The Balance Sheet

A preferred share is an equity instrument.  As per the illustration on the right, the balance sheet of a company is comprised of three elements, presented on opposite sides.  The assets of the company (what the company owns and what it is owed) are on the right.  The assets are what the company uses to operate and generate a profit.  On the top right of the balance sheet, are listed the liabilities of the company.  In effect, what the company borrowed to acquire assets.  And finally, on the bottom right, resides the shareholders equity.  This is effectively the paid-in capital along with any undistributed and accumulated profits from past years.

 

If a company does not have any debts or liabilities, it effectively is in a “no-leverage position”.  All of the assets are paid for.  A company with very little equity, where the assets are almost entirely financed by the debts, is known as a “highly levered” company.  A company without any equity, and where the debts exceed the assets, is effectively a bankrupt company.

 

The Stakeholders

A company has essentially two classes of stakeholders.  The lenders that loaned money and shareholders that provided the capital.  Preferred share investors are a hybrid class, but should always be considered shareholders.  In the event of a company wind down (forced or voluntary), the lenders, such as a bank or bond holder, always get paid first from the sale of the company’s assets.  Should there be any proceeds left after the lenders have been paid, the equity owners can receive their claim.  In the case of lenders, they have a legal right to the assets (pledged or unsecured), while the equity owners do not have any legal protection.

 

Many fortunes in modern economic history and especially in Canada have been built on the “backs” of preferred shareholders.  Simply put, it’s a great deal for the company.  When you need to finance a company, you can borrow or issue shares.  As stated previously, if you borrow, the lenders have a legal claim against the assets of the company.  If you sell equity to common shareholders, you dilute their share of any profits from the operations.  But what if you could raise financing without having to give the legal right to the assets in the event of a wind down, but at the same time, not have to share in the company’s profits?  Preferred shares fit this definition to a T.

 

Preferred shareholders are equity holders.  The dividend on preferred shares must be paid before dividends on common shares- thus the term preferred.  Therefore, many believe therein lies the safety.  However, the capital invested is no safer than the common equity. 

 

In exchange for their investment in the company, they usually receive an enticing quarterly dividend payment.  In many cases in Canada, dividends from Canadian issuers are favourably treated from a tax point of view.  In effect, the higher dividend is a sweetener for accepting equity-like risk of capital and bond like returns.

Why preferred shares are issued?

In many cases, preferred shares are issued by financial institutions-banks, thrifts, credit unions and insurance companies.  The reason is based in the regulatory side of the equation.  Financial regulators force financial institutions to have a stated amount of equity for each dollar of assets (outstanding loans).  Preferred shares are treated as equity by the financial regulators.  Thus financial institutions in need of capital will often resort to the issuance of preferred shares as way to “bulk up” their equity. 

When are preferred share a good investment?

In a word; almost never.  Here is a citation from the dean of investment research, Benjamin Graham in his book The Intelligent Investor p. 58.  Ben Graham ran the equivalent of a modern day mutual fund with great success, and was a mentor to the likes of Warren Buffet and Bill Ruane.

“...Really good preferred stocks can and do exist, but they are good in spite of their investment form, which is an inherently bad one.  The typical preferred stockholder is dependent for his safety on the ability and desire of the company to pay dividends on its common stock.  Once the common dividend are omitted, or even in danger, his own position becomes precarious, for the directors are under no obligation to continue paying him unless they also pay on the common.  On the other hand, the typical preferred stock carries no share in the company’s profits beyond the fixed dividend rate.  Thus the preferred holder lacks both the legal claim of the bondholder (or creditor) and the profit possibilities of a common stockholder (or partner).

    These weaknesses in the legal position of preferred stocks tend to come to the fore recurrently in periods of depression...”

The problem is as follows, when prices of the preferred shares are depressed, it is almost always in response to a crisis that is affecting the common shares as well.  If we look at the crisis of 2008-2009, we can turn to the Royal Bank common shares as an example.

Three Examples of Preferred Share Investments

We will look at three conditions of purchases: depressed prices on the common shares, normal circumstances and depressed prices on the preferred shares. As an investor, you should ask yourself the following question:  On an absolute and risk adjusted basis, when is investing in preferred shares the winning approach.  The goal being to generate income and protect your capital.

 

Investment at Depressed Prices on Common Shares

Let’s look at an example where the investors would have made two $10,000 investments in late February of 2009-the low for the common shares of Royal Bank.

