Hello friends, in this article, we see the chapter 14 summary of the book Security Analysis. Chapter 14 is all about the What is Preferred stocks, and their origin story, and also their advantage and disadvantage.
Preferred Stocks Analysis:-Security Analysis:- Chapter 14
So, from this chapter, we discuss the only preferred stocks, and their Analysis based on the Advantages and Disadvantages of the Investor to buy that preferred stocks. let’s start
The author told, In The Intelligent Book also is that Preferred stocks are not Attractive Investment, it is Unattractive Investment.
The author says, ” Preferred stocks represent an Unattractive form of investment.”
so let’s find out why
Because 1st reason is that the Preferred stocks Principle and their income return is limited. whatever they told first is that amount only paid by the company.
and Second Reason the author told, is that Those are Preferred stocks holder, they don’t have any Claim on company. or in the author’s words is that ” Interest payment gets at any cost.”
and also Author says, ” Preferred stocks are the Limitations of Bond and Stocks Mixers, and Preferred stocks are more vulnerable than bond at the worst Condition of company.” (Security Analysis Chapter 14)
Because preferred stocks have a claim after Bond Holder.
What is the difference Between Bond and Preferred Stocks? (Security Analysis Chapter 14)
The difference is that those are bond interest is compulsory to pay by the company, if the company is not paying, this type of company called a Defaulter.
Those are preferred stocks Dividend payment depends on the Board of directors of the Company, they pay or not pay.
If a company’s earnings are good and also make more than the preferred stock’s dividend, so usually preferred stock payment is done, but in this claiming point of preferred stocks looks unusefulness ( no benefited ).
If Companies Perform Bad and they generate very low earning, so bondholders have a claim on the Asset of the company, but they don’t have Practical value of that asset just like, we discussed in the bond Analysis series in all previous chapters. (Security Analysis Chapter 14)
Because, If the business fails, then properties value also fail, means decreases
so Investor think and they make the general rule, ” Bond instruments form is not have the special advantage as compare to preferred stocks. If the company is good then preferred stocks and bonds are also good. If the company is bad, then the bond is also bad.”
Read this again and think above two lines.
But the author says, ” this type of investor thinking is not good. Preferred stocks are weaker than Bonds.”
Because, bondholders get the money but those are directors of the company, they stop preferred stocks dividends.
why this happen
Because, if the company is capable, but they don’t pay preferred stocks dividend, and they give a reason like, that the Company has the good time in future, for that purpose they suspend the dividends of the preferred stocks. and say if the company grows, then you get the benefit also. for example, like, the company wants to expand.
that’s why they try to collect cash and save cash or in future any emergencies come, for that emergencies, they save the cash to deal with that problem. (Security Analysis Chapter 14)
so this happens with preferred stocks dividends.
so those are preferred stocks holder have the following types of conflict problem
Conflict of Interest come to Preferred stocks Holder:- Security Analysis Chapter 14
1 ) first is that what happens in the company I don’t care, I just want the continuous income.
2) Second is, If Company suspends the dividend, in the future, the company will perform well and become a great company.
and If the company uses the proper money of the holder of the preferred stock, then they get a good return on that money in the future.
so these two types of conflict of interest come to preferred stocks holder, and also a conflict of interest come between preferred stocks holder and commons stocks holder
Because, if companies director stops payment of preferred stocks dividend, then this money helps to build a company or grow the company.
so Because of this activity, common stocks holder get more benefits than the holder of the preferred stock
how this when, let’s see
When a company grows, then earing grows and share price is also growing so that’s benefit goes to the Common Stocks holder.
Preferred Stocks holders, not get the benefit of the company growth, because they get regular, whatever the dividend payment. This payment depends on what decides when we buy that preferred stocks.
So being great company, they don’t get benefit or advantage of that great company, as much as we see one side.
On the Other Side, The common Stocks Holder gets a benefit on earning and the preferred stockholder gets a benefit on companies expenses.
And also Board of Director of companies have also the conflict of Interest
Many times, they favor Common stocks holder, more than preferred stockholders, because they give the vote for the selection of companies’ board of directors. (Security Analysis Chapter 14)
Or In many times, the board of directors is not favored for common stocks holders, instead of that, they favor Management people.
Because, they get the salary, from the management. so many times, they don’t see the best interest of the common stockholder or preferred stocks holder, instead of that, they only see their own best interest.
Then the author says, ” this is the weakness of preferred stocks holder as compared to the bondholder.”
there is only one solution is that Preferred stocks holder has to be voting rights on the enterprise when the dividend is suspended by the director, then preferred stocks holder have to be immediately voting control to put money in the right place.
