Personal finance advisors often recommend preferred stock to clients who tend to be more conservative. This advice makes perfect sense because from a fixed dividend point of view. Individuals who are interested in proven strategies such as compound interest, which happens to be a favorite of billionaire investor Warren Buffett, generally want to know how much income they will generate because they intend to reinvest in a programmatic fashion.
It is fairly easy to understand why some investors flock to preferred stock, but what about the other side? Why are some companies more likely to issue preferred stock than others. Technology giants such as IBM and Microsoft have always stayed with a strategy of issuing common stock and then buying back shares when the time is right. When we look at the lists of preferred stocks that investment analysts recommend, we tend to see major banks at the top; there is a good reason for this, and we will explain it later as we explore when it makes sense to issue preferred stock.
The first thing to know about preferred stock, which is sometimes referred to as preferential shares, is that it is discretionary. Whereas common shares have to be issued and distributed when a business incorporates as a stock corporation, this is not the case with preferred stock. There are good reasons that call for a preferred stock strategy, and they include the following:
- Retaining control of the company: Since preferred stock does not confer voting rights, board executives do not have to worry about majority shareholders increasing their voting rights through common stock acquisition.
- Fixed dividend payments: Instead of paying out dividends based on a formula that may increase or decrease compared to the last earnings reporting period, companies only need to pay out the stated amount, and this brings a sense of stability to corporate accountants. Preferred stock holders should not be unhappy when holders of common stock get a higher dividend payout in a certain quarter because they are always welcome to acquire common shares.
- Preferred stock agreements: With common stock, shareholders can hold on to their shares for as long as they want. The company may entice them with a repurchase offer, but there is no obligation for investors to sell. With preferred stock, issuing companies can draft contracts that allow them to repurchase share even if the investor does not necessarily agree. In addition to this call feature, a preferred stock contract may have a maturity date similar to a bond, which lets investors know exactly when their shares will be subject to buyback operations.
- Optimal debt ratios: Issuing preferred stock sounds a lot like issuing a bond. The fixed dividends, maturity dates, and repurchase options make these instruments very similar to bonds, but there is a key difference in the sense that they still reflect equity. A company that may have already incurred into debt by means of corporate bonds may be better off issuing preferred stock.
Finally, as for the reason major banks are more likely to issue preferred stock, it is all a matter of financial reporting. Preferred stock appears as a different asset class on the report of bank holding company, and it looks better.