 

 The common shares of Royal Bank hit a low of $25.52 in late February 2009.  The annual dividend rate was $2.00 per share, so the yield was 7.84% per share.  Conversely, you could have purchased Royal Bank Preferred shares Series AT that were issued on February 26, 2009 at a price of $25 and an annual dividend income of $1.5625 per share.  If we invested $10,000 in the Series AT shares at a price of $25, we would receive 400 shares.  In addition, a $10,000 investment in Royal Bank Common shares at a price of 25.52 would yield 391 shares.

 

Let’s try and map the profit picture for the Series AT preferred and common shareholders.  For simplicity reasons, we will use the year end of 2013 or two months prior to redemption date of the Series AT shares as the end date. 

 

Year	Projected Income: Series AT Shares	Projected Income: Common Shares
2009	$1.5625 X 400sh.	$2.00 X 391sh.
2010	$1.5625 X 400sh.	$2.00 X 391sh.
2011	$1.5625 X 400sh.	$2.10 X 391 sh.
2012	$1.5625 X 400sh.	$2.31 X 391sh.
2013	$1.5625 X 400sh.	$2.54 X 391sh.
Total Income	$3,125.00	$4,281.45
Gain (Loss)	($25-25$) X 400sh.= $0	($63.50-$25.52) X 391sh.= $14,850.18
Total Profit	$3,125.00	$19,131.63

 In order to model the future price of the common shares, we have to project the future dividends paid to common shareholders into the future.  The common share price will be largely driven by the value of the dividend in the future.

 

We will assume that the dividend yield on the common shares will be 4%, which is about the middle of the range under current interest rate environment. 

 

 

Year	Dividend
2010	$2.00
2011	$2.10
2012	$2.31
2013	$2.54

In 2005, the dividends on the common shares were $1.18; today it’s $2.  The dividend increased 69% in five years.  Let’s be conservative and assume the dividend increases by only 27% over the next 4 years to $2.54.  So the dividend increased as per the table on the right:

 

Therefore, $2.54 / 4% = $63.50.  This is the price that the common shares should be worth at a 4% yield if the Royal Bank dividend on common shares will be $2.54 in 2013.  A 27% dividend increase over the next four years is a very likely scenario; especially when we look at the past.

 

Clearly, buying the common shares at depressed prices is a clear winner in this example.  In fact, in times of crisis, the investor mentality is such that the issuer was able to capitalize on the fear in the market, and raise money at favourable terms.

 

Investment under Normal Circumstances

Let’s compare the return characteristics available to the common share owner V.s. the Series AT shareholder from the issue date of the AT shares under normal circumstances.  We know the preferred shares have callable feature of $25.  Let’s assume that the shares will get called away because if the conditions are not in the favor redeeming for the issuer, the company can simply convert and extend the shares- thus the shares the preferred shareholder may not receive the $25 in cash at the redemption date. 

 

Remember, the capital of the shareholders: preferred and common is equivalent.  Preferred shareholders are promised that common dividend will be cut before those on the preferred shares.  This is the only legal responsibility on the part of Royal Bank towards the preferred shareholders.

 

Let’s try and map the profit picture for the Series AT preferred and common shareholders.  For simplicity reasons, we will use the year end of 2013 or two months prior to redemption date of the Series AT shares as the end date.  We will begin the calculation on the first day of 2010.  Let’s assume we invested $10,000 in each shares.  This would give us 357 shares of the Series AT ($10,000 / $28) and 181 common shares ($10,000 / $55)

 

Year	Projected Income: Series AT Shares	Projected Income: Common Shares
2010	$1.5625 X 357sh.	$2.00 X 181 sh.
2011	$1.5625 X 357sh.	$2.10 X 181 sh.
2012	$1.5625 X 357sh.	$2.31 X 181 sh.
2013	$1.5625 X 357sh.	$2.54 X 181 sh.
Total Income	$2,231.25	$1,614.52
Gain (Loss)	($25-$28) X 357 sh.= $-1,071.00	($63.50-$)55 X 181 sh.= $1,538.50
Total Profit	$1,160.25	$3,153.02

 Clearly, the expected profit on the common shares in this example is predicated on dividend increases.  But since the preferred shares will mature for less than the price at the beginning of January 2010, the common shares do not need any increase in dividend to be a more profitable investment.  In fact, for the common shares profitability to equal the preferred AT shares ($1,160.25), the price of the common shares would have to fall $2.68 over the next four years.

