Preferred shares are an incredible opportunity for the enterprising investor. Known to many academicians, including the father of value investing Benjamin Graham, as having the worst characteristics of both stocks and bonds, there is a price when those negative traits become opportunity. Warren Buffett (Trades, Portfolio) is proof of how the bad traits of this financial derivative can secure a comfortable retirement.
The first structural design issue of a preferred share is its capped price. Like a bond, the money raised by selling a preferred share is owed to the buying party. Unless it is a convertible preferred share, that specified dollar amount raised is the maximum owed. An astute observer of preferred share price movement will notice a level where many preferred shares stop appreciating. PAR value or face value is the term often used.
The other main downside of a preferred share is its position in bankruptcy. If a company dissolves in bankruptcy, because a bond is more senior, the bond holders will claim any value remaining in the company before preferred share holders do. This means since bond holders get paid after suppliers, pensioners, and tax agencies do, what you have is a security second to last in the financial pyramid scheme. If the senior investors made off with the only value remaining, preferred holders will get nothing.
Because these negative designs of a preferred share, occasionally it creates the conditions ripe for opportunity. During a financial crisis, as witnessed in 2007-2009, investors were fearful of any security that does not have the "safest, most-senior & secured" features. Thus, investors were flocking to securities like treasury bonds. Examine the substantial drop in the 30-year US government bond rate.
This mass exodus out of equities will cause havoc for a company with a one-star business predictability rank.
As witnessed with Wells Fargo from 2007 to 2009, the price drop was devastating. Many investors were so devastated by losses that they left the securities market permanently.
For the enterprising investor, like Warren Buffett (Trades, Portfolio), this havoc created opportunity. Notice below the appreciation in value for this "unwanted" preferred share of Wells Fargo (WFC.PJ). From near 6 to 22 in one year, those courageous value investors were able to secure a fine retirement.
If you are new to investing or missed the last crisis, be assured there will be opportunity again.The only thing we can do is prepare.
