Preference Shares

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.

• Their “Bond” Side: The main attraction is the fixed dividend, which is very similar to a bond's coupon payment. This dividend is usually stated as a percentage of the share's par value. Because of this fixed payment, the market price of preference shares is highly sensitive to changes in interest rates. If new preference shares are being issued with higher yields, the price of existing, lower-yielding shares will fall, and vice versa.
• Their “Stock” Side: Despite the bond-like features, a preference share is still a form of equity, representing ownership in the business. The company's board of directors must declare the dividend; it's not a mandatory legal obligation like a bond's interest payment. If the company is in a tight spot, it can suspend preference dividends. Also, preference shares rank below all forms of debt, meaning bondholders and other lenders get paid before preference shareholders if the company fails.

The name says it all. Holders of these shares enjoy two major preferences over their common stock counterparts.

1. Dividend Priority: This is the big one. A company cannot pay a single penny in dividends to its common shareholders until it has paid its preference shareholders their full, promised dividend. This provides a strong incentive for a healthy company to keep the preference payments flowing.
2. Liquidation Priority: If a company is wound up and its assets are sold, preference shareholders are in line to get their initial investment back before common shareholders see anything. It’s important to remember, though, that they are still at the back of the queue behind all the company's creditors and bondholders.

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.

• Cumulative: If a company skips a dividend payment, the missed payment is not lost forever. It accumulates as a “dividend in arrears.” The company must pay all these missed dividends to cumulative preference shareholders before it can resume paying dividends to common shareholders. This is a powerful protective feature.
• Non-Cumulative: If a dividend is skipped, it's gone for good. Poof. This makes them significantly riskier and, consequently, they usually offer a higher yield to compensate for this risk.

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:

• Limited Upside: Your return is generally capped at the dividend. You won't get rich from a company's runaway success unless you own convertible or participating shares.
• Interest Rate Risk: When rates rise, the value of your fixed-dividend shares will fall.
• No Say: With no voting rights, you're just along for the ride, trusting management to run the ship well.
• Event Risk: A takeover or merger could lead to your shares being called, or a severe downturn could lead to suspended dividends or, in the worst case, a total loss if the company goes bankrupt.

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.