LEVEL: BEGINNER
The investment world is an interesting place; while it’s popular in some circles to bash on Wall Street and stockholders for having too much political and economic power, the fact is that there is a pretty rigid hierarchy in the financial world when it comes to equity–and the most common form of ownership, that is “common stock” equity, is at the lowest level of the totem pole, even if this is what many billionaires have much of their wealth in.
At the same time, the higher form of equity, preferred stock, is considered more desirable in certain situations and, as the name suggests, preferred stock is much harder to buy than common stock, although it also comes with extra benefits of ownership that common stocks do not offer. But you would be wrong to think that preferred stock is limited to an ultra-secret club that you can only access with a secret handshake. In fact, as counterintuitive as it sounds, there are plenty of ways to buy common stock in preferred stock to buy preferred equity in a company. Confused? Don’t be–let’s take it step by step.
Common Stock
Common stock is the type of shares that are sold every day on exchanges like the NYSE. The Dow Jones Index (.DJI, tracked by the ETF DIA) is an index of the performance of companies’ common stock. Common stock gets the most attention, the most headlines, and the most amount of liquidity, volatility, and price fluctuation.
Preferred Stock
Preferred stock or preferred shares are a separate asset class which are given preference over common stock, and which are not traded on the NYSE, NASDAQ, and other American exchanges (although they are publicly traded in other countries). Preferred stock is most commonly issued in the case of financial institutions (investment banks, retail banks, investment funds), REITs, and utility companies. While there are tax benefits to preferred stock, most investors look at these in terms of adjusting a portfolio’s risk portfolio rather than to save money on taxes.
This is because preferred stock generally is paid dividends on a company’s net revenue before common stock. In some cases, common stocks do not offer dividend rights but preferred stock do–so while investors will buy common stock for share appreciation, they will buy preferred stock for a right to a company’s profits.
This is one reason why there can be a conflict of interest between preferred stock holders and common stock holders. While shareholders looking for value appreciation will want the company to reinvest as much cash into operations as possible (to fuel future growth), owners of preferred stock might be more interested in receiving more dividends in exchange for their ownership.
Bonds and Debt
In terms of ownership, preferred stockholders are at the top of the heap, but when it comes to having an interest in a company’s solvency, there is one group of investors that have precedence over preferred stockholders. Bondholders do not actually own part of a company–they are just the financiers who have lent money to the company. As such, it is in their best interest that the company they have lent money to succeeds–but not too much.
This is because bondholders have agreed with debtors to lend a certain amount of principal in exchange for a certain amount of interest paid over a certain interval. Let’s say that interest is 10%. If the company’s revenue increases by 500%, the bondholder will still only get 10% on his initial loan. While that 10% is more likely to be paid than the company’s revenue is going to quintuple, that lack of risk exposure also makes bonds less valuable as an investment instrument.
The Liquidation Chain
These three types of investors: common stockholders, preferred stockholders, and bondholders, are all interested in a company’s growth but they are invested in different ways and have different motivations. What happens when the company fails to make a profit? If the company stays solvent, only bondholders will get their “guaranteed” payback, while common stockholders and preferred stockholders can see the value of their ownership decline.
What about the worst case scenario–a bankruptcy? In this case, there is a clear order in which investors get paid as the company is put into administration and its assets are converted into cash. That chain goes as follows:
1. Bondholders get their cash first. As the company is liquidated, all debtors are given their principal and outstanding interest owed.
2. Preferred stockholders get their cash second. If there’s money left over after debtors are compensated, preferred stockholders will be paid.
3. Common stockholders get the rest. Since common stock is the last in line to be converted to cash in the case of a company’s bankruptcy, the shares usually fall the fastest in the case of a company’s bankruptcy. This is one reason why common stock is a less preferred investment vehicle, especially in high risk situations.
Preferred Stock ETFs
While preferred stocks cannot be bought on an American exchange, there is a convenient loophole: ETFs. Several ETFs exist that solely buy preferred stock in companies. iShares (PFF) has one of the most popular on the market. PowerShares also has two (PGX, PGF) as well as several others on the market (PSK, SPFF, PFXF, IPFF).
Professional investors looking to diversify will buy not only common stocks, but also some amount of preferred stocks and bonds (we will look at bond ETFs separately). When building your portfolio, don’t limit yourself just to common stock–have a look at preferred stock to see how it fits into your investment strategy and style.