Thursday, July 17, 2008

Security Analysis: Chapters 14 and 15

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

Still on the subject of fixed-income investing (for a description of the various groupings of investment types, see Chapter 5), Graham and Dodd add some special notes for investors when it comes to preferred stocks.

In most cases, preferred stocks (at par) enjoy the privileges of the worst of both worlds. They carry no upside (like bonds), yet offer no guarantee of payment (like stocks). As such, by their very setup, they are an unattractive form of investment.

Studies carried out by the authors demonstrate that pref shares have fallen from economic peaks to troughs far more than have bonds, despite the fact that both are ordinarly "fixed-income" type investments.

Nevertheless, in the finance industry, preferreds are considered close in form to bonds. If a company does well, preferred dividends are paid easily, and if a company does poorly, the bonds don't get paid either, and as the authors have discussed, liens are worth little. However, this argument fails to take into consideration the middle-ground: companies that are neither great nor poor. In practice, pref dividends are often withheld merely when payment is inconvenient as opposed to impossible. This results in wild fluctuates in market values of pref stocks, and as such does not make sense for an investor looking for stable fixed-income investment.

Therefore, before making fixed-income investments in preferred shares, the authors require that the prefs not only meet all the requirements of a safe bond (as discussed in Chapters 8 to 11), but have a larger margin of safety such that dividends will likely always be paid, and that the company's stability be of utmost importance, since during bad years if earnings turn downward or negative, the pref dividends will take a hit.

The authors' analysis of public markets demonstrates that only 5% of preferred shares actually meet these requirements. In such cases, the companies would be better off issuing bonds in order to obtain tax benefits and a lower cost of capital. History shows, however, that these safe preferreds are left over from a time when the companies were not as strong as they are today, and so they were not in a position to issue bonds.

In most cases, therefore, preferreds are an unattractive form of investment, as they lack the upside of common shares, and lack the stability of bonds. The fixed-income investor must search for the exceptions: where the stability and coverage of earnings is so high that prefs behave as though they are bonds.

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