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Are The Preferred Shares The Way To Go?

10/14/08 11:41:40 AM
by Koos van der Merwe

In today's collapsing market, yields of preferred shares are reaching astronomical levels.

Security:   RBS.PR.M
Position:   Accumulate

A preferred stock is a capital stock that provides a specific dividend that is paid before any dividends are paid to common stockholders. Preferred stock also takes precedence over common stock in the event of a liquidation.

Like common stock, preferred stocks represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. In the event the company goes bankrupt, preferred shareholders are paid off before common stockholders.

In general, there are four different types of preferred stock: cumulative preferred, noncumulative, participating, and convertible, also called preference shares.

So are preferred stocks the way to go? Prices of preferreds are less volatile than ordinary stocks and therefore need less watching. However, the strength of the company issuing the preferred is very important. Warren Buffett recently invested money in General Motors, accepting their preferred shares as security. He is in effective saying, "This is a company that will not go bankrupt, and will honor the dividend promised on their preferred shares." So what else is out there?

Graphic provided by: AdvancedGET.
Figure 1 shows the yield on preferred shares of ABN Amro and Royal Bank of Scotland. These are European banks that have suffered badly in the recent credit crunch. Both are listed on the New York Stock Exchange and can be easily bought and sold. The only problem, of course, is the risk involved. What are the chances of a default on the yield paid? It can be disconcerting to hear news such as that Britain launched its biggest retail bank rescue when the four largest banks -- HBOS, Royal Bank of Scotland, Lloyds TSB, and Barclays -- asked for a combined 35 billion-pound lifeline.

So the question is, will Britain allow the Royal Bank of Scotland to "vanish" from the economic scene in much the same way as Lehman Brothers and others have in the United States. Fear of the unknown is the concern. Is the world at the start of an economic crisis, or is the world starting to emerge from an economic crisis?

Graphic provided by: Omnitrader.
Figure 2 shows how the price of the preferred has fallen from $25.17 in September 2006 to $2.52 as of October 10, leading to the incredible yield of 36%. A yield of this magnitude on its own would and should scare any investor away. Figure 2 also shows how volume increased as the price fell, yet decreased as the price rose. Also note the relative strength index (RSI), which has given numerous buy signals that have failed.

Koos van der Merwe

Has been a technical analyst since 1969, and has worked as a futures and options trader with First Financial Futures in Johannesburg, South Africa.

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