 

Investment in Preferred Shares at Depressed Prices

Preferred shares can become a good investment when they are depressed because of overall market sentiment, or because of momentary problems with the underlying operations.  However, the common shares will always provide more profit potential.  The preferred shares investment might be coveted because the risk adjusted return is favourable.  And if the preferred share option is chosen, once the prices have returned to “normal”, the common shares will usually offer a better long term profit. However, these opportunities are few and far between.

 

Again, we can look at an example with a Royal Bank preferred share.  Royal Bank Non-Cumulative Preferred Shares Series W pays an annual dividend to its holders of $1.23 per share.  The issues can be redeemed by the bank for $25.00.  We will leave the other possible maturity options available to the issuer for another discussion, as they are not obligated to redeem, rather expected to.

 

Prior to the crisis in early 2008, the Series W traded in a band of $22 to $24 per share with corresponding yields of 5.59% and 5.13%.  The dividend on the common shares was $2.00 per share traded in a range of $45-$50 per share, and corresponding yields of 4.44% and 4%.

 

Let’s look at the potential profit had you purchased the Series W at their lowest price of the crisis of 2008-2009.  These shares actually traded at their lowest levels in November of 2008.  The low was $15.10 per share.  From their trading range in early 2008 to the lows reached in November of the same year, the share price declined by $6.90 ($22-$15.10) or 31%.  Again, since the preferred shares do not offer any more guarantee than the common shares on the capital invested, the Series W shareholders suffered significantly...actually, more than the common shareholders, as the common shares fell from a their range to around $35 which corresponds to a 22% decline at that time.

 

On one hand, we could have invested $10,000 in the Series W Royal Bank shares and obtained 662 shares at a price of $15.10.  Alternatively, we could have invested $10,000 in the Royal Bank common shares obtained 285 shares at a price of $35.00. 

To facilitate the calculation, we will assume that the shares are held until the end 2013, a few months prior to the scheduled $25.00 call in February 2014.  For this reason, we’ll assume that the value of the Series W shares will be $25.00 at the end of 2013.  Again, we are trying to illustrate the best possible outcome for the investor.

Year	Projected Income: Series W Shares	Projected Income: Common Shares
2009	$1.23 X 662sh.	$2.00 X 285 sh.
2010	$1.23 X 662sh.	$2.00 X 285 sh.
2011	$1.23 X 662sh.	$2.10 X 285 sh.
2012	$1.23 X 662sh.	$2.31 X 285 sh.
2013	$1.23 X 662sh.	$2.54 X 285 sh.
Total Income	$4,071.30	$3,120.75
Gain (Loss)	($25-$15.10)X 662sh.= $6,553.8	($63.50-35)X 285sh.= $8122.50
Total Profit	$10,625.10	$11,243.25

Clearly, the preferred shares have the income advantage from the theoretical purchase date in November 2008 until the theoretical sale date at the end 2013.  We will assume the same closing price for the common shares at the end of 2013, if we apply a 4% dividend yield on a projected $2.54, we get a $63.50.

Conclusion

We have demonstrated why investors should avoid preferred shares in most cases: because equity (like common stock) risk is taken on in exchange for (usually) slightly higher returns than bonds, and preferential tax treatment of income.

With the three examples above, we confirmed what one of the legend of investing Ben Graham stated in one of his books.  Preferred shares are rarely the preferred investment.  The reason is because they are a hybrid security.  They do not offer the promise the return of capital at maturity backed by legal claim, nor do they offer a share in the profits in the company.  What they do offer is a higher, and usually tax advantaged, dividend income stream.

The examples used above were not selected to advocate purchasing the Royal Bank common shares.  Rather the selection was based on the fact that the Royal Bank had both common shares and a variety of preferred shares floating in the market during the crisis of 2008-09.

 

The reality is that preferred shares are a tool for companies to increase their profits which is to the benefit of common shareholders or it is a tool for companies to solidify their balance sheet which is to the benefit of the lenders and bond holders. 

To answer to some of our critics, the example above was meant to illustrate the fact that common shareholders and preferred shareholders are indeed equity owners.  In times of severe duress, preferred shareholders are not protected by any legal covenants-only the lenders and bondholders and thus take on the same risk of capital as common shareholders.