Stocks come in two primary categories: preferred and common. Both categories share the following three characteristics:
- They represent a share of ownership in a company.
- They are available for purchase and for sale in the open market.
- They are acquired in the same way.
However, there is one key difference: Common stocks generally have higher return potential because they profit from both capital gains and dividends, while preferred stocks profit primarily from dividends.
Since most stock market profits come from capital gains, when the ability to benefit from them is eliminated, the return potential is much lower.
This seemingly incredible disadvantage does have an upside. Because returns are not contingent on volatile capital gains, preferred stocks are considered a low-risk investment. For many income investors, the more certain investment environment of preferred stocks can be very attractive.
Although common stocks are by far the most widespread type of stocks (hence their name), there are considerable advantages to having preferred stock as part of a balanced portfolio, particularly for income investors. Of course, as with any investment, some risks are involved as well.
The pros
Higher priority
If a company becomes insolvent and its assets are liquidated, preferred stockholders get to cash in their shares before common stockholders (but after bondholders and creditors), which gives them a better chance of getting their money back.
Dividend protection
Like bonds, preferred stocks are often considered a fixed-income investment. Further, most preferred stocks are cumulative, meaning that if a company is unable to pay dividends in a period, it will have to make those payments later before it’s able to pay out any dividends to common shareholders.
Regular payouts
Dividend payouts for preferred stocks are predetermined, while common stock dividends are paid depending on the company’s financial condition. Not only do preferred stocks have a more regular payout, they also generally enjoy a larger one as well.
The cons
No rights
Preferred stock investors have no voting rights. While common stockholders can vote on corporate matters, preferred stockholders do not usually get a say. Ultimately, less risk means having less at stake, which in turn means less need to participate in decision-making.
Buy backs
Preferred stock may be “callable,” which means the company can buy preferred shares back at any time, for any reason. One big reason could be dividend rates. If a company can call back its preferred stocks and reissue at a lower dividend rate, it can effectively save a lot of money. Basically, callable preferred stock is a tool a company can use to protect itself from market fluctuations.
Common conversion
Depending on the company and type of preferred stock, the stock can be converted into common shares. A conservative investor may not view this as very desirable. Sometimes, the preferred stock converts automatically after a particular date while, in other cases, the board of directors (or even the investors) initiates the conversion. Whether this is advantageous or not depends on the condition of the common stock and the investor’s wishes.
Tax implications
On the one hand, because preferred stocks aren’t volatile, selling preferred stock isn’t very likely to produce a capital gain. On the other hand, for the same reason, they also aren’t likely to produce a capital loss. The dividends are considered taxable income, but the tax rate will depend on whether the dividends are considered qualified.
The bottom line
For investors close to retirement or for income investors interested in frequent dividends, preferred stocks—a low-risk way of earning a steady and predictable flow of income—may be right for you.
