Why don’t we have preferred stock in our portfolios?

Question: How does Mills Wealth Investment team think about preferred stock compared to common stock?

This is a pretty detailed in-the-weeds question, but I think the answer can help explain a little about how we think about building “efficient” portfolios that barbell risk assets on one side of the portfolio and high-quality defensive asserts on the other side, typically high-quality bonds that tend to perform well when risk assets sell off.

By controlling the amount that goes into either side, we can build portfolios that tend to create a fairly high degree of certainty of the range of long-term expected returns and the maximum expected drawdown that will be experienced in market selloffs. Armed with this information we can help clients know what to expect as we choose portfolios that can accomplish client goals with an acceptable amount of risk.

First, let me begin by saying all investments at some point in the business cycle can be great investments, especially after periods of duress when yields are 2-3x higher than normal, but generally, you will not find preferred stocks in our portfolio. Let me explain why.
In a normal investment climate, which we define as a period where prices are not at extremely low valuations (typically seen after a severe bear market or period where investors are very pessimistic about the future), preferred stocks will have a higher income than common stocks and usually higher than high-quality bonds.

Many investors tend to chase higher yields, especially during the retirement years when they may want more income. Investors must remember there are no free lunches in markets, higher yields mean higher risk.

How does MWA think about preferred stock: Normally we will not own preferred stocks in a portfolio because the incremental yield from “preferreds” is not high enough in most investment climates to make up for the lack of industry diversification and the amount of preferreds can decline in a market panic.

We would rather own very safe and predictable assets on one side of the portfolio and higher risk (higher returning) common stocks on the other side of the portfolio. A common stock’s price will increase when its profits or the company’s future outlook improves.

Common stock controls the company through voting and tends to pay higher returns than most other types of paper ownership investment structures when the company is successful.

When investing in common stock only a small percentage of the companies that are publically traded drive the long-term returns of the entire market (usually less than 15% of the stocks account for all of the long-term returns of most broadly diversified market indexes). To reduce the risk of owning a poor-performing common stock, We use diversification (the only free lunch in investing) to own a large grouping of stocks (through an Index ETF or Mutual Fund).

By owning a large group of stocks, or multiple markets of stocks, diversification works to improve the certainty of future outcomes. In MW portfolios on the higher-risk side of the barbell, we attempt to remove lower-returning swaths of the market (like real estate, utilities, and preferred stocks) and keep only the areas that offer the highest returns over the time horizon selected.

Assets that fall in the middle of the risk spectrum are typically removed. When rebalancing is applied (this is where we sell the winner and add to the loser and visa versa, the risk is balanced, and maximum returns for the risk are available.

What is a preferred stock?

In a company’s capital structure (who gets paid first in bankruptcy is an important question. Typically, the bank gets paid first then high-quality bonds that may be secured by assets, then higher-yielding bonds that are unsecured, preferred stock and last is common stock.

Even though it is called the stock a” preferred stock,” preferred usually acts more like bonds, but without the protection of being higher in the capital structure of a company. The higher yields on a preferred is not enough to protect from the decline that often occurs if the company gets in trouble or the markets catch a cold.

Another reason we shy away from preferred’ s is the lack of industry diversification. Preferreds are a niche product and are mostly issued by financial companies, and may cause investors to assume more uncompensated credit risk than they realize.

Financials tend to be more cyclical businesses and are correlated with interest rates. In times of economic distress like the financial crisis or COVID-19, financials were hit extra hard. In times of bank runs financials may get hit harder and have a greater risk of going to zero, than other industries, so if investors are not paid a premium for accepting this risk, we generally think this is an area for most investors to avoid.

When building a low-correlation diversified portfolio, we want assets that zig and zag differently. In rising markets, we want the highest-returning assets. In market declines we typically want to own the safest assets that tend to rise or at least not fall as fear spreads. Because preferred stocks are in the middle of the risk spectrum, they tend to offer higher yields with less protection.

We generally think most investors will find better portfolio investment returns for the risk by combining super safe, diversified credit investments with pure common stocks which have much more expected returns. By combining the two and systematically rebalancing, selling the winner and buying the loser and visa versa, as prices move, a portfolio approach can often provide higher safer returns for the risk taken.
Mike Mills