Barbells and Preferreds

10/04/2013 10:00 am EST

Focus: STOCKS

Jack Adamo

Editor, Jack Adamo's Insiders Plus

Income expert Jack Adamo believes it is now time to build positions in preferred stocks; below, he explains why and discusses two of the initial preferreds that he is adding to the model income portfolio at Insiders Plus.

Steve Halpern: We're here today with Jack Adamo, Editor of Insiders Plus. How are you doing, Jack?

Jack Adamo: I'm well, Steve. Thanks.

Steve Halpern: You've long been considered among the advisory world's top experts on income investing. Today, we're going to discuss a specific sector of the income universe, preferred stocks. First, could explain what preferreds are and how they differ from traditional shares?

Jack Adamo: Yeah, the difference between common and preferred stocks is that preferred are higher in the capital structure, which means, in the event of liquidation of the company, preferred shareholders get paid before common shareholders.

Of course, they're kind of between bonds and stocks. They are lower in the capital structure than bonds, higher than stocks, and higher than common stocks. They also typically will pay, there are a few exceptions, but typically, they pay a solid steady dividend that does not vary, unlike a common stock dividend, which may vary.

The preferred is the same every year quarter until, it either is redeemed, in the case of redeemable preferred, or perpetually, in the case of perpetual preferred.

Steve Halpern: You note in your recent research that you've been focused on real estate investment trusts and MLPs as income vehicles that you preferred, but you've recently been shifting your attention to the preferred sector, why the change of heart?

Jack Adamo: Yeah, that's been occurring gradually over the last few years for two reasons. The REITs are getting very overvalued and the MLPs are as well, less so, but their yields are not what they used to be. Two years ago you used to be able to get MLPs with yields of 7% to 9% quite easily and quality MLPs.

MLPs have certain stepped tax structures that makes them a little bit more expensive to handle for your accountant and they're not appropriate for tax-deferred vehicles like IRAs, et cetera, where REITs are.

Preferred now are giving higher current yields. They're less overvalued. They're not overvalued in my view with most of them. They have less tax hassles usually.

Steve Halpern: Now, you recommend an approach called a Barbell Approach, in which you buy both the preferred and the common stock, to get a better balance for both long-term growth and current income. Can you explain this Barbell Approach to preferreds?

Jack Adamo: Sure, Steve, yeah, well, the only problem with preferred stocks, every investment has it's pluses and minuses, the preferreds generally have higher, not always, but generally, have higher dividends than the common stocks; however, as I mentioned before, that dividend remains the same, never grows in 99% of the cases.

Common stocks, the dividend will grow over time, provided that it's a good company and it grows. What I've been doing now, I've been buying some of a good common stock that has had good long-term track record, and a good preferred that goes with it, that have a higher current yield.

Now, the preferreds, nowadays, the preferreds I'm buying, usually the lowest one I'm buying is around 6.5% for the current yield, whereas the common stock, the S&P 500 average common stock yield is 2.66% over the last five years. It's even lower now.

The rate of growth on the dividend is only 5%. In terms of dividends, it would take 32 years for the S&P dividend to grow to the dividend in aggregate, to grow to the dividend in aggregate to common stocks, so there's...to the preferred stocks that I recommend. So, it's better for the current income aspect to have these preferred.

On the other hand, if you have a superior common stock, like the ones I'm buying, you're going to get some boost on the growth side too, even ten years out, when the total return on a good stock would normally be catching up with the total return on a preferred, this way you're getting some of both.

You've got that solid reliable income for ten years and the growing income from the common in the interim that will eventually surpass it. It's a really good, as I said, Barbell Approach that will give you really good current income and good long-term growth.

Steve Halpern: Let's look at your strategy in terms of some specific issues. One of your new recommendations for your high yield portfolio is Annaly Mortgage Management 7.875% Accumulative Series A Preferred (NLY-PA). Could you tell us about Annaly and this preferred in particular?

Jack Adamo: Yeah, the preferred, as I've said, as you mentioned, has about a 7.92%, their current yield, it's set up from a mortgage investment trust. A mortgage real estate investment trust called Annaly Mortgage Management (NLY).

It's been around for a long time. It's done well for a long time. It's up about, not quite, triple in the last ten years. It was doing better than that, but the real investment trusts that are mortgaged back are getting beaten up pretty much lately. It's down quite a bit. It's always been a volatile stock.

As I said, you can pretty much rely on that to triple every ten years. There's a lot of attention to this group now. It might be a little bit lower going forward. As I said, with all the ups and downs, that's what it's done over the last ten years.

It actually, and this is a rare instance where the common stock here, in this case, it's actually a common real estate investment trust, actually has a higher dividend than the preferred. That's not normally the case. This is very unusual, but mortgage backed REITs do have higher yields.

In this case, you're looking at somewhere in a 10% to 12% range on the Annaly common, NLY is the symbol.

Whereas, the preferred gets a little closer to 8%, but I like the paired trade of the barbell trade here anyway, because the preferred is much more stable. It's much more stable. You can rely on that every year. I think it's good. There're a lot of dividends to go around and, as I say, this is a stable aggregate.

Steve Halpern: Another new recommendation is Cullen/Frost Bankers (CFR). There you've been recommending the 5.375% Perpetual Preferred Series A (CFR-PA). Now, you call Cullen/Frost one of the best little banks in Texas. What makes this such an attractive issue?

Jack Adamo: Well, again we have a company with a really great growth rate. It's about in the two-and-one-half fold in the last ten years. That growth rate has accelerated quite a bit over the last two years.

It's one of the most highly recommended stocks by R. Christopher Whalen, who is the best bank analyst anywhere.

He's held a number of government positions related to regulation, et cetera. He's now a principle in three different investment firms.

He's a regular guest on Bloomberg's and simply, without a doubt, the most knowledgeable banking analyst. This is one of his favorites. The common stock has got a decent yield on its own. It's yielding about 3%, a hair under 3%.

The preferred they have, its current yield is about 6.46%. If it gets redeemed, this one is redeemable, it's redeemable in 2018, if it gets redeemed, the annualized rate of return will be 9.4%. It probably won't get redeemed. If it does, that's an extra boost, which that again is 6.5%; you're getting about 9.4%.

Steve Halpern: Is that a situation where you would also look at a Barbell Approach buying both perpetual preferred along with the common?

Jack Adamo: Yeah, that's why I said the common has a decent yield, about 3%. It's got good growth. The perpetual preferred is about 6.5%, so you're doing really well there.

Steve Halpern: Finally, you point out that both of the preferred that we've discussed here today are eligible for a specific tax break. Could you explain to us nerds what you mean by that?

Jack Adamo: Now only one of them, Steve, may be, I don't know if I mentioned that in my original write up, but because Annaly is a real estate investment trust, it is NOT eligible for the lower dividend tax rate that is part of the tax structure nowadays.

REITs already get a tax break at the corporate level. They're not taxed at the corporate level, so all real estate investment trusts, not just this one and not just preferred, are taxed as ordinary income.

They do better in an IRA or 401(k), or Keogh, et cetera. You get the better tax rate. On the other hand, the Cullen/Frost, both the preferred and the common, they are eligible for the reduced dividend rate.

Steve Halpern: Thank you very much for joining us today. We really appreciate your insights.

Jack Adamo: Steve, it's always a pleasure talking to you. Thank you.

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