You can invest like Warren Buffett – Now!

Given the damage to investor confidence and the fear in the market, a relatively safe category of financial instruments are now yielding an excellent return.

This category of financial instruments are the preferred stocks of publicly traded firms. Firms and especially banks issue preferred stock to investors in order to bolster their capital without having to issue additional common stock and hence diluting the value of common stock.These preferred stocks are either perpetual or may be redeemed by the issuing firm after a few years.  There are a lot of other wrinkles that preferred stocks have (like being convertible to common stock etc ) which are not relevant to the current discussion.

The upside for investors in preferred stock is that they are provided with dividends at a fixed/agreed upon coupon rate and these dividends have to be paid ahead of paying any dividend to the holders of common stock. The downside is that preferred stock does not usually appreciate in value similar to common stock. Preferred stock are traded on an exchange much like common stock and have more in common to bonds than to stocks.

Warren Buffett’s recent investment in preferred stock of Goldman Sachs and GE at a coupon rate of 10% has brought these instruments to the spotlight.

While the average investor may not get the same opportunity with Goldman or GE , there are other opportunities out there in the market due to the battering that preferred stocks have received (warranted or not) along with regular common stocks.

Risk and Reward

There are a few risks associated with preferred stocks :

- If the firm goes into bankruptcy, like common stock, they stand in line after creditors. However they get paid before any payments to common stock holders

- If a firm is in dire straits and if it does not pay dividend at all, unlike bond holders, preferred stock holders won’t get paid

These risks are out weighed by

- The tax benefits compared to bonds – these dividends are taxed at the lower 15% capital gains tax rate

- The materially higher dividends paid when compared to common stock and also the relatively stable preferred stock price when compared to common stock price

How to find the right preferred stock to invest in

The site www.quantumonline.com lists most of the traded preferred stocks that are eligible for the 15% dividend tax rate along with their coupon rate. This can be a launch point for your analysis.

There are a few preferred stocks that currently stand out based on their yield and their issuing firms ability to stay solvent in this turbulent environment – either due to the US Government implicit guarantee (Bank of America and JP Morgan) or due to excellent capital structures (HSBC and Allianz)

- HSBC (ticker -HCS) : Based on the current stock price, it yields 9.8%

- Allianz (ticker – AZM) : Based on the current stock price, it yields11.1%

- Bank of America (ticker – BAC-H): Based on the current stock price, it yields 9.07%

- JP Morgan (ticker – JPM-I): Based on the current stock price, it yields 8.6%

These are now worth looking at as a less risky (than common stocks) alternate to investing in bonds or staying in Cash.

Note : No asset class is safe these days with all kinds of  financial instruments which nobody realized existed getting into distress territory due to extreme fear and large out flows from them. The safest asset in the intermediate term seems to be US $ (not even gold) as no country/central bank holding it can afford to exit it without causing irrepairable self damage.