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.
Those reassuring comments helped quell anxiety far more than any
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
Preferred stock is a form of equity ownership in a company. The
shares aren't granted voting rights, but they do carry quarterly
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
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
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
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
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
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
StreetAuthority's Market Advisor