Are Preferred Stocks The Answer To The Growth Gap?

In his Financial Peace University classes, Dave Ramsey bases his math for building wealth on a 12 percent return. He tells his participants to “find good growth stock mutual funds that average 12 percent.” I have coordinated and facilitated over a dozen classes since 2011 and I hear many attendees ask “Where does he find these mutual funds that return 12 percent?”

I can tell you from experience that finding mutual funds that average 12 percent in a company sponsored 401k is nearly impossible. That is not to say that a mutual fund within a given 401k plan might not experience a year where it returns 12 percent, but to find one that averages 12 percent is rare. Most 401k plans are limited in scope and often do not provide access to the best funds out there. The new trend is targeted date funds. I have discussed these in my book Simple Wealth Building Strategies and personally stay away from such funds.

Stepping away from the 401k world, because there are no sure-fire winners there that will grow your assets by 12 percent, you will have to look in your IRAs and other investment accounts to achieve this rate of return. You can find mutual funds that average 12 percent over a ten year period, but as every fund prospectus will tell you “past performance is no guarantee of future results.” Therefore, basing your present investment strategy on the past performance of a mutual fund will result in future disappointment because no fund’s return is guaranteed.

Dave does not recommend owning individual company stocks. I differ from him on this, but admit that if you choose to purchase individual company stocks, do your due diligence and move slowly. The three steps to purchasing individual company stocks are research, research, and research. Individual company stocks are not likely to provide the kind of return you need year over year to average 12 percent, unless that return is a combination of dividends and capital gains. But some actually can produce high returns and, therefore cannot be ruled out as a whole. To get high returns with dividends and capital gains, you will have to sell for a gain when the stock’s value grows more than 12 percent. The cycle of buying and selling can result in a diminished return due to the ups and downs of the in-and-out strategy. Therefore, you are not likely to find a 12 percent return in individual company stocks.

Picking a winner in individual company stocks is much harder than it looks and finding mutual funds that will return an average of 12 percent FOR YOU is equally as difficult. So where can a person find an investment that can offer decent returns and bridge the gap between his or her target and reality? I have become fond of holding a select number of preferred stocks offered by companies that have strong fundamentals. Preferred stocks are securities issued by individual companies that act like bonds. They trade like stocks, but pay a fixed rate of interest usually every quarter.

These can pay 12 percent or more depending on the price at time of purchase and the coupon rate (interest rate set on the preferred shares). The greater the discount to par value these stocks are, the higher the rate of return. Most preferred shares have a par value of $25, although some have $50 and $100 par values. This means that when initially offered, the shares cost the investor either $25, $50, or $100 per share. On the secondary market, this price can be higher or lower. The higher the price, the greater the premium, the lower the price the greater the discount to par. When you buy at a premium, you reduce the yield. When you buy at a discount, you increase the yield.

Here are a few simple rules I follow when purchasing preferred stocks. I hope they will help you enhance your investments so you can use stocks to generate the 12 percent Dave Ramsey uses as a target for growth.

Rule number 1 — Always buy at a discount. That’s the first and most important rule I follow. This is important because if the company calls the preferred shares and you purchased those shares at a premium, you lose the amount you paid above par. If a preferred stock has a par value of $25 and you paid $29, you effectively lose $4 per share, which reduces your return. The yield is another important factor when purchasing a preferred stock. A preferred stock that has a yield of 9 percent at $25 will only yield 7.75 percent at $29. However, a preferred share that pays 9 percent at $25 would pay 10.22 percent if you were to buy it at a $3 discount or $22 per share.

If you have to break this rule, don’t pay more than a 1 percent premium or the value of the first dividend for any shares. On a $25 par value preferred share, you should only pay $25.25 per share or if a preferred share pays a $0.68 quarterly dividend, then only pay $25.68 a share. This will ensure that you make back the premium quickly and eliminate any room for loss. Your effective yield will still be lower, but you will have recaptured the premium in the first dividend cycle following your purchase.

Rule number 2 — Only buy shares that are callable exclusively into cash. Convertible shares will convert into shares of the issuer and this can result in a loss in value depending upon the conversion factors. Some shares have convertible options, but I like to stay with those that are callable exclusively into cash. When you purchase these shares at a discount, you stand to increase your return in the event that the shares are called. If you do purchase preferred shares that are convertible, be sure to research the underlying securities to lower the risk of loss of value. It is less complicated when the shares only convert to cash.

Rule number 3 — Always buy Cumulative shares. This means that if the dividend is suspended for any reason, the dividend will accumulate and when it is unsuspended, the company must pay all accumulated dividends. Of course the key here is to continue to hold the preferred shares even when there is evidence that the issuing company might have financial concerns. It doesn’t happen often, but it can and you have to be mindful about this kind of activity. I have held preferred shares for years and have never had a suspended dividend. I have had several companies call their preferred shares, but I have never experienced a suspended dividend.

Rule number 4 — Understand the different classes of preferred stocks. Research all of the preferred classes of stock issued by a company and choose the one that provides you with the greatest amount of ROI. Companies often offer different classes of preferred stocks. The different classes often carry different yields. Purchasing a preferred stock that gives you the best ROI is not always the one with the highest yield. You can find that a preferred stock selling at a discount will produce a better ROI than a higher yielding stock purchased at a premium. If the premium reduces the yield enough, it might be more advantageous to purchase a different class selling at a discount. Do the math. It will be well worth your time in the long run.

Rule number 5 — Find participating preferred stocks if you can. Participating preferred stocks entitle the holder to receive additional dividends (over and above regular dividends) if the Board of Directors declares them. It also allows the holder to financially participate in the sale of the company by receiving the proceeds based on a pro-rata basis. Unfortunately, the majority of preferred stocks are nonparticipating. I have been looking for a list of these so I might be able to do some analysis and determine if it would be to my advantage to add some to my portfolio. Participating preferred stocks are illusive little creatures and often they are reserved for venture capitalists such as Warren Buffett. If you find one, do your due diligence and research, research, and research before you decide to purchase.

Adding preferred stocks to your portfolio can create a simple income stream that takes the money from one company and makes it available to purchase stocks from another. Dividends from preferred shares are added to the cash reserves of your account where it becomes available to purchase other stocks. Here is the strategy. Find three preferred stocks that pay out on different cycles. Each month you will receive a dividend. This becomes the seed money needed to grow your investments and increase your financial resources. This cash can then be used to purchase other investments, or if held in a regular JTWROS account, it can be used to replenish an emergency fund or as a vacation fund.

I prefer to always use the dividend to increase investments. Money unplugged from an investment is unproductive money. Unless you need the money, keep it where it can work for you and take advantage of compounding. Preferred stocks can add a little life to a portfolio in an economy of low interest rates and minimal economic growth.