What are Preferred Shares?
A preferred share (or stock), is a stock that provides investors with regular income.
Similar to a bond, a preferred share is sold to investors at a set price (AKA "par value," which is typically $25 per share), along with conditions for receiving income in the form of stock dividends. Preferred stock holders get first dibs to receive income from a company’s operations, in exchange for the right to share in the overall appreciation of the company.
There are several different formulas used to determine how much income a preferred shareholder may receive for a given period, but the three most common are: variable, fixed plus variable, and fixed.
I would discuss the first two, but I personally will probably never buy them, so I won’t bother. This is because a variable preferred share, to some degree, is determined by a baseline interest rate, say, the interest rate of a 5-year bond issued by the Bank of Canada. Interest rates are unpredictable, and I have no interest in receiving unpredictable income, so I strictly invest in preferred shares that pay a fixed amount.
Before preferred shares are traded on public stock exchanges, they are sold to investors on the primary market by an underwriting group, like an investment bank. Once purchased, buyers are free to sell their preferred shares on secondary markets, like the Toronto Stock Exchange, or the New York Stock Exchange.
Because preferred shares are traded on public stock exchanges, the price of preferred shares are subject to volatility. A decline in the price of a preferred share might be related to difficulty at the company level. It can also occur due to rising interest rates, as we are presently seeing.
As interest rates rise, the competition between income producing assets increases. Since a preferred share is more risky* than a bond, especially a bond issued by the Government of Canada, a rise in interest rates usually correlates with a decline in the value of preferred shares, as investors sell their preferred shares for guaranteed income.
As the price of a fixed preferred share declines, the dollar amount it pays stays the same. This means that, as the value of a preferred share falls, the yield that it pays to a buyer goes up.
For example:
Buzzwug’s Bumbles issues preferred stock to investors at a par value of $25, with quarterly payments of $0.25, for a total of $1 per year. This means that buyers on the primary market would have invested their dollars in exchange for the right to receive a 4% pre-tax return per year.
$1 per share dividends ÷ $25 par value x 100 = 4%
Let’s say the benchmark interest rate set by the Bank of Canada rises from 1% to 3%. Because preferred shares do not guarantee payment (although it's in their best interests to do so, if they want to continue to attract long-term capital from investors), the price of Buzzwug’s Bumbles preferred shares decline by 25% in response, to a price of $18.75 each, ouch!
Because Buzzywug pays a fixed amount of $1 per year, the lower price increases the dividend yield of the preferred share to 5.33%
$1 ÷ $18.75 x 100 = 5.33%
Personally, I’m never psyched to buy a preferred stock that isn’t selling at a discount.
If I buy Buzzywug’s preferred shares at $18.75, yielding 5.33%, and it declines another 25% to $14.06 per share and stays there for 10 years, I will still make money over that period, for so long as the company remains financially sound, it is reasonable to expect that preferred dividends will continue to be paid.
However, if interest rates decline, the price of preferred shares tend to increase. If rates fall far enough, the value of Buzzywug's preferred shares might reprice back to its original par value of $25, which can have a significant positive effect on 10-year returns.
This is what I call investing with a "margin of safety," where a significant event would have to occur for me to lose money over time. Also, there is a probability, in the event interest rates change course, that I stand to gain a considerable amount more than originally intended, although it's dangerous to begin from the premise of prospective gain. The first rule of investing is to never lose money. This is why the primary consideration of any investment should be how much an investor stands to lose, and whether or not any prospective loss, should it manifest, is likely to be small.
As a rule, I always enter an investment with reasonable expectations. In the second scenario, where the price of Buzzywug's preferred shares return to par, my cumulative interest would be far greater than the 53.33% that I would gain were shares to remain at my original purchase price of $18.75 over 10 years.
28.3% cumulative gains wouldn't be so bad either, and this is the important consideration: In the case of persistent, high interest rates, what return would I be satisfied with?
