Published:
October 13, 2008
The
correct answer is 
(C.) Preferred stocks
Warren Buffett recently purchased $5 billion of
Goldman Sachs (NYSE: GS) preferreds
and $3 billion of General Electric
(NYSE: GE) preferreds -- with both
investments carrying a yield of 10%.
Normally, Warren Buffett likes to
buy a solid common stock at a good
value. He's a pretty patient
investor and is willing to wait
while his undervalued investment
appreciates to its potential. And
for Buffett, that patience has paid
off. Since he started investing in
1964, he's had an astonishing total
return of +400,863% -- head and
shoulders above the comparatively
meager +6,840% returns delivered by
the S&P 500.
But Warren Buffett has also seen a fair share of
bear markets in his time. And he knows just how
much of a drag an economic slowdown -- or a
recession -- can have on common stock prices.
With such experience, Buffett has
learned one of the best places to shelter a
portfolio during these rocky times --
preferred shares.
|
|
Bear Market |
S&P 500 Performance |
|
02/66 - 10/66 |
-22.2% |
|
11/68 -
05/70 |
-36.1% |
|
01/73 - 10/74 |
-48.2% |
|
11/80 -
08/82 |
-27.1% |
|
08/87 - 12/87 |
-33.5% |
|
03/00 - 10/02 |
-49.1% |
|
What Buffett Sees in Preferreds
There are three key advantages that preferred shares have over
common shares -- advantages that become even more important in times
like these. They offer investors...
1.) A higher level of
protection
2.) Significantly much higher yields
3.) Greater price stability
While
preferred shares are bought and sold on all the major
exchanges, just like common shares, they come with better
guarantees. For instance, dividends paid
on common stock are not guaranteed and can fluctuate from
quarter to quarter. In fact, just last week Bank of America
(NYSE: BAC) announced it would cut its common
share dividend by -50%! This is one of the largest
institutions in the country, and not that long ago, its
dividend was thought to be rock-solid.
By contrast,
preferred shareholders are almost
always
guaranteed a fixed dividend paid on a regular basis. Also,
in the event of bankruptcy or other corporate restructuring
-- something investors have to think a little more about
these days -- preferred shareholders are repaid before common
stock owners.
These factors make preferreds act a little more
like bonds than stocks, and as such, they don't have the
same volatility as common shares. So while you might give up
a little price appreciation in bull markets, you definitely
don't see the same downward pressure in challenging markets.
But as we'll see, what shareholders might give up in
potential appreciation is more than compensated for during
this historic opportunity in the sector. And that was a trade-off Warren
Buffett was happy to make.
Historically Higher Yields for Preferred Shares
As you can see in the chart, the average yield for
stocks in the S&P 500 is currently a miserly 2.8%. A
six-month CD is only a slight improvement with a
3.2% yield. A 10-year "AAA"-rated corporate
bond will let you capture a yield of 4.9%. Preferred stocks, on the other hand, are
currently averaging a 9.0% yield, per the PreferredsOnline
Index.
And of course the best news is that 9.0% is only the
average
yield. There are dozens of high-quality preferred
stocks paying yields above 10% right now.
But don't make the mistake of thinking higher
preferred yields are |
 |
the
result of distressed share prices. Instead, a series
rate cuts by the U.S. Federal Reserve has been ratcheting down
interest rates, driving the yields down on everything from
Treasuries to money market accounts. And uncertainty
in the market overall has caused an investor "flight to
quality," which has also has put additional downward
pressure on government-issued securities. The effects
have been dramatic. A 3-month Treasury bill that yielded
3.2% at the beginning of the year is now yielding 0.5% --
which almost equates to stuffing your money under your
mattress.
Meanwhile, hurt by the credit mess, cash-strapped banks sought to
shore up their balance sheets by issuing billions of
dollars in new preferreds. As the
supply of preferred stocks started to rise, two things
happened. New issuers realized they had to raise their
offering yield to attract buyers, and the share prices of
existing preferreds dropped until their yields were
competitive with those of newly issued preferreds.
There's Never Been a Better Time for Safer Income
Not only do preferreds pay higher yields than stocks,
but their payouts are more secure than common dividends. Preferred shareholders have a claim to a company's assets
ahead of common shareholders -- that's why they're called
"preferred." In other words, if a company runs into trouble,
it must service the preferred shareholders before it can
even think about paying a dime to common stock investors.
While a preferred stock can still default on its payments,
ratings company Standard and Poor's classifies this as an
"extremely rare" occurrence. Principal Global Investors
estimated the historical default rate for investment-grade
preferred stocks was less than 0.2%.
And unlike common dividends, preferred payouts are predictable
-- they don't go up and down with a company's earnings. In fact, a number of banks like National
City (NYSE: NCC) and Citigroup (NYSE: C) have cut their
common share dividends in reaction to the credit crisis -
while continuing to pay their preferred dividends at their
issued yield like clockwork.
Preferred Shares Are Less
Volatile
And after the last few months of whiplash-producing market
swings, investors will enjoy the lower volatility of these
holdings. In the last month, we've seen more than
our fair share of swings to the downside -- including a
historic drop of 777 points on the Dow. But while the
S&P 500 lost -20.4% in the last 30 days, many
investment-grade preferred stocks significantly outperformed
that mark. Consider that J.P. Morgan's 8 5/8 Preferred
(NYSE: JPM-PI) lost only -1.3% over the last month, and that's before
adding in the dividend.
Moreover, while they make for a particularly timely
investment now, preferred stocks are also a great way to diversify
your portfolio to ensure regular dividend payments. After
all, many of these securities pay monthly dividends.
This is particularly important for retired investors, many
of whom depend on their portfolios to pay their regular
bills.
A Better Yield Than Buffett's
This once-in-a-generation chance to pick up preferred
shares is one of the factors that Carla Pasternak, editor of
High-Yield Investing, considered when she chose a
preferred stock for her latest "Income Security of the
Month." With a solid
10.1% yield,
this preferred stock has made reliable distributions since
its IPO in December 1992. In total, investors who
bought when the preferred issue went public have enjoyed
over 180 consecutive payments -- come rain or shine.
And considering the challenges of the past year, this preferred
stock has held up
very
well. During that time, it has registered a total return of +8.5%
versus the S&P 500's loss of -26% -- outperforming the
broader index by 36.5 percentage points!
But that's nothing new, as this preferred stock has
outperformed the S&P by nearly 25 percentage points over the
last five years.
Carla has put together a comprehensive
analysis of this exceptional preferred stock opportunity.
In her profile, she spells out in detail how the safety of
its government-backed holdings and legally obligated monthly
dividend payments are especially attractive given the current conditions in the
markets. And of course, with its solid 10.1% yield this idea
is right on par with the yields generated by Warren Buffett's headline-making deals. To read
Carla's report,
please visit this link.
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