Preference Share

Preference Share (also known as Preferred Stock) is a fascinating hybrid, a bit like a platypus in the financial zoo – it has features of both stocks and bonds. Like a bond, it typically pays a fixed, regular income, known as a dividend. This dividend is the main attraction and is usually set as a percentage of the share's face value (or par value). But here's the “preference” part: the company must pay this dividend to its preference shareholders before it can pay a single cent to its common stockholders. However, unlike bondholders, who are creditors, preference shareholders are still owners of the company. This ownership usually comes without the power, as most preference shares do not carry voting rights. They represent a middle ground in the company's capital structure, offering more security than common stock but less than bonds. In the United States, these are almost exclusively referred to as Preferred Stock.

The “preference” isn't just a fancy name; it signifies a privileged position in the financial queue. This pecking order becomes critically important in two scenarios:

• Dividend Payments: In good times, when the company is profitable, preference shareholders are first in line for dividends. If the company's board decides to distribute profits, they must satisfy the fixed dividend obligation to preference shareholders before common stockholders see any cash. This provides a more predictable income stream compared to the variable (and sometimes non-existent) dividends of common shares.
• Liquidation: In bad times, if a company goes into bankruptcy or liquidation, preference shareholders have a higher claim on the company's assets than common stockholders. After all debts are paid to creditors and bondholders, preference shareholders get their money back next. Only if there's anything left over do the common stockholders receive a share. This priority provides a crucial safety cushion, though it's no guarantee you'll get all your money back.

Not all preference shares are created equal. They come in several varieties, and understanding the differences is key to knowing what you’re buying.

• Cumulative: This is a big plus for investors. If a company faces a tough year and decides to skip a dividend payment, a cumulative feature means that missed payment isn't lost forever. It accumulates as a “dividend in arrears.” The company must pay all these missed dividends before it can resume paying dividends to common stockholders. Most preference shares issued are cumulative for this reason.
• Non-Cumulative: This is riskier. If the company skips a dividend, it's gone for good. The company has no obligation to pay you back in the future. As an investor, you'd demand a higher yield for taking on this extra risk.

• Participating: These offer a taste of the upside. In addition to their fixed dividend, participating preference shareholders can receive an extra dividend if the company's profits exceed a certain level. They get to “participate” in the company's success alongside common stockholders.
• Non-Participating: This is the standard model. You get your fixed dividend, and that's it. No matter how spectacularly the company performs, your dividend payment remains the same.

• Convertible: These shares come with a special option: the right to convert them into a fixed number of the company's common shares. This feature is valuable because it allows an investor to benefit from a rising stock price. You can enjoy the steady dividend income and then convert to common stock if you believe the company has strong growth prospects.
• Non-Convertible: These shares cannot be converted. You're locked into the fixed-income features for the life of the share.

• A callable (or redeemable) preference share gives the issuing company the right, but not the obligation, to buy back the shares from investors at a specified price (the call price) on or after a certain date. Companies often do this if interest rates have fallen, allowing them to refinance their preference shares at a lower dividend rate. For investors, this is a downside as it caps their potential capital gains and forces them to reinvest their capital at potentially less attractive rates.

Preference shares can be a powerful tool in a value investor's arsenal, but they require careful analysis. They offer a yield that is typically higher than the company’s bonds, compensating the investor for taking on more risk (being behind bondholders in the payment queue). The legendary investor Warren Buffett is a master of using preference shares to his advantage. During the 2008 financial crisis, his firm Berkshire Hathaway made a $5 billion investment in Goldman Sachs. This wasn't in common stock, but in cumulative preference shares paying a hefty 10% dividend. The deal also included warrants, which gave him the right to buy common stock at a fixed price later on. This “Buffett Bailout” structure gave him a secure, high-income stream during a volatile period, plus massive upside potential through the warrants. He struck a similar deal with Bank of America in 2011. For ordinary investors, the key is to look at preference shares like you would a bond. Their price will move inversely with prevailing interest rates. When rates rise, the fixed dividend on an existing preference share becomes less attractive, and its market price will likely fall. Before investing, always read the fine print (the prospectus). Is it cumulative? Is it callable? What's the company's financial health? A 10% dividend from a financially shaky company is far riskier than a 6% dividend from a rock-solid blue-chip company. The details make all the difference between a smart income investment and a risky speculation.