If the answer to that is low, even unfairly low, you're less likely to be disappointed, compared to entering an investment with high expectations of return. If you a feel a rush of adrenaline at the thought of your potential investment returns over time, it's likely you're expectations are too high, which is dangerous. For that adrenaline is what often powers risk-taking behavior, and sets you up for failure if volatility strikes.
Determining Dividend Safety
The safety of a preferred share depends on how much excess cash a company produces over its promise to pay. If a company struggles to earn cash for a sufficient period of time, they may pause dividend payments, or cease them entirely.
The fun part about publicly traded companies, is that they are legally obligated to make all of their financial information public.
For example, head to Intact Financial's investor relation's page, and you can find quarterly financial statements, and audited annual reports, going back all the way to 2009.
Bringing up Intact's 2021 annual report, and navigating to its consolidated financial statements (on page 147 of the pdf), and you can take a gander at the company's financial conditions.
What we need to figure out are two things: a) How much does the company pay per year to its preferred shareholders and debt holders, and b) By how much does its operating income cover its debt interest and preferred dividend payments?
To do this, we have to navigate to the financial statement labeled" Consolidated statement of changes in equity." For Intact, this is located on page 150.
When you the document, you will be shown a lot of numbers! Don't worry. As preferred shareholders, we're interested in two things:
In what currency are the financial statements reported in, and by how much?
How much money does the company pay out in preferred dividends?
Highlighted in red at the top corner of the page, you will notice that the currency for reported figures is in $CAD, and is reported in millions, meaning each number represents one million dollars. So, for the line "preferred shares," under the title "Dividends declared on," the reported "53," equals $53 million dollars that the company paid in preferred dividends during 2021.
We now need to find out what the company's pre-tax earnings are. Pre-tax earnings are simply the money a company has left over, after all of its operating expenses, including the interest it has paid to debt holders. We want to use pre-tax earnings as our baseline, as a company is unlikely to pay dividends to preferred shareholders before it deals with necessary expenses to run its business.
To find Intact's pre-tax income, navigate to page 148, titled, "Consolidated statements of income." The consolidated statements of income is where a company accounts for its income earned, weighed against its expense of doing business.
Find the line titled "Income before income taxes." This Intact's pre-tax income.
The exercise is to now see how much Intact's pre-tax income covers its preferred dividend payments. To do this, we will divide the 2021 pre-tax figure by the amount paid to preferred shareholders that year, to get a multiple of how much the company's pre-tax earnings cover preferred dividend payments.
$2,568 ÷ 53 = 48.45x
As you can see, the company earns a very large amount over its preferred stock payments, making continued dividend payments to preferred share owners a high probability.
As a rule, I will not purchase preferred shares in a business, where its pre-tax coverage of preferred share payments is less than 5x. I will also assess its pre-tax preferred coverage over the past 5 years, to make sure that its ability to continue to make payments isn't steadily declining.
Another key point to note is whether or not the company is growing its pre-tax earnings. To determine this, simply bring up at least a few annual reports to see how a company's pre-tax earnings have changed over time.
If you want to save time, you can go to a website like investing.com, and enter the company you wish to analyze into the search bar. Once a company is searched, navigate to "Financials," then, "Income Statement," and you will find simplified financial information on the company's past four years of business, including its pre-tax income. The key data that you will need from actually pulling up a company's most recent annual report, is what its annual payments to preferred dividend shareholders are. Once I have that, I often use websites like Investing.com to determine if my preferred dividends are safe.
That's it! At least the basics, anyway.
How to buy a preferred share
There are a couple things you should know before buying a preferred share, or any marketable security that is purchased through on an investment brokerage:
Online brokerages that are tied to your financial institution tend to charge fees. They may charge a fee for inactivity (avoid these exchanges at all cost. Being encouraged to trade is evil and should be condemned), or a fee for having below a certain amount invested. It is important that you are able to justify fees in relation to the interest you earn before you open a brokerage account. If you're being charged $100 per year in fees from your bank's investment brokerage, and you are earnings less than $500 in interest per year, these fees will have a significant impact on your yearly interest earned.
