Cumulative Preferred Stock

Cumulative preferred stock is a type of preferred stock that includes a special provision protecting its shareholders. If a company is unable to pay its promised dividend in a given period, this provision ensures that all missed dividends must be paid out to the cumulative preferred shareholders before any dividends can be distributed to common stockholders. These unpaid dividends, known as dividends in arrears, accumulate over time. Think of it as an IOU from the company to its preferred investors. This feature makes it a significantly safer investment than non-cumulative preferred stock, which offers no such guarantee for missed payments. For investors who prioritize a steady and reliable income stream, the cumulative feature provides a crucial layer of security, making it a popular choice for conservative, income-focused portfolios.

Let's make this crystal clear. Imagine you own a share of cumulative preferred stock in “SteadyEddie Inc.” The stock promises to pay you an annual dividend of $5. Unfortunately, SteadyEddie Inc. hits a rough patch in Year 1 and decides to suspend all dividend payments to conserve cash. As a cumulative preferred stockholder, you don't receive your $5, but the company now owes you that money. Your dividend is “in arrears.” In Year 2, business booms! The company's board decides to reward shareholders with a dividend. Before the common stockholders can see a single cent, SteadyEddie Inc. must first settle its debt with you. They must pay you:

• $5 for the missed dividend from Year 1
• $5 for the regular dividend in Year 2

So, you receive a total of $10 per share. Only after this payment is made can the company consider paying dividends to its common stockholders. This “first in line” privilege is the core benefit of cumulative preferred stock.

• A Strong Safety Net: The primary advantage is the legal obligation for the company to make you whole on any missed dividends. This significantly reduces the risk of losing your expected income compared to other types of stock.
• Priority in Payouts: You are ahead of common stockholders in the queue for profits. This priority also extends to a worst-case scenario: if the company goes bankrupt and undergoes liquidation, preferred stockholders are paid from the remaining assets before common stockholders are.
• Predictable Income: Much like a high-quality bond, cumulative preferred stock is designed to provide a fixed, steady stream of income. This predictability is highly attractive to retirees and investors seeking stability over high-growth potential.

• Limited Upside Potential: That fixed dividend is a double-edged sword. If the company's profits explode, common stockholders may receive massive dividends, and their share price could soar. You, however, will still receive your fixed payment. You trade high-growth potential for stability, creating an opportunity cost.
• No Seat at the Table: Preferred stock typically comes with no voting rights. This means you have no say in company decisions, such as electing the board of directors. You are a financial stakeholder, not a voice in governance.
• Interest Rate Risk: The market value of your preferred stock is sensitive to changes in the broader economy's interest rates. If new bonds and other preferred stocks are issued with higher yields, your older, lower-yielding shares become less attractive, and their price on the open market may fall.

Legendary investors like Benjamin Graham often saw preferred stocks as hybrids—part stock, part bond, and sometimes a master of neither. However, a savvy value investor can find attractive opportunities in cumulative preferred shares under the right conditions. The key is not to be seduced by a high dividend yield alone, but to hunt for value. A value investor might become interested when:

• The Price is Right: The stock is trading at a significant discount to its par value (its face value), especially if the company's financial health is sound.
• A Turnaround is Brewing: A company has suspended dividends due to temporary, solvable problems but has strong underlying business fundamentals. An investor who buys during this “period of pessimism” can potentially collect a windfall when the company recovers and pays out all the accumulated dividends in arrears.

For the value investor, the cumulative feature provides a powerful margin of safety. It’s a contractual promise that strengthens the investment case, but only if you've done your homework and are confident in the company's long-term ability to honor that promise. A promise from a failing company is worthless.