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Most investors focus on buying and selling common shares of stock but preference shares, also called preferred stock, can be a lucrative investment vehicle as well.
Preference shares combine some of the benefits of corporate bonds with some of the characteristics of common shares. Their primary benefit is that they always pay a dividend to their shareholders.
Preferred shares come in several varieties including callable, cumulative, convertible, and participatory. Each has distinct differences.
Understanding Preference Shares
Preference shares get their name from the fact that their shareholders have a higher claim on the issuing company's assets than common shareholders. The company has committed to paying a dividend. The amount of the dividend may be fixed or may float with the value of an interest rate benchmark.
In the most extreme case, if the company goes bankrupt, preference shareholders must be repaid before common shareholders.
Short of bankruptcy, preferred shareholders are paid dividend payments at a fixed rate. Common shareholders may or may not get a dividend, according to the decision of the company's directors.
In exchange, preferred shareholders give up the voting rights that common shareholders enjoy.
Callable Preferred Shares
Callable shares are preferred shares that the issuing company can choose to buy back at a fixed price in the future.
This stipulation benefits the issuing company more than the shareholder because it essentially enables the company to put a cap on the value of the stock.
For example, if the company retains the right to repurchase callable shares at $45 a share, it may choose to buy out shareholders at this price if the market value of preferred shares looks like it might exceed this level.
Callable shares give the company the power to limit its maximum liability to preferred shareholders.
Convertible Preferred Shares
Convertible shares are preferred shares that can be exchanged for common shares at a fixed rate. This can be lucrative for preferred shareholders if the market value of the common shares increases.
For example, assume an investor purchases five shares of convertible preferred stock at $50 per share. Each of those shares of preferred stock can be converted to three shares of common stock. The investor will make a profit on the initial $250 investment if the five preferred shares are converted to 15 common shares when the value of common shares moves above $17 ($17 * 15 = $255).
Once the shares have been exchanged, the shareholder gives up the benefit of a fixed dividend and cannot convert common shares back to preferred shares.
Shares may also fall into the category of participating convertible preferred (PCP) stock, which has additional benefits.
Cumulative Preferred Shares
Preference shares that include a cumulative clause protect the investor against a downturn in the company's profits. If a company has missed any dividend payments in the past, this clause requires it to pay the dividends it owes the preferred shareholder before any are paid to common shareholders.
For example, if a company guarantees dividends of $10 per preference share but cannot afford to pay it for three consecutive years, it must pay a $40 cumulative dividend in the fourth year before any other dividends can be paid.
Participatory Preferred Shares
All preference shares have a fixed dividend rate, which is their chief benefit. Participatory preference shares provide an additional profit guarantee to shareholders.
That is, participatory shares guarantee additional dividends if the issuing company meets certain financial goals.
For example, if the company has a particularly lucrative year and meets a predetermined profit target, holders of participatory shares receive dividend payments above the normal fixed rate.
The Bottom Line
Preference shares are an option for investors looking for a relatively stable source of income. Their prices are not as volatile as those of common stocks. They are not bought for a quick profit. They are bought to provide a steady stream of payments.