Preferred Stockholder

A preferred stockholder is a part-owner of a company who holds preferred stock. Think of them as a hybrid investor, sitting somewhere between a regular stockholder and a bondholder. They enjoy a higher claim on a company's assets and earnings than common stockholders but a lower claim than bondholders. In the event of a company's liquidation, preferred stockholders get paid back their investment after the company’s debts are settled but before the common stockholders see a penny. Their main perk is receiving a fixed dividend, which must be paid out before any dividends are distributed to common stockholders. This fixed payment makes preferred stock behave a bit like a bond, offering a steady stream of income. However, this hybrid nature comes with its own set of trade-offs, making it a unique, and sometimes misunderstood, security in an investor's toolkit. For a value investing practitioner, understanding the rights and limitations of a preferred stockholder is crucial to avoid mistaking a fixed-income-like instrument for a true share in the business's long-term growth.

The “preferred” in preferred stockholder sounds great, doesn't it? It implies a VIP status. In some ways, it is. But in the world of investing, every advantage comes with a corresponding disadvantage. Preferred stockholders occupy a unique middle ground in a company’s capital structure. They get some of the security of a bondholder and some of the ownership of a stockholder, but they don't get the full benefits of either. They give up the massive upside potential of common stock for the safety of a more predictable dividend. They also sacrifice the legal protections and highest-priority claim of bondholders. Whether this trade-off is “good” or “bad” depends entirely on an investor's goals: are you seeking stable income or long-term capital growth?

The two main privileges that give preferred stockholders their name relate to payouts—both during the company’s life and at its potential end.

• Dividend Priority: This is the big one. A company must pay dividends to its preferred stockholders before it can distribute any profits to common stockholders. These dividends are typically a fixed amount, stated as a percentage of the stock's par value. This makes them a reliable source of income. Some preferred shares are even more attractive:
  1. Cumulative preferred stock: If the company misses a dividend payment, the unpaid amount (called “dividends in arrears”) accumulates. The company must pay all missed dividends to preferred stockholders before common stockholders can receive anything.
  2. Non-cumulative preferred stock: If a payment is missed, it's gone forever. For this reason, cumulative shares are generally safer and more desirable for investors.
• Liquidation Priority: If a company goes bankrupt and its assets are sold off, preferred stockholders are higher up in the pecking order than common stockholders. After all creditors and bondholders have been paid, preferred stockholders get their turn. Common stockholders get whatever is left, which is often nothing.

From a value investor's perspective, which emphasizes owning a piece of a wonderful business, the drawbacks of being a preferred stockholder are significant.

Because the dividend is fixed, a preferred stockholder's return is capped. If the company hits a home run and its profits soar, common stockholders will see their dividends and stock price rocket upwards. The preferred stockholder? They just keep getting their same, fixed dividend. They own a slice of the company, but they don't get to participate in its spectacular growth. They get a predictable return, not a potentially extraordinary one.

Want a say in how the company is run? Stick to common stock. Preferred stockholders typically have no voting rights. They can't vote for the board of directors or on major corporate decisions. They are silent partners, providing capital in exchange for income, but with no influence over the management that generates that income. This passivity is a major red flag for investors who believe in being active, engaged owners of a business.

Since preferred stocks pay a fixed dividend, they are sensitive to changes in prevailing interest rates, much like bonds. If market interest rates rise, newly issued preferred stocks and bonds will offer higher yields. This makes existing preferred stocks with their lower fixed dividends less attractive, causing their market price to fall. The inverse is also true: if interest rates fall, the value of existing preferred stock may rise.

Value investing legend Warren Buffett has famously said his favorite holding period is “forever.” This philosophy is rooted in buying great businesses at fair prices and benefiting from their long-term compounding growth—a benefit reaped primarily by common stockholders. For this reason, many value investors see preferred stock as an inferior vehicle for wealth creation. Why accept a bond-like, fixed return when you can own a piece of the business's future triumphs (and failures)? However, this doesn't mean it's a useless tool. In fact, Mr. Buffett himself has used preferred stock masterfully. During the 2008 financial crisis, Berkshire Hathaway made strategic investments in companies like Goldman Sachs and Bank of America by purchasing preferred stock. But these weren't your average preferred shares. They came with very high dividend yields (around 10%) and, crucially, warrants. These warrants gave Berkshire the right to buy common stock at a fixed price in the future, providing the equity upside that standard preferred stock lacks. For the average investor, the lesson is this: standard preferred stock is primarily an income-generating instrument, not a growth engine. It can have a place in a portfolio focused on cash flow, but if your goal is to harness the power of compounding by owning wonderful businesses, the common stockholder's seat is the one you want at the table.