But practically is not happening. If in any company happen like this then preferred stockholder not take good advantage of that voting right.
So this thing of control also becomes useless.
Then after this author says, ” Yield or risk is not Commensurable.”
High Yield is not offset High risk
If you buy preferred stocks, and you have fear is that you will lose your principal amount and for this offer company give you a high dividend yield. so for this, they don’t offset.
What thing is offset is the thing is you have to get a good chance of principle profits, without losing it.
let’s see some qualifications of preferred stocks
Qualification of Preferred Stocks:
Here is one question come is that what criteria to buy preferred stocks
The author says, ” there are Three criteria for buying preferred stocks.”
1) Preferred stocks, have to fulfill the Minimum requirement of bonds
2) Exceed these minimum requirements by a margin to offset discretionary Feature of Dividend payment ( means those bonds minimum requirements, they have to exceed well with good margin)
Because we have those risks ( which risk) is the board of directors of the company can suspend our dividend payment, because, they have the power for this.
then author show, the 21 companies list, in those company have preferred stocks that were listed on New York Stock Exchange in 1932.
Between 21 companies only 5 companies perform well in depression also.
then, the author says, ” Sound Preferred stocks are not impossible things, but it is exceptional phenomena.”
exceptional because sound preferred stocks are the mistakes of the company. (Security Analysis Chapter 14)
The mistake is, because, the company can issue bonds but they issue preferred stocks.
If they issued the bond, they get the Tax benefit, but on preferred stocks, they don’t get that benefit.
If preferred stocks perform well, then the company don’t get benefit from them, because the preferred stockholder is only benefited.
and on dividend company have to pay tax.
The author says, ” Issuing preferred stocks only benefits the company, because, they can stop any time dividend of preferred stocks.”
If the company is not suspending the dividend of preferred stocks, then the benefit is going to the holder of the preferred stock, because, company issues bonds but they issue preferred stocks and they don’t get tax benefits also.
Now some Investor says, Like that, We don’t agree with this, because the company is giving limited income to the preferred stocks and the company can invest properly money, that comes from by issuing preferred stocks and can get the better return on their investment ( that money come from by issuing preferred stocks). Whatever company pay to preferred stockholder on that basis company earn double profit. so this benefit gets the company.
But, the author tries to say is that ” the main purpose of preferred stocks is that company can suspend dividend at any time.”
So in this case, then the author is right.
Because in this case the only company is benefited
If the dividend suspends the loss goes to the preferred stockholder and if the dividend payments, then the company gets lost. (Security Analysis Chapter 14)
So if this type of Problem happen in preferred stocks, then why this is very much popular ( in 1940 before)
then the author says, ” just before the first world war, the majority preferred stocks is the industrial issues and they have speculative natures.”
Because they get discounted price than the par value. so profit possibility is moe and after that continue for 15 years got prosperity in the USA in 1920 on this basis preferred stocks give the awesome return.
On this basis, preferred stocks perform better than bonds, but actually, that is not.
Then the author talks about the study of the University of Michigan.
The University recently study ( 1940) and then, the author observes and prove that
Preferred stocks are without bond is better than preferred stocks with bond.
This means, If a company issue bond and preferred stocks and you buy preferred stocks of this company so this is not a wonderful idea, instead of that you can buy the preferred stocks of those company that don’t issue bonds.
When adverse development happens means depression/ recession comes, then company earnings decrease, so in that, if the company has issued the bond, then this bond gets benefited, than preferred stocks. so buy only those companies’ preferred stocks, they are not issued the bonds.
The other thing, the author observe from the Michigan university’s study is that preferred stocks stability depends on common stocks stability.
If common stocks decline then preferred stocks also decline.
then Author says,” is like, if Head’s come win common stocks, and if tail comes, preferred stocks lose.”
Why do common stocks holder win?
Because Heads means the good performance of the company and common stocks holder get unlimited capital gain.
And tail means, Company perform badly then preferred stocks also decline in values, as same as common stocks holder.
If Investor Analysis is good and they think in the future company give a multi-bagger return, then why do you buy preferred stocks instead that buying common stocks and participating in profit.
If the Investor is doubtful then buy the preferred stocks, why this doing is good
because they have to take risk of principle by buying Common stocks.
so they get lost, so they don’t have to do, at that point they get the good opportunity to principle profit.
so this is all about Chapter 14 of the Security Analysis book by Benjamin Graham and David Dodd.