Preference Shares (also known as 'Preferred Stock') are a unique type of company stock that acts like a hybrid between a stock and a bond. Imagine a security that offers the regular, fixed income of a bond but is technically a slice of ownership in a company, just like a stock. That's a preference share in a nutshell. Investors who buy them are entitled to a fixed dividend payment, which must be paid out before any dividends are distributed to common shareholders. Furthermore, in the unfortunate event of a company going into liquidation, preference shareholders have a higher claim on the company's assets than common shareholders. They get their money back first. This “preference” in payments gives the security its name. However, this preferential treatment comes at a cost: preference shares typically do not come with voting rights, meaning investors have no say in how the company is run. They offer a steady income stream and a degree of safety compared to common stock, but with less potential for sky-high returns.
Understanding preference shares is easiest when you see their two personalities.
The name says it all. Holders of these shares enjoy two major preferences over their common stock counterparts.
Preference shares are not a one-size-fits-all product. They come in several varieties, and it's crucial to know what you're buying.
This is perhaps the most important distinction.
Many preference shares are 'callable,' meaning the issuing company has 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 do this if interest rates fall, allowing them to “refinance” their preference shares at a lower dividend rate. This is great for the company but a risk for the investor, who might lose a high-yielding investment.
These shares offer the best of both worlds. They give the holder the right to convert their preference shares into a predetermined number of the company's common shares. This feature provides the safety and fixed income of a preference share while retaining the potential for capital gains if the company's common stock soars. Naturally, this attractive feature usually means a lower dividend yield.
A rarer breed, participating preference shares allow investors to receive an extra dividend on top of their regular, fixed one if the company's profits exceed a certain target. They get to “participate” in the upside along with common shareholders, which is not the case with standard preference shares.
So, do these instruments have a place in a value investor's portfolio? Absolutely, but with caution. The legendary investor Warren Buffett is a master of using preference shares. During the 2008 financial crisis, he famously invested billions in companies like Goldman Sachs and Bank of America through preference shares. He didn't just buy the standard off-the-shelf kind; he negotiated fantastic deals with high dividend yields (around 10%) and attached warrants that gave him the right to buy common stock at a low price later on. This strategy gave him steady, safe income during a panic while positioning him for massive gains when the market recovered. For ordinary investors, preference shares can be a source of stable, tax-advantaged income, often with higher yields than government or high-quality corporate bonds. They can become particularly attractive when the market panics and sells off all assets indiscriminately, pushing the price of sound preference shares down and their dividend yield up. However, a value investor must also be aware of the pitfalls:
In short, preference shares are a tool. For the right company at the right price, they can be a wonderful, income-generating asset. But as with any investment, you must read the fine print and understand exactly what you are buying.