Preferred stock is an equity security that gives its holders certain priorities over common stockholders. Common stock investors may buy and sell common stocks for capital appreciation, but the best way to maximize the advantages of preferred shares is to hold them long-term.
High Dividend Income
The main advantage of preferred stocks is high dividend income. Preferred stocks pay higher dividends than common stocks. The longer a preferred stockholder holds his shares, the more dividend income he receives.
Preferred stocks are usually issued with a fixed dividend, so preferred shareholders know exactly how much they are going to receive each quarter.
Preferred stockholders have priority over common stockholders in receiving dividends. When a corporation declares dividends, it must pay them on preferred stock before paying them on common stock. A corporation can cut or suspend dividends at any time, but this is considered a last resort, when a company’s survival is at stake. Even then, the dividends on cumulative preferred stock continue to accrue to the shareholders and must be paid in full before any other dividends may be resumed.
Preferred stockholders have priority over common stockholders in filing claims against corporate assets in bankruptcy liquidation, so holding them is safer than holding common stocks. The high dividend causes them to fluctuate less than common stocks, because a decline in preferred share prices makes them more attractive to income investors, whose buying can stem or even reverse a preferred stock’s decline.
Return of Principal
Preferred stocks are issued with the par value at which they may be called (redeemed) by the issuer. If a preferred stockholder holds his shares until they are called, he will get back their stated par value. If an investor buys preferred shares at a discount to par, he stands to realize a capital gain in addition to collecting the dividend income.
Preferred stocks have several limitations when compared to common stocks: no voting rights and limited upside potential. Small retail investors generally do not fret over lack of voting rights: the number of votes a stockholder has equals the number of shares he owns, so a small stake does not give an investor much influence over corporate affairs. The limited upside potential stems from the call feature -- the ability of the issuer to call, or redeem, preferred shares at a pre-determined price: investors who know that their preferred stock can be called from them at a certain price will not be willing to pay a premium over that price.
- “PassTrak Series 7: General Securities Representative License Exam”; Dearborn Financial Services; 2003