Preferred Picks for Safe Income

01/31/2014 10:00 am EST

Focus: STOCKS

Jack Adamo

Editor, Jack Adamo's Insiders Plus

For those seeking safe, reliable income in the current low interest rate environment, Jack Adamo sees opportunity in high-quality preferred stocks; here, the editor of Insiders Plus highlights two favorite bank-issued preferred stocks.

Steve Halpern: Joining us today is Jack Adamo, editor of Insiders Plus. How are you doing today, Jack?

Jack Adamo: I'm well Steve, thank you.

Steve Halpern: In your latest newsletter, you note that bonds don't currently offer the return investors are seeking, while dividend stocks appear to be getting increasingly overvalued. To overcome this challenge, you've been looking at a less traditional area, preferred stocks. Can you tell us a little about that?

Jack Adamo: Yes. The important thing to remember about preferred stocks is you're looking at different metrics than you are with other stocks. Normally, with other stocks, even dividend stocks, you're concerned with growth.

With preferred stocks, you're not looking for growth in earnings. What you're looking for is solidity and consistency, financial strength of the company paying. Growth is of a secondary concern. It's only an indication that the company is financially healthy.

That's the primary thing and I think, at this time, with the S&P 500 yielding only 2%, and preferreds yielding 6%, and treasuries yielding, practically, nothing, preferreds have a very important part in a portfolio nowadays.

Steve Halpern: For listeners who might not be familiar with the basics of preferreds, could you just give a brief explanation about what a preferred stock is.

Jack Adamo: Yeah. Most preferred stocks are a floor above equities; they trade just like a common stock, but they are higher in the capital structure, which means that preferred stocks get their dividends paid before any common stock dividends are paid.

And, in the unlikely event of a company being liquidated, preferred shareholders would get compensated, from what assets are left, before common stock shareholders would be, so it's more protection. They generally have higher yields and you sacrifice a little bit of growth for that.

Steve Halpern: Now, you recently recommended two preferred stocks, both of which were issued by banks. Let's look at the first one, which is BB&T Series E Non-Cumulative Preferred Perpetual (BBT-PE). Could you tell our listeners a little about that?

Jack Adamo: Yes. Let's talk about what that title means, Non-Cumulative Preferred Perpetual. Non-cumulative means that if they miss a dividend they are not required to make up that dividend, so when you're looking, generally, you would prefer to have cumulative preferreds, but non-cumulatives are fine if you have a very strong institution.

BB&T has paid dividends back to 1990, which is as far back as I have records, and almost every year they have increased their common stock dividend, almost every year except for 2009, during the crash, when they reduced it, and it's back up to growing.

They have never missed a common stock dividend going back to 1990, which also means that they've never missed a preferred stock, because they're required to pay preferred stock before they pay the common.

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What I'm saying is, that's the important thing to understand about cumulative and non-cumulative. If you're getting a non-cumulative like this one, you want to make sure you have a very strong institution, which we do here.

Steve Halpern: You've also recommended PNC Financial, 5.375% Series Q Preferred (PNC-PQ), which is also non-cumulative. Could you share your thoughts on that position?

Jack Adamo: Yeah, Steve, but let me finish a little bit more about the BB&T one. I want to tell you, as I said, it's important that you have a strong institution behind that, so I want to tell you a little about them.

The preferred stock dividends from BB&T are only 7% of their net income, so, in other words, in the last year, all the money they made after taxes, only 7% of that went to pay preferred dividends, so that is one sign of how strong that is, how safe your preferred dividend is.

Another indication of that is that the Tier 1 common stock ratio, under the new strict Basel III requirements, very high Tier 1 capital ratio of 9.6%, had earnings growth this year.

A little bit slow, but as I said, we're concerned with the shows of strength rather than the slow growth. It has a good return on assets, a good efficiency ratio, and the stock is yielding about 6.5% at its current price.

Now, having said that, let's move back onto PNC. PNC, like BB&T, has never missed a common stock dividend since 1990, again, which is as far back as I have records.

Like most banks, it reduced its dividend in 2009, but in PNC's case, just like BB&T, that dividend is going back up again, and, as I said, it has never missed a common stock dividend, much less a preferred stock dividend. PNC is also yielding about 6.5%.

The preferred stock dividend is only 6.8% at its net income, so again, there's, like, 93% of their net income on top of that, that you have as your insurance.

It has an even stronger Tier 1 capital ratio of 10.5%, so we're talking about two very strong banks, which, nowadays, you have to worry about if you invest in a bank, especially the big money center banks.

They have very high exposure to derivatives and that sort of counterbalances any good they may have on their capital ratios. BB&T and PNC have very, very low derivative exposure. That's a little bit complicated topic to go into, but, you want to stay away from banks that have high derivative exposure.

Steve Halpern: Would you consider both of these to be all buy and hold positions that you would be recommending for long-term investors?

Jack Adamo: Yes. I think they belong as a part of everyone's portfolio at this point, I think, because, as I said, the S&P 500 are yielding only 2%. These are yielding 6.5%.

Even factoring in some growth of dividends on the common stock, you're probably looking at ten years, or more, before common stock dividends and total return would match the returns you're getting on these preferred stocks.

As you get older, of course, this becomes more important. That steady income and higher income becomes a more important part of your portfolio. If you're in your 20s you want smaller, you're going to have children to raise, college to pick up, you want to have these preferred stocks as a smaller part of your portfolio.

As you get older, up in your 50s and 60s or higher, you want these steady dividend, stronger stocks to be a larger part of your portfolio.

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

Jack Adamo: Thanks for calling, Steve. Take care.

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