Published: June 28, 2010

Investors may feel like they have nowhere to turn during times like these. Equity investors have seen a -35% return in the S&P 500 during the past 10 years, making it known as "The Lost Decade." Meanwhile, those who turn to bonds are likely to find themselves sorely disappointed -- the 10-year T-bill currently yields a measly 3.02%.

So what's an investor to do? Well, there is a security that provides diversification with bond-like regular income along with a shot at capital gains. Trouble is, most people haven't heard of it. And if they have, investors often shy away from them because they seem too complicated. It's a real shame, because these readily available securities often make terrific investments for a portfolio.

The security in question is known as "preferred stock." Investors should think of preferreds as stock-bond hybrids, because they share characteristics of both. Let's walk through how a preferred issuance is characterized and how investors can score juicy and stable returns.

Hospital REIT Ashford Hospitality Trust (NYSE: AHT) issued eight million shares of 8.45% Series D Cumulative Preferred Stock (NYSE: AHT-PD) at $25 a share, callable in 2012. What does this mean?

Eight million shares issued at $25 means the company raised $200 million from the offering. Series D is just to distinguish this preferred offering from other ones they've already made.

The most attractive thing about preferred stock is that it comes with a fixed dividend payment, usually stated as a percentage of the par value. In this case, Ashford's preferred shares pay 8.45% of $25 per year -- or $2.11 a share. Ashford suspended its common dividend in December of 2008, but left the preferred payment in place. This is because the company cannot suspend the preferred dividend unless it first suspends dividends on the common stock. This gives an added element of safety for investors looking for stable income.

"Cumulative" means that if the company should miss a payment on the preferred stock, holders are entitled to receive all of the dividend payments the company missed paying when (or if) it begins paying the preferred dividend again. The company can miss a payment on preferred stock, but won't necessarily go into default and risk sinking the company as it would with a missed bond payment.

The $25 price at which the preferred stock was offered is called the fixed liquidation value, or par value (just like a bond). If Ashford were to ever be liquidated because of bankruptcy, bondholders always get paid back first, then preferred stock holders are second in line ahead of common stockholders, who usually get wiped out. Preferred holders would theoretically get $25 a share.

"Callable 2012" means the $25 share price is also the price at which Ashford could call the stock. Beginning in 2012, Ashford can buy back the Series D preferred stock at $25 a share, and holders can't refuse. Companies usually only do this if the stock trades for more than $25 so it can either get the stock back at a discount to the market price or if the company thinks it is better to spend the $20 million in one lump than keep paying some $17 million in dividends each year.

The trading price of preferreds tends to stay within a tight range. The securities trade more like bonds than stocks, so their prices tend to reflect the market's confidence in the company's overall health. Most investors buy preferreds less for capital gain potential than for the dividends, though preferred shares trading below par could indicate potential capital gains down the line.

We've seen this happen before. In fact, Ashford's Preferred D stock traded as low as $7 when the market was crashing back in 2008. It's now near $21. Besides the +200% capital gain off the stock itself, smart investors have enjoyed $2.11 a share in annual dividends.

There are four things investors should look for when choosing a preferred stock.

1. Is the company in good shape? A company need not be in growth mode to make its preferred stock worthwhile, just sailing along and meeting its debt payments with ample cash reserves will do just fine.

2. Is the preferred cumulative? Investors may want this backstop should things go south.

3. Are the preferred shares you buy senior to other issuances? A company may issue several different series of preferred stock. Investors may want to make sure their series is the most senior. That way, its dividend gets cut last and is closer to the top in the event of liquidation.

4. Where is it trading relative to par? A significant discount to par may either offer a great value, as it turned out with Ashford, or may correctly reflect pessimism about the company's health. This could lead to a big capital gain if you analyze correctly.

Action to Take --> Some preferred stocks that currently fit my criteria for compelling investment candidates include: Ashford Hospitality Trust 8.45% Series D Preferred, JPMorgan Chase (NYSE: JPM) 5.72% Series F Preferred, Sunstone Hotel (NYSE: SHO) Cumulative 8% Series A Preferred and NorthStar Realty (NYSE: NRF) Cumulative 8.75% Series A Preferred. Ticker symbols for preferred stock will vary depending on which broker you use.

-- Frederick Steier
Contributor
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