Targeting Safe Income? Preferred Stocks Can Help

Income Investing, Retirement, Strategies

In early 2020, much of the world went into a lockdown due to a medical pandemic. Governments warned millions could die. The world was scared. Headlines like, “Coronavirus sparks stock market chaos” were common.

Wikipedia reports:

“During March 2020, global stocks saw a downturn of at least 25%, and 30% in most G20 nations. …. Goldman Sachs warned that the US GDP would shrink 29% by the end of the 2nd quarter…and that unemployment could skyrocket to at least 9%. Australian Prime Minister Scott Morrison has called the looming economic crisis ‘akin to the Great Depression’.”

In the midst of the chaos, Tim Plaehn, editor of The Dividend Hunter published a special report, “9 Preferred Shares To Take You Through the Recession.” I quickly perused the report, mistakenly thinking, “Too risky” and moved on to the next item in my reading stack.

In a recent interview, Tim said preferred stocks are great options for conservative investors, concluding, “I’ve increased the number of preferred stocks on the recommendations list.” Readers asked about his remarks. Oops!

I re-read the report, realizing I needed to learn more about preferred stocks. More research followed. I wrote a primer, explaining how preferreds are different and can be good, safe investments.

Today, Tim tells us how to find the good ones.

DENNIS: Tim, thanks again for your time helping to educate our readers.

When I read your report, I saw companies dealing with shopping centers, hotels, medical buildings, etc. The market was in panic, no one knew what to expect, they had cut their common stock dividends, and they looked risky to me. I missed a great buying opportunity.

Tim, as your readers pay for your service, I won’t mention any company. One recommendation said, “They slashed the common stock dividend to 2 cents, down from 40 cents.” At the current market price, the preferred shares would yield 14.9%.

The stock was priced over normal $25.00 face value and dropped to $6.40. You recommended readers buy up to $18. It’s currently just under $20, and continues paying the guaranteed $.55 dividend quarterly. 100 shares would cost around $2,000, with $220 in annual dividends; that’s still an 11% yield.

Here is a screenshot of their performance:

I’m cautious about the old saying, “If it sounds too good to be true, it probably is.”

Tim, please educate our readers on what you look for in preferred stocks, the criteria has to be different.

TIM: You recently used George Orwell’s quote, “All animals are equal, but some animals are more equal than others.” Preferred stocks, with their guaranteed payments get preferential treatment.

The company you mentioned is Golar LNG Partners. They have gas carriers under long term charters.

Like all stocks, I have to look behind the scenes. In addition to pouring over their financial reports and announcements, I regularly listen in to their earnings calls. I look at their management, have they got real experience, do they know what the heck they are doing?

With preferred candidates, there comes a fork in the road. Why did they cut their common stock dividend by 95%? It can be a sign of disaster, or a great omen for preferred shareholders. In this case, it looked like they were uncertain about the future and took the opportunity to cut dividends along with the rest of the market.

When they left a 2-cent dividend, that signals they plan to continue to pay preferred dividends. Remember preferred shareholders are guaranteed $.55 per quarter and are in the first of the line.

Even if a company sees a reduction in profit, and their growth will come back very slowly, it still bodes well for preferred shareholders.

DENNIS: You said cutting the common stock dividend can be a disaster or great omen. How do you know the difference?

TIM: Good question. Let me use a hypothetical example. Take two companies who are office building real estate investment trusts. Both need to raise money to buy $10 million in properties.

Company A sells bonds and company B raises the money by issuing preferred stock.

When the economy is good, both generate good cash flow.

Company A must use the cash to pay interest on the bonds, dividends, and save some of the cash to repay the bonds. When they mature, they may pay them off, issue new bonds, or they may sell the properties. If it was new construction, and now they are occupied with solid, long term tenants, they are likely to earn a nice profit.

Company B may generate identical cash flow; however, we need to understand how preferred stock can help them and their shareholders. They don’t have bond maturities staring them in the face. They are less likely to be faced with trying to sell their properties at the exact wrong time in the market. They have more flexibility.

Dennis, I spend a lot of time looking at cash flow. You can have a company that is losing money on paper, yet is doing fine. The IRS does not let them write off the entire cost in the first year. Depreciation is called a non-cash type expense. Assume the IRS says their $10 million building has to be written off over 20 years. Think about it; if they broke even, they generated $500,000 in cash and preferred shareholders are guaranteed their dividends.

This isn’t something the average investor can garner from looking at the bullet points in their glossy earnings announcement. Research takes time, but you can find solid preferred opportunities generating plenty of cash; they are out there.

My overall concern is the viability of the company to stay solid and continue to pay their dividends through both good and bad times. Common shareholders are not guaranteed anything. I need to be comfortable that preferred shareholders are taken care of. Paying preferred dividends is like the holy grail, they jump through hoops to honor those guarantees.

DENNIS: You recently told us, “I spend as much time talking to subscribers about portfolio management as I do about the specific investment recommendations.”

You believe in diversification, and don’t want your readers “all in” on any single type of investment. Holding cash on the sideline allows us to quickly take advantage of opportunities when they present themselves.

You added all 9 to your recommended buy list. Since then you have sold some. Why do you decide to sell?

TIM: There are several reasons I recommend selling. If something has changed, or I sense they may not be able to continue their dividends, I will issue a sell, sometimes mid-month, not waiting for the next monthly issue.

I much prefer the positive reasons. In this case, they have given us some good profits, and our readers need put some cash on the sidelines for the next opportunity – they are still out there.

We have one REIT specializing in medical office buildings. The price dropped below face value, offering a 7.7% return. It is now priced around 5% over face value. Should the stock get called in we would lose that 5%. With the fed unlikely to raise rates anytime soon, I anticipate the price may go a bit higher and I will probably recommend our readers take profits.

DENNIS: I mentioned not paying attention to your special report was a mistake.

When the market tumbled, I bought two stocks that I felt were underpriced. In one case, we are up 90% and the current dividend yield is .78%. The second case is up 18% with a 7% dividend. We were thrilled, sold some at a nice profit, and have stop losses in for the remainder.

The price volatility, which allowed us to jump on the opportunity when they went on sale is now a concern. The yield in the first case is terrible and, in the second case, dividends were cut and we don’t know what the future holds.

My mistake? Knowing what I know now, I would have much preferred (pun intended) to diversify and add some preferred stocks at the time. I’d have nice, guaranteed dividends coming in while I make up my mind.

I also feel many of your preferred recommendations may be long term keepers, regardless of the market volatility.

Tim, it appears that common stocks may jump all over the place, while preferred stocks are much more stable; as long as the company is not going out of business and making some profit.

Does that make sense?

TIM: Yes is does, as long as you understand what affects the price of a preferred stock.

In a normal market, they are predominately interest rate sensitive. If treasuries or CD rates were 5%, instead of .5%, investment capital would shift toward that market and stock prices may come down. Rising interest rates are unlikely in the current environment.

The upside of a preferred stock is limited when the price approaches face value; however, solid payers, priced under face value, offers investors an added bonus.

Remember we are The Dividend Hunter. Our subscribers want to allocate some of their portfolio to solid, dividend paying stocks, not be continually trading or worrying about the daily market gyrations. As long as their dividends are safe, and coming in like clockwork they are happy.

DENNIS: Thank you again for your time.

TIM: My pleasure Dennis

Dennis here. Tim has made a believer out of me! Preferred stocks are much less volatile. I look at them as an income source, and don’t worry about the market.

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