The Preferred Way for Income & Gains

preferred stock - The Preferred Way for Income & Gains

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Investors aren’t the lemmings that many companies might take them for. And because of some push-back from bond investors back in the early 19th century, we have an innovation that continues to deliver for investors seeking income with some potential for appreciation: the preferred stock.

Back in the early 1830’s, America’s railroad network was under pressure to expand towards the western territories. But at the same time, the leaders of the Eastern American railroad companies were in a tough financial spot. They had already leveraged themselves to acquire land and easement rights for rail lines, to build the lines and to fund the cost of rolling stock.

In doing so, bond buyers and bankers were reticent to extend further credit to many of the railroad companies. They feared that if the new expanded lines weren’t going to pay for themselves that the additional debts might not be paid.

But in true American style of financial innovation, the preferred stock was born. And one of the first companies to issue them successfully was the B&O Railroad company in 1836.

The Preferred Stock

The successful pitch was that preferred stock would pay a fixed dividend much like a bond. And it would also have a bond-like credit standing; if the company defaulted, preferred stockholders would be paid before any common stockholder.

But the kicker was that if B&O was successful with the expanded new lines, the company would be worth more. And as such, the preferred stockholder would participate in the gains unlike the traditional bond buyer.

The same attraction continues today for preferred stock. Investors get the assurance of dividend payments (usually fixed at higher levels than common stock) and can also profit from rising underlying company valuations.

And preferred stock also has the benefit of enabling investors to earn more during times of stagnant general stock market conditions. And that’s exactly the sort of conditions that have been plaguing the general stock market for much of this year.

Beating the S&P 500

Since the beginning of February, the S&P 500 has largely been flat, trading in a range up and down, despite the underlying stronger economy fueled by increasing consumer spending and business investment. But preferred stocks as tracked by the S&P Preferred Stock Total Return Index have turned in a return of 4.50%.

And the market for preferreds should continue to outpace the general market as long as we’re stuck in this general malaise.

There are many preferred shares in the market that offer great individual company opportunities for income and gain. But one of the easiest for individual investors seeking exposure to the market is the iShares US Preferred Stock ETF (NYSE:PFF).

This ETF has synthetic exposure to preferred shares in American banks, real estate investment trusts (REITs) and insurance companies along with lesser exposure to other industry groups.

The yield is attractive at 6.13% — far higher than the yield of the general S&P 500 index. And the return from February 1st of this year nearly matches the S&P Preferred Stock Index noted above.

However, there is an alternative that I’m suggesting in a closed-end investment fund run by Flaherty & Crumrine called the Preferred Income Opportunity Fund (NYSE:PFO).

Unlike the ETF, this closed-end fund  provides direct ownership of actual preferred stock in banks, insurance companies and other industry group companies. And also unlike the ETF, the closed-end fund is now trading at a discount to the actual net asset value of the preferred stocks held in the fund by some 3.88%.

That means that you can buy the Flaherty & Crumrine fund at 3.88% less than what it is worth. And to make it even more enticing, the fund generates and pays a higher dividend of 7.28% on a monthly basis.

And while it has trailed the return of the ETF by a minor margin since February, the long-haul return of the Flaherty & Crumrine fund has dwarfed the iShares ETF. For the trailing ten years, the closed-end fund has generated a return of 185.78% compared to the iShares ETF of 98.32%, proving that active management in preferred stock can be all the more valuable for individual investors.

Neil George is the editor for Profitable Investing and by company policy does not have any current holdings in the securities mentioned above.

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