PrefBlog

A very nice piece by John Heinzl in today’s Globe: An Investor with a Preference for Preferreds.

Update: Finally got a heckler in the Globe’s comments section! An individual who was too ashamed to sign his name wrote:

There is a problem with the authors comment about firs loss protection. Pref Shares are equity from a balance sheet stand point, and the financial regulators treat them as such.

Pref Shares are equity investments with stated yield that must be paid before the common share dividend. THIS IS THE ONLY protection. It is not a bond, meaning the issuer does not have to make good on it to stay in business, nor do pref shareholders have any stake in the event of an insolvent company.

For reference, Please read p. 58 of Benjamin Graham’s book The Outstanding Investor. Or have a read at this study of preferred shares. http://www.pallas-athena.ca/Income_Investing_Preferred_Shares.html

Firstly, I don’t understand the author’s problem with my statement regarding first-loss protection. I was not referring to the balance sheet treatment specified by accountants or the regulatory treatment specified by Basel II – I was referring to the investment characteristic of first-loss protection.

• 1 – How much money did CIBC lose in 2008-2009?
• 2 – How much of this loss was borne by common shareholders?
• 3 – How much of this loss was borne by preferred shareholders?
• 4 – What conclusions may be drawn regarding first loss protection?

I am not aware of any book authored by Benjamin Graham titled The Outstanding Investor and neither is Wikipedia. The commentator may possibly be referring to The Intelligent Investor; I commented on an extract from this book dealing with preferred shares in my early 2009 post, Benjamin Graham et al. on Preferred Stocks. Briefly, Mr. Graham was writing in another time, under a very different tax regime; I agree that under the conditions described, it would be highly unusual for an individual investor to find an attractively priced preferred share – but those conditions no longer apply.

The essay published on the Pallas Athena Investment Counsel website, titled Preferred Shares: A Tutorial again references page 58 of the mysterious book The Outstanding Investor and quotes an extract from it that appears to be a verbatim copy of part of the passage from The Intelligent Investor discussed briefly above.

To be brutally frank, I do not consider the Pallas Athena analysis to be worthy of much detailed comment. Their first example assumes:

the dividend increases by only 27% over the next 4 years to $2.54.
…
Therefore, $2.54 / 4% = $63.50. This is the price that the common shares should be worth at a 4% yield if the Royal Bank dividend on common shares will be $2.54 in 2013. A 27% dividend increase over the next four years is a very likely scenario; especially when we look at the past.

Given these assumptions, why would one ever invest in anything but Royal Bank common?

PA’s second example differs only in the starting price for the common.

This assumption is repeated in the third example. The preferred share used in the example is RY.PR.W at its lowest price, but the authors display their lack of familiarity with the preferred share market with the statement:

We will assume that we the shares are held until the end 2013, a few months prior to the scheduled $25.00 redemption in February 2014. For this reason, we’ll assume that the value of the Series W shares will be $25.00 at the end of 2013.

There is no “scheduled $25.00 redemption in February 2014”. That is when the shares become callable at par, which implies only a ceiling to the potential price, not a floor. This is, of course, favourable to the preferred share, but is inexcusable anyway. Naturally, the authors make the same assumptions about the future common as they do in the other examples (only the purchase price is different), leaving one to wonder yet again: why would anybody ever invest in anything but RY common if these assumptions are to be regarded as solid?

The authors conclude, in part:

The reality is that preferred shares are a tool for companies to increase their profits which is to the benefit of common shareholders or it is a tool for companies to solidify their balance sheet which is to the benefit of the lenders and bond holders.

Certainly, that’s as good a one-sentence explanation of the existence of preferred shares as any, but the authors neglect to inqure as to what price the company is prepared to pay for these benefits.

Preferred shares form a region on the continuum between debt and equity that will be attractive to many. That’s about the only general statement I can make!

I was not able to find composite performance numbers for Pallas-Athena Investment Counsel; if anybody has more luck, please let me know!

This entry was posted on Wednesday, February 3rd, 2010 at 11:18 am and is filed under Press Clippings. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.