple and warrants on AIG. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends AIG and Apple. The Motley Fool owns shares of AIG, Annaly Capital, Apple, and Citigroup, and has options positions on AIG.
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