Preferring preferreds

Published: Dec 3, 2007 12:01 a.m. ET

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Commentary: It's December. Do you know where your dividends are?



Mathew Emmert edits the independent real-time newsletter service Dividend Gambit and is the former editor of the Motley Fool Income Investor. Emmert owns shares of Merrill Lynch and Countrywide-B preferred shares in his model portfolio. (

CHARLESTON, S.C. (MarketWatch) -- There are some opportunities among select beaten-down financials, but with many of their preferreds offering the same capital gains potential, much higher dividend yields, and a bit more security, they're potentially a better way to play this possible bottom.

Stomach-churning volatility aside, there's little doubt some of the premiere names in the financial business have crashed headlong into some attractive valuations.

However, as an analyst who focuses exclusively on the power of dividend-paying investments, the primary challenge for me in this instance is that though I believe many of these firms can ultimately survive these troubled times, several of these formerly untouchable folks are facing rumored dividend cuts.

I mean, let's face it, as we've recently seen in cases like Thornburg Mortgage and Freddie Mac, liquidity problems or unforeseen capital requirements can erase dividend payouts faster than congressional hearings can erase memories.

"I'm sorry, sir, an aide must have paid that dividend because I have no recollection of that payout whatsoever."

Making a preference

Yet all that said, there does appear to be an attractive opportunity for dividend investors to lock in some tremendous capital appreciation potential, along with far more secure yields. And to do so, they just need to be examining some of the preferred stock issuances of these firms as opposed to their common shares.

Ok, sounds easy enough, but what does this mean exactly? Well, despite its name, preferred stock tends to trade more like a bond or other fixed-income security, because the income they pay is typically fixed barring a temporary deferral or an outright default on the security (in which case you'll have bigger fish to fry anyway).

Because I also look for the equally important aspects of capital appreciation and dividend growth when seeking stocks for Dividend Gamibt's model portfolio, and preferreds tend to lack both of these promising benefits, it's not often I find myself holding them. But there are times when you simply get that perfect storm as an investor, allowing you to pick up both growth and massive income from these somewhat safer preferred issues. And that's exactly what we're attempting to do here.

By a Countrywide mile

Clearly the largest independent mortgage issuer in the U.S., Countrywide Financial CFC, +0.00%, has its share of issues, and despite the fact that Friday's 15%-or-so price surge has some pulling up their happy pants, I'd say any realistic investor would still have to classify the status of its common dividend as questionable at this point. Even with the stock having moved from $9 to $14 Friday, it may well still seem cheap at roughly 40% of book value -- but given the unprecedented size of the real estate boom, it just makes sense to me that we're going to see a record-setting bust as well.

So, you can be sure this will be a long recovery. While there will certainly be up days, that means capital appreciation is fairly indefinable in the near term. And without the dividend security propping you up, you could clearly be looking at the distinct possibility of a zero return for some time.

On the other hand, the company has a Class "B" preferred stock issue, Countrywide Capital V 7% Trust CFCPRB. It has a face value of $25, meaning that's the price you'd receive if the security were called or matured, the dates of which are November of 2011 and 2066, respectively (i.e. the actual stated maturity date is 2036, but it's extendable at the firm's discretion for up to 30 more years). In this case, let's say the company does turn around pretty quickly and it decides to call the preferred away from you. In that instance you receive your $25 per stub, representing a 75% capital gain from the current price even after yesterday's 12%-or-so increase (try to hold back your tears of emptiness and loss).

On the other hand, let's say the firm is just able to tow the line for the foreseeable future and has neither the intention nor the ability to call anything. That means you're going to receive your $1.75 annual dividend (a better-than 12% yield on the current price for those playing along on the home game) for possibly the next 58 years, which alone could well represent a market beating return. All told, not a bad risk/reward play.

Finally, though I think it's highly unlikely given the firm states its $5 billion in cash and $33.2 billion in available liquidity will allow it to fund its operating and business needs organically through at least 2008, let's assume the company runs into problems serious enough to warrant a deferral in the preferred dividend payment. Again, this is very unusual without a major default or bankruptcy that impacts everything, but in this case this is a cumulative preferred, which means that you are entitled to all missed payments in addition to ongoing payments once the firm gets back on its feet. Further, if it defers payments as long as five years the covenant says the firm must sell common stock to pay preferred dividends in arrears.

Another possibility

A somewhat less rewarding but also far less risky play is a non-maturing floating-rate preferred issued by Merrill Lynch MER, -1.02%. As a floater tied to 3-month LIBOR, this one can be a solid hedge for those with a lot of fixed-rate exposure. The Merrill Lynch Floating-Rate Non-Cumulative 1 MERPRG adds 0.75% to the 3-month LIBOR rate, which provides a current yield of about 5.9%. But though there's no maturity date, there's still capital upside as the thing is currently trading at about $19 but is callable at $25 a stub anytime after 11/28/2009. That's about a 32% capital gain plus your fluctuating 5.9% annual yield (paid quarterly).

You've also got the added benefits that LIBOR has been soaring lately due to some of the shenanigans with the Federal Reserve and the value of the dollar, making a call more likely if rates continue to rise -- and this one is a traditional preferred so it qualifies for the reduced 15% tax rate on dividends. And though probably unlikely in the case of LIBOR, if rates fall materially, you do have some built-in downside protection with a guaranteed 3% minimum annual yield.

Important notes

There are similar opportunities among pretty much all the financials who've seen trouble lately, especially Bank of America BAC, +1.75%, Citigroup C, +1.47%, and Washington Mutual WM, +0.13% (likely in order of safety).

Volatility with these things is an absolute certainty, so using limit orders and buying in chunks is imperative -- and this is NOT one for those who might need to pop a few anxiety pills between trades.

Also, the covenants or properties of these things make all the difference, but can vary widely. For example, quote services make it really easy to confuse a call date with a maturity date, yet they're completely different things. The best free site on the Web that I've seen to verify covenant information is

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Quote References

  • CFC
    +0.00 +0.00%
  • MER
    -1.05 -1.02%
  • BAC
    +0.58 +1.75%
  • C
    +1.10 +1.47%

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