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During the market's darkest days of fear and
uncertainty last October, Warren Buffett wrote a bullish op-ed
piece in The
New York Times arguing in favor of U.S. stocks.
Those
reassuring comments helped quell anxiety far more than any
government intervention.
Buffett was putting his money where his mouth was.
Ever the opportunist, he took advantage of the panic-driven
sell-off by putting Berkshire Hathaway's (NYSE: BRK-B) mountainous cash
stockpile to work. And with a limitless array of investment
options, there was one asset class at the very top of his
shopping list.
Preferred stocks.
Preferred stock is a form of equity ownership in a company. The
shares aren't granted voting rights, but they do carry quarterly
dividend distributions.
Preferred dividends are more durable than common share
dividends, and can't be easily slashed or discontinued. Even if preferred payments are
temporarily suspended, they must be repaid in total before a
single
penny can be handed to common shareholders.
Preferred shares also have a higher claim on assets in the event of liquidation. Fortunately, this particular
advantage doesn't come into play all that often. Default rates on investment grade
preferreds have averaged just 0.2% over time, according to
Principal Global Investors.
Buffett's Sweetheart Deal
Buffett capitalized on the chaos in the financial sector by
investing $5 billion in Goldman Sachs (NYSE: GS) perpetual preferred
shares. With a 10% fixed yield, the investment stands to
throw off $500 million in annual dividends for years to come.
And if Goldman decides to buy back the shares at some point, it
must fork over an additional +10% premium above and beyond the
original principal.
Buffett later struck a
similar deal
to invest $3 billion in General Electric (NYSE: GE) preferred shares.
This is hardly the first time the Oracle of Omaha has made
bold, calculated bets on these unique, tax-advantaged
securities. In fact, he stunned the market by pouring hundreds
of millions into 9% convertible preferred shares of Salomon
Brothers just before the crash of 1987.
He then collected
dividends while common stockholders got steamrolled.
Of course, the rest of us aren't going to negotiate the same
favorable terms as Warren Buffett -- but that doesn't mean we
can't take a page out of his playbook.
Irrational Disconnects Remain
For the most part, preferred owners look forward to fixed dividend
payments and don't really participate in
the underlying company's performance. In times other than extreme
market duress, preferreds trade within a very tight range --
fluctuating maybe a few pennies one way or the other.
However, last year was anything but ordinary, particularly for
financial firms.
Rattled by the collapse of storied companies
like Bear Stearns and Lehman Brothers, investors dumped their
shares. Other banks flooded the market with newly-minted preferreds to
strengthen Tier 1 capital ratios on their weakened balance
sheets.
Naturally, that gush of supply overwhelmed an already weakened
market. As with any supply/demand imbalance, prices were driven
sharply lower, which sent yields shooting in the opposite
direction -- peaking at 19.6% in March.
Since then, investors have realized that the sky isn't
falling and any remote threat of a systemic collapse has
been averted.
Confidence and liquidity have flooded back into the preferred
stock sector, sending prices higher.
For example, Wells Fargo Cap IV 7% (NYSE: WSF) hugged the $25
mark for years before plummeting to around $10 back in March.
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At
that price, the annual payments of $1.75 per share
(which were meant to provide a 7% yield) suddenly represented a
colossal payout of 17.5%.
But the shares quickly found their way back home to $25 --
providing a gain of +150% on top of the dividends.
There's a similar story behind most other preferred stocks.
Some of the upside potential
in preferreds is
already gone,
but investors who missed the boat can still find many preferreds
still trading at sizeable
discounts.
The rally in preferreds isn't over. With generous
payouts above 8% (the highest you'll find from sound,
investment-grade companies), any further capital appreciation
will just be icing on the cake.
Good Investing!
-- Nathan
Slaughter
Chief Investment Strategist
The ETF Authority
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