Brokerages charge commission on trades. This is one advantage that high-yield savings accounts and GICS have: they are free to open, and fees are easy to avoid entirely. Once more, it is important that you factor in the loss incurred from a commission when you purchase a publicly traded investment, and how it impacts your future expected return.
Buying a preferred share
Talk to a representative at your financial institution about opening an investment account. An investment account can opened as a tax-advantaged, registered vehicle, like a TFSA or RSP, or it can be opened as a non-registered vehicle, and fully subject to capital gains tax.
Be sure to open a "cash account," not a "margin account." A margin account allows you to purchase investments on margin (by borrowing money), and trading advanced financial instruments that are utterly dangerous and destructive to society. A cash account means that, if you don't have the cash, you can't buy. The forced self-restraint is good, and will help protect your financial wellbeing.
Once you have an account with your financial institution's brokerage, your should be provided with easily accessible information on how to place a trade.
Here is an example of how to do that with RBC Direct Investing. Please note my disclaimer that I do not receive any remuneration, donation, or gift of any kind for any institution or platform that I recommend. I just believe that RBC is the best bank for savers large and small. If you're curious to why, please reach out!
The last point I want to make on buying marketable securities, especially illiquid ones. An illiquid security simply means that there's a not a whole lot of volume (the number of shares being traded around). When you go to make an order, you'll notice that there are different options for the buy offer you would like to place, like "market," or "limit."
When it comes to illiquid securities, I like to place a "limit" on the price I'm willing to pay for a security. With my recent investment in Intact Financial's Series A 5.2% Preferred Shares, it took me a couple days just to buy $750 worth. I simply set a price in-line with where the price last traded at, and then waited. It's not perfect, but I'm not in this to sell. I'm in this to buy and hold. So I don't care if a security is illiquid and might be difficult to get out of. If getting in and out of your investments quickly is something that matters to you, this blog is probably not the place for you.
A note on volatility
The reason this blog is focused on income producing assets, whether in the form of savings accounts, GICs, or investments traded on stock exchanges, is because I feel that the average investor is better of focusing on how much extra income they generate from their investments on a quarterly and annual basis. The theory is that, if an individual buys an asset that is subject to volatility, and is focused on improving income generation over time, rather than focusing on the daily, monthly, and yearly changes in the value of their portfolio, they will be less likely to sell during market corrections and crashes (i.e., do the wrong thing), and more likely to buy when share prices are low and showing higher prospective dividend yields (i.e., do the right thing), resulting in above-average returns for the individual over time.
As you can see from the above graph, the returns of the average investor tend to be quite low. This is not because they are incapable, but because they are poor at regulating their own behavior.
Now, there is no shame in generating below average returns, if the kinds of investments that you feel personally comfortable with is interest earned on high-yield savings accounts and GICs. Stick to where you're comfortable.
This why I want you to detach yourself from the returns that I personally achieve over the life of this blog, and to think about what you are behaviorally capable of enduring, and what kind of return you would be satisfied with over time.
I personally can watch my portfolio decline 50 percent or more and remain focused on economic facts about what I own and why. How much could you bare? 25 percent? 10? Zero?
This question is important. It will distinguish whether you or not you are suited to purchase assets that experience volatility, and, if so, how much of your portfolio should be allocated to them. Portfolio construction is something that I will get into eventually, with the topic of volatility in mind.
The goal is to employ a strategy that you can sustain forever.
In the meantime, I hope this article has been somewhat informative.
"Stay the course"
- John Templeton
*Preferred shares are considered more risky than bonds, because they are subordinate in bankruptcy proceedings to debt holders. Companies are also generally legally obligated to pay interest to debt holders, whereby any unpaid interest is accumulated and claimable in bankruptcy court, though not guaranteed. But, usually everyone loses in bankruptcy proceedings, so potato potato. As long as the business has ample room to meet its interest payments (including preferred dividends), I'm in. I simply avoid buying preferred shares or bonds from companies that have even a moderate chance of bankruptcy, and it's my opinion that you should probably do the same. Justifying any risk of loss, even under the guise of diversity, is stupid. Please don't do it, no matter how much a company promises you.
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