Prefer Distressed Stocks? Then Buy Distressed Preferred Stocks

By Alexander MacLennan - August 24, 2012 | Tickers: C, NBG, NBG-A | 0 Comments

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When companies encounter tough times their shareholders suffer as earnings decrease, growth estimates are cut, and financial difficulties threaten to drag the entire company under. However, it is companies like this that often end up becoming the greatest turnaround stories. Skilled, diligent, or just plain lucky investors can more than double their money.

But investing in a turnaround is not easy. Many more investors get burned as their companies fail to reverse their fall. Other investors get diluted into oblivion as secondary offerings are done to raise capital or debt is exchanged for equity. But there is another way to bet on a company's recovery with less risk of dilution and a slightly larger safety net in the event of bankruptcy. And these shares are preferred stock.

A Comparison to Common

When companies are looking to raise capital, they often do so through an issuance of preferred stock. Preferred stock is best thought of as a hybrid between debt and equity. Investors are paid a dividend on a regular basis as described in the prospectus of the issuing company. However, companies are allowed to suspend their dividend without being forced into bankruptcy. Depending on the preferred stock, dividends may or may not be cumulative, that is the company would have to pay previously missed dividends in the future. Preferred stock also has a liquidation value which is often $25 per share but can vary dramatically depending on the issuer.

Most importantly for a turnaround investor, preferred stockholders rank higher than common stockholders. In the event of a bankruptcy, preferred stockholders will receive more than the common stockholders, who are normally wiped out. But preferred stock still ranks behind bonds and bank loans, so preferred holders do not usually emerge from a bankruptcy with their investment completely intact.

Holders of preferred stock can still make significant gains from a turnaround with returns that sometimes even rival those of the common stockholders. While share dilution can hold back the recovery of the company's common stock, the liquidation value of preferred shares remains the same. Sometimes this allows the preferred shareholders to recover all of their lost value while the common share price has little hope of ever reaching its highs again because of dilution. However, the biggest gainers from a full recovery are typically the common stockholders because the common falls the furthest allowing investors to buy at a lower bottom. But sometimes preferred stock represents a better value than the depressed common and that is when investors have to ask themselves not if they want to bet on a recovery, but how they want to.

The Great Citigroup Recovery

When the markets began to melt down in 2008, Citigroup (NYSE: C) investors fled both the company's common and preferred stocks in fear of a total collapse. Fortunately for Citigroup, Uncle Sam rescued the company by taking an equity stake in the company. The issuance of equity to the federal government diluted common stockholders but the liquidation value of the preferred shares did not change. When fears subsided, the common stock rose from just under a dollar to briefly peak around $5 (Common stock prices given are pre-reverse split since these prices better reflect the actual recovery of the stock over this time frame).

That's a gain anyone would be happy to have in their portfolio, but preferred stockholders who bought at the bottom earned even more in this recovery. Common stockholders gains were restricted by the share dilution from the sale to the government. In fact, for Citigroup common stock to return to its pre-recession high, the company would have to be worth over $1.5 trillion. Preferred stockholders maintained the same liquidation value on their shares and saw their shares rise from a record low of around $5 per share, back to near their $25 liquidation value where they trade today. As a bonus, preferred stockholders were collecting a dividend of about 6%, varying by the issue of preferred, on the liquidation value during the recession when dividends were eliminated for common stockholders. Even now common stockholders receive only four cents as a year of dividends.

Another Recovery to Come?

With the recoveries executed by so many of America's banks, it may be time to look at other banks with publicly traded preferred stock. Greece's largest bank, National Bank of Greece (NYSE: NBG), issued a series of preferred stock that trades on the New York Stock Exchange. National Bank of Greece preferred stock (NYSE: NBG-A) currently trades just above $3 per share. The current discount to the liquidation value of $25 per share comes from fears that the Greek debt crisis will threaten the bank. Currently the bank has suspended the dividend on the preferred stock to conserve cash, which has further depressed the value.

But neither the Greek government nor the euro zone is likely to let National Bank of Greece fail completely. If the decision is made to recapitalize the bank, common stockholders will likely bear the most losses with their stakes being significantly diluted. Being higher up the in the repayment order, preferred stockholders are less likely to be hurt by a recapitalization, and their liquidation values will likely be left alone. Preferred stock is still at risk of being wiped out; it is just less likely to be wiped out. This presents another way to invest in National Bank of Greece that may even outperform the higher risk common stock in the end.

The Advantage of Being Preferred

While common investment logic tells us that higher risk should mean higher reward, this is not always the case. With preferred stocks, one can avoid the pitfalls of share dilution and being last in line in a bankruptcy. Preferred stocks are not always the best way to bet on a recovery since common stock is designed to follow more closely the overall valuation of the company. However, the numerous types of securities offered to everyday investors means that we have to do our research to find the best option for us. And sometimes the added security of preferred stock, a more constant dividend, and a potential for multi-bagger returns is just enough to convince us that we want to invest in a recovery through non-common stock means.

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