Preferred Stocks

This department is designed to help readers to a better understanding of the general business conditions which affect their investments. It is obviously impossible to give advice as to specific investments.

by HOWARD DOUGLAS DOZIER

PREFERRED stocks are the hybrid security of the corporate financial structure and are of doubtful paternity. They resemble the bond in some respects, but frequently behave like common stocks. The contract under which they are issued is one of checks and balances. They remind one of the New York fruit vendor’s reply to Theodore Roosevelt’s question as to how his business was: ’What I make on the peanut I lose on the damned banan’.’ The charter privileges and preferences granted at one place in the preferred-stock contract are frequently limited and hedged about elsewhere, Care in selection is, therefore, necessary. A great deal of verbiage has to be used in establishing that nicety of relation which it is desired to bring about between the issuer and the buyer. One who contemplates putting his money in this type of security ought not to allow himself to be soothed too easily by that agreeable-sounding adjective ‘preferred.‘

Historically, preferred stocks have come into existence mainly through the promotion of industrial and public utility enterprises and through railroad reorganizations. In a great many of the early promotions the bonds and preferred stocks issued were just about equal to the value of the property acquired. Preferred stocks put out in many promotions were designed primarily to raise money or to acquire property and were dressed up for that part. Some of them were issued to the holders of defaulted railroad bonds and were called ’preferred’ to make them a little more palatable to those who had to accept them.

On the other hand, some issues of preferred stocks have come into being because the issuing corporation has been so successful as to be able to go into a favorable security market and exchange preferred stock for its outstanding bonds on favorable terms. This is, of course, good corporate financing.

With these preliminaries out of the way, let us now assume that the reader is on the point of buying a preferred stock and that he has put to himself this series of questions before making his final commitment: —

Where does the preference lie, and of what practical value is it likely to be? A stock may be preferred as to dividends, or as to both dividends and assets in case of liquidation. Particular attention should be directed toward the phrase ‘in case of liquidation.’ It is quite as important also to know what claims upon earnings outrank those I of preferred stock as it is to know what claims those of the preferred stock outrank. Without thisknowledge a preferred stockholder may learn too late that, while he is entitled to receive his dividends before the common stockholders get theirs, the fact is that bond interest charges may be so heavy as to eat away all, or more than all, of the funds available to security holders, and that his prior claim is a claim on nothing, or even less.

A prerequisite of the preference as to assets is liquidation. Now, liquidation of a corporation for the accommodation of the preferred stockholders is an all but unheard-of financial event. Corporations do not generally get into trouble because of obligations to their preferred stockholders, but on account of those to their bondholders and to their banks. By the time a corporation’s affairs reach the point where liquidation is necessary, they have probably already reached the pass where liquidation will not benefit the preferred stockholders.

It sometimes happens, too, that the scope of the preference as to assets is not clearly defined. Not many months ago the writer was called as a witness in a public utility rate case to express an opinion on what rate of return on the fair value of the utility’s property a schedule of rates should produce in order to be reasonable. An examination of the financial structure of the company revealed an issue of preferred stock of no par value, preferred as to both assets and dividends. Yet not a word was said anywhere regarding the amount of the preference per share as to assets. It might have been ten dollars or it might have been a thousand. This was merely an oversight on the part of the company and was afterward corrected. Yet in spite of this defect the stock was bought and sold as usual because the company was living up to its contract in so far as the preference as to dividends was concerned. An omission such as this without detriment to the stock raises the question, of course, as to its saving quality when included. But, whether it be valuable or valueless, the prospective buyer will want to make certain of the definiteness of his position.

Is the dividend cumulative, and if so does this feature make more certain its receipt? At present there are listed on the New York Stock Exchange something over three hundred and twenty-five issues of preferred stock, of which about three hundred carry cumulative dividends. This question of cumulative dividends is just now far from academic. Nearly one half of all the industrial and public utility preferred stocks so listed are over $600,000,000 in arrears on their dividends. Some have begun to work themselves out from under the load, many more have not, and some will not. One ought not to judge harshly even when history is on his side, but the prudent investor should certainly raise the question with himself as to whether the preference provisions in the stock he is considering buying belong to that class of worldly benefits which render their most conspicuous service when it is least needed. The investor as contrasted with the speculator will act most wisely perhaps if he confines his purchases to those preferred stocks whose dividends are alive, and leaves to the more speculatively inclined those whose dividends are already dead and bloated, but as yet unburied.

Is the preferred stock under consideration ’par- I ticipating’? This clause, when written into the preferred-stock contract, is a simultaneous appeal to both the conservative and the speculative propensities of the prospective buyer. A participating preferred stock promises a definite amount of dividend per share and at the same time a sharing in whatever other income may be available and paid after the common has also received a stated amount. For instance, a $5.00 dividend on preferred followed by a like payment on common may in turn be followed by a $1.00 payment on both. This part of the agreement is illustrative of how a preferred stock may face in the direction of the bond and at the same time in the direction of the common stock. The extent to which a preferred stock has been able to live up to its participating character is a fact which the prospective purchaser should ascertain.

Is the preferred stock callable? Approximately two thirds of the industrial and public utility preferred issues listed on the New York Stock Exchange are, most of them at prices ranging from $105 to $110. This means that the corporation issuing the stock has retained the privilege of buying a part or all of it back at this price after due notice. This in effect pegs the maximum price, for obviously an investor will not buy to-day for $125 a stock which its issuer has a right to buy back from him to-morrow at $110, Even when an investor buys at around the call price, and at an unusually good yield, he has no assurance that his handsome yield will continue for long.

In the course of the preparation of this paper I picked out at random a very high grade preferred stock for purposes of analysis and illustration. Its dividends were selling for about $0.95 to the $100 of investment, when other good income could be bought for about $4.00 to the $100 of investment. The explanation of this difference was the callable feature. The very certain receipt of $6.25 a year, if the stock was not called, was rendered uncertain because the issuing corporation could terminate it on very short notice, and as a matter of fact it was actually doing so. The yield was very high so long as it should last, but it was not lasting.

Is the preferred stock entitled to vote, and if so under what conditions? A good many years ago an important railroad spent millions of dollars for the common and preferred stocks of a second road, both stocks carrying voting power, in order to get control of the latter. It did gain paper control, but no sooner had it done so than the prospective subsidiary called its preferred stock and killed enough voting power in the hands of its nominal owner to throw control of itself into the hands of a third road which it liked better as a master. Such occurrences are rare and may not be of concern to the average investor. But it does concern him, and may concern him vitally, whether the voting power exists to run in ahead of his claims a mass of bonded and bank debt creating obligations against both assets and revenues prior to his own.

How much more in preferred dividends than in bond interest should $100 buy in the market? This is a general question, but it can be made concrete by an investor who is considering a specific stock. Considerable research seems to warrant the conclusion that in ordinary times one can buy with $100 from $.50 to $.75 per year more of preferred dividends than of bond interest. When the spread exceeds this it will generally be found that something is wrong either with the securities themselves or with the market.

Enough has been said in answer to this series of questions to indicate that no class of securities deserves more scrutiny at the hands of the prospective investor than do preferred stocks.