Published: November 4, 2009

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.
 

 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.

-- Nathan Slaughter
Editor
StreetAuthority's Market Advisor