When should you buy preferred shares rather than common stock and what’s the difference?
When you talk about stocks, it’s a good bet you’re talking about common shares trading on the exchanges.
But there’s another type of equity investment, ownership in a company, that can offer some very attractive advantages over common stock.
They’re called preferred shares. You might have heard about them, but do you know all the differences between preferred and common shares? Do you know when you should buy preferred stock versus common stock?
In fact, Warren Buffett is a big fan of buying these types of shares to lock in a dividend payment and ride the potential upside in the company.
Buffett bailed out Bank of America with a $5 billion investment in preferred shares August 2011. The shares paid a 6% annual dividend and were convertible to common shares at $7.14 each.
The Oracle of Omaha exercised his right to convert those preferred shares to 700 million common shares June 2017, making an instant profit of $11.7 billion on top of the annual dividends collected since 2011.
I bet now you want to know more about preferred shares and when you should buy them versus common stock?
What is a Preferred Shareholder?
When a company issues ownership shares to investors, it can issue them in one of two forms.
Most commonly, this is done by issuing common shares. These shares represent a fractional ownership in the company and a share of future profits. Each share also usually carries one vote when the company has major changes it needs to put to owners.
By comparison, the company may also issue preferred stock. Preferred shares also represent an ownership stake in the company but differ from common stock in some very important ways.
- Preferred shares usually have no voting rights
- They have a scheduled and fixed dividend amount
- Preferred shares have a ‘par’ value around which they usually trade
- Some preferred stock can be converted into common stock at a fixed ratio or price
I’ll go further into detail on these later but they have the effect of making preferred shares much more like fixed-income bonds than common stock. You know what your dividend yield will be when you buy preferred shares and you don’t quite participate in the upside as much as common shareholders.
Preferred shareholders enjoy other benefits of buying the shares versus common stockholders. They get paid out before common shareholders in any distribution, that includes dividends and in a bankruptcy.
How are Preferred Shares and Common Stock Different?
Preferred shareholders are higher up on the distribution chain compared to common shareholders. The company may delay its preferred dividend payment to conserve cash but all payments must be caught up before common stockholders can collect any dividends.
When you buy a share of preferred stock, you’ll have a contract to receive a fixed dividend payment at fixed intervals. While many companies pay out regular dividends on their common stock, each payment has to be set and approved by the board of directors.
Preferred shares have a par value around which they trade, usually close to how much they are worth in common shares. Since most of the payout is fixed on a share of preferred stock, unless the common shares rise above the conversion price, the price of preferreds act very much like bonds. Prices rise when interest rates fall, and vice versa, because of the fixed dividend payment.
While both shareholders are technically owners, only common stock usually has a voting right.
Are there Similarities between Common and Preferred Stock?
The similarities between common stock and preferred really end at the idea of equity ownership.
They both represent an ownership of the company though preferred shares have no voting rights and do not participate quite as much on the upside in earnings. This is because the conversion rate for most preferred shares is usually fairly high so a stock really has to boom higher for it to make sense to convert.
This means that common shareholders will see the returns from higher earnings before preferred shareholders, until the price of the common stock is high enough for conversion to make sense.
Which is Better, Preferred Stock or Common Stock?
Common and preferred shares each have their place in a portfolio. I prefer common stock (pun intended, couldn’t resist) but there are times when you may want to buy preferred shares.
Preferred shares give you more certainty because you have that fixed and contractual dividend. You also know you’ll get paid out before common shareholders in the event of a bankruptcy, though there’s usually little or nothing left after paying creditors and bondholders anyway.
Common stock is generally better when the economy and the company is growing normally. There’s more certainty of sales growth during this time so you don’t need that extra assurance that comes with preferred shares.
Should I Buy Preferred Stock?
I hold some preferred stock but not much. I usually buy preferred stock when the economy is tumbling and the future is less certain for some companies. Buying preferred stock gives you a little more certainty because of the fixed dividend payments and the higher-level of ownership.
Buying preferred shares during a bear market also gives you quite a bit of upside potential because you can convert the shares into common stock if the company pulls through. Warren Buffett did a lot of this during the financial crisis, bailing out many of the large banks with billions invested in their preferred shares.
He collected a sizeable dividend and did very well when the common stock rebounded.
Outside of these times of economic and market stress, I usually just invest in the common shares of companies I like or in peer loans through Lending Club. I’ve found peer loans to offer that same mix of solid returns comparable to stocks but more safety because of their bond features.
Learn more about how I invest in peer loans with these three strategies.
How Do I Buy Preferred Shares?
It’s easy to find preferred shares on your brokerage platform. Preferred stock will have the same symbol as common stock but will have a suffix attached, usually PA, PR, PRX or P. You can find the preferred symbol on the company’s investor relations page or call up customer support at your brokerage account.
You can also usually find the preferred shares if you start typing the common stock symbol into your symbol lookup and then add a period.
When I do this in E*Trade for Bank of America, I see eight different series of preferred shares.
If I click through to the first series of preferred stock, the EE series, I see that the shares pay a 5.55% dividend versus the 1.6% dividend paid on the common stock.
So you can see why people might like preferred shares.
You can buy preferred shares just as easily as you buy common stock. Make sure you understand if the rate is floating or fixed and how much each preferred shares is worth in regular common shares.
Preferred shares are probably not going to be a large portion of your portfolio versus the amount you hold in common stock but they can be a great tool in certain situations. Preferred stock has advantages over common shares in the fixed dividend while common shares are generally better for price appreciation.
