Below, The Complete Investor explains the benefits preferred stocks can bring to your income portfolio and suggests one great candidate.
“Income Portfolio, no surprise, is shaped to meet the needs of investors whose over-riding investment goal is a nice, steady stream of money for ongoing expenses. To help meet those needs, we’ve always focused more on high-yielding equities than on fixed-income instruments, and this is likely to remain the case. That’s because as a rule we think investors gain more by owning the stocks of companies positioned to increase their dividend payouts—matching or, better yet, outpacing inflation—than by owning debt issued by those or other companies. Fixed-income securities represent borrowing by a company and, once the securities are issued, their payoffs can’t be changed. Thus they’re not the best choices any time inflation is likely to pick up, because the fixed-interest payments you receive from your bonds simply become worth less and less as everything you need to buy becomes more expensive. Moreover, fixed-income securities are subject to interest rate risk. That is, when rates rise—which goes hand in hand with inflation—bonds fixed at a lower payout rate become less desirable and decline in price. In today’s environment, as deflation fears recede, bonds are likely to undergo further correction, making the majority of fixed-income investments even less attractive.
“To lessen the impact of such a decline, the fixed- income positions that we do recommend in Income Portfolio are skewed toward shorter maturities. That’s because typically the shorter the maturity of a fixed-income instrument, the less sensitive it is to the negative effects of higher rates.
“Fortunately for income seekers, the universe of income investments offers a lot more variety than plain vanilla bonds and good old income stocks. There also are various ‘hybrid securities,’ which can help fine-tune an income portfolio to achieve better trade-offs between risks and return. One handy type of hybrid security is preferred stock, which combines features of both equities and fixed-income instruments; while preferred stocks technically are equities, they resemble bonds in key ways.
“This issue we’re adding one such security, the preferred stock of Comcast, to Income Portfolio. Its features are illustrative of preferred shares in general. Much like common stock, the Comcast Corp. 7% Preferred (CCW 25.50 NYSE – yield 6.9%) pays a dividend—in Comcast’s case, a quarterly payment of $0.4375, amounting to nearly a 7% yield. As with common share dividends, the company’s board of directors must declare these payments. Thus while a default on preferred dividends is rare, investors in preferred shares still need to review the company’s prospects and be confident that its cash flow is dependable.
“Unlike stocks and like bonds, preferreds have a face value, which for Comcast preferred is $25. The relevance of face value is that on or after a specified date—akin to a bond’s maturity—a company can call away its preferred shares at face value. If the preferred isn’t called away, it may have an ‘expiration’ or maturity date, which typically is set far in the future. Most preferreds are perpetual. Comcast’s preferred shares could be called away starting September 1, 2011. Currently they’re trading just slightly above the face value; if they were called away, it would be a virtual wash, and meanwhile, for well over a year you’d be getting a nearly 7% dividend. So the call- away risk for Comcast is one we’d readily take.
“Another bond-like feature of preferred stocks is that their dividend payments are fixed for the life of the security. Also similar to a bond and in contrast to common stock, preferreds don’t give investors an opportunity to share in the success of the issuing company and thus offer only limited upside. And like bonds, preferred shares offer some degree of interest rate risk, though they’re generally less sensitive than bonds to interest rate changes. Preferred shares generally trade at a premium to the common stock, offering higher income and less price volatility, and Comcast preferred is no exception.
“Comcast, the largest U.S. cable company, serves more than 24 million subscribers, offering high- speed Internet access and telephone service along with cable. While these primary businesses are capital-intensive, Comcast lately has been harvesting returns on large past investments and has generated record-breaking levels of free cash flow—$4.4 billion in 2009, up 21% year over year, for a free cash flow yield exceeding 10%. In fact, the company has so much free cash that it recently moved to gain control over General Electric’s NBC business. ...
“In 2009’s challenging economic environment it managed to increase revenues by nearly 3%. ... Comcast is a well-run, financially strong company with a proven record of providing market-leading services. Its size gives it a strong competitive edge relative to its peers, and its operating metrics and balance sheet are among the strongest in the industry. The almost 7% yield and a strong BBB+ rating of the Comcast preferred make the case for investing in the preferred stock very strong.”
Stephen Leeb, The Complete Investor
