Related Sites QuantumOnline.com Jubak's Journal Recent articles: • My 15% earnings test for finding stock gems, 1/31/2003 • The pro forma problem won't go away, 1/30/2003 • Find a turnaround with a shot at success, 1/28/2003 More... | Jubak's Journal 3 preferred stocks I prefer Some investors in hot pursuit of yield are taking another look at preferred stock. Here are the basics of how these equities work, plus three issues that are well-positioned now. By Jim Jubak The search for high yields -- make that high, safe yields -- is taking investors where many havent gone before . . . such as into preferred stocks. Thats unfamiliar territory to many investors. What, for example, are Citigroup 6.21% Depositary Shares, Series G Preferred? And how are they different from Citigroup 6.23% Cumulative Redeemable Depositary Shares, Series H Preferred? But with the 10-year Treasury bond yielding just 4% and the two classes of Citigroup preferred I cited above yielding 6%, it seems like a good time to get to know this sector. Lets start with some of the basics and end with three preferred stocks that offer an appealing combination of yield, potential appreciation, and safety right now.
What are preferred shares? Theyre called preferred because they have preference over common shares -- the class of stock that most investors own -- when it comes to the payment of dividends (if cash is running low at the company) and in the case the company has to liquidate. (In most liquidations, investors who hold common stock get nothing.) Preferred shares pay a dividend that is stipulated and in most cases fixed at the time theyre offered to the public. Dividend payments do not go up over time as the company gets more profitable, as they usually do with common shares that pay a dividend. Preferred shares generally do not carry voting rights in matters that come before shareholders. When do companies issue preferred shares? When they have the cash flow to pay the dividends but dont want to issue bonds because they either dont want to add debt to the books or because capital is cheaper in the equity markets. Typically companies issued preferred stock instead of common shares when they want to prevent the dilution of voting rights and when they want to write very specific financial terms for the shares. Preferred stock comes in an almost infinite variety of flavors, each with slightly different financial characteristics. Are all these differences really important? Not for investors taking a first cut at finding opportunities in the asset class -- although you should never buy a preferred without reading the prospectus to check on those niggling little details that can bite hard later on. Major distinctions to keep an eye on include:
Don't reach too hard for yield in this economy Ok, so enough of the general principles. What sort of preferred stocks are best right now? Id recommend preferred shares that are slightly out on the risk curve right. In other words, the companies that issued these shares arent rock-solid credits, so investors required a higher yield, a dividend premium for taking the risk that the dividend might not be paid, before they purchased the shares. But I wouldnt go too far out on the curve. It doesnt pay to reach too hard for yield right now. Heres my reasoning: The trouble with all income vehicles right now is that interest rates look like theyre near a bottom for this cycle of the economy, assuming nothing goes unexpectedly wrong with the economy or on the world stage. I dont know when interest rates might start creeping upward. With the economy so weak, Id be surprised if we got much of a jump this year. But if you look five years into the future, I think its reasonable to assume that interest rates will be higher than they are now. And that will put downward pressure on the price of all now-issued fixed-income vehicles. To keep up with the rising yields paid by new issues, the prices of existing issues will fall until their fixed payout is equal to the new and higher market interest rates. Now, preferred stocks issued by companies with less than rock-solid credit ratings have a way to combat this. If the economy improves -- or at least stabilizes -- and companies can improve their credit ratings, the price of their preferred shares will rise as the credit risk premium is removed from the stock. This pressure for an increased price from improved credit quality will at least partially offset any pressure for a drop in price caused by climbing interest rates. Why not go as far out on the credit risk curve as you can? Because the current economic recovery is still very iffy. Gross domestic product grew at only 0.7% in the fourth quarter of 2002. If the economy stalls again, companies that are now major credit risks will become even greater risks and that will lead to a drop in the price of their preferred shares. To give you an idea of the relative kinds of volatility Im talking about look at the preferred issues from Merrill Lynch Id call Merrill a modest credit risk. The brokerage industry isnt exactly coining money and Merrills debt-to-equity ratio (at $3.38 in debt to every $1 in equity) is well above both its own and the industry average. So its preferred has more than average volatility for the sector. The Class D preferred (MER-D) that Ill talk about in a moment has a 52-week high of $26.40 and a low of $23.13. Thats a 14% swing from low to high. But its nothing like the volatility in JP Morgan Chase preferred, thanks to the markets perception of a high degree of credit risk at the bank. The class A preferred (JPM-A) hit a 52-week high of $87 on Jan. 21 after a low of $70.50 on Oct. 29, 2002. Thats a 24% move from low to high. And the stocks volatility doesnt appear to be behind it, since it moved back down to $82.95 by Jan. 31. Three preferreds that pique my interest Now, finally, here are the preferred stocks of three companies that I think are worth a look. Dont take my word on any of these preferred stocks. Do your own homework. The best one-stop shop on the Internet for information on these issues that Ive found is QuantumOnline.com. On their site (the link is at left under Related Sites), click on the button in the left-hand margin that says stock lists and scroll down to the Preferred Stocks table. Intrepid explorers of the sector will notice that I havent included a convertible preferred issue among my suggestions. Well, convertibles are another very complicated story -- a very interesting one right now, Id say -- for another day. Theres only so much new territory an investor can cross in a single journey. New developments on past columns A surefire way to find surprise stock winners One analyst who covers Hughes Supply Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Citigroup and Hughes Supply. He does not own short positions in any stock mentioned in this column. | |||||
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