Following Buffett and Keynes

01/05/2009 10:33 am EST

Focus: FUNDS

Mark Skousen

Editor, Forecasts & Strategies, High-Income Alert

Mark Skousen, editor of Forecasts & Strategies, recommends a fund that buys preferred stock like two investment masters.

Warren Buffett knows how to make money in a bear market. Not that his Berkshire Hathaway (NYSE: BRK-A) has been a winner this year—it’s down 40% in 2008. But when Buffett invested in Goldman Sachs two months ago, he took preferred stock yielding 10% to limit his downside risk.

Preferred shares are like unsecured bonds, but they are senior to common stock (in case of bankruptcy, he gets paid before the common shareholders), and paid a 10% annual dividend. If Goldman Sachs wants to retire these preferred shares, the company has to pay Buffett a 10% premium to their face value. (The vast majority of preferred shares are callable at par, not at a premium.)

The British economist John Maynard Keynes managed money for King’s College at Cambridge University during the 1929-1946 period, which involved the stock market crash, the Great Depression, and World War II, yet he managed to make 12% a year during this 17-year period.   
 
How did Keynes achieve such a remarkable success? He acquired preferred shares of big utility holding companies in the United States. “They are now hopelessly out of favor with American investors and deeply depressed below their real value," he said.
 
He bought, among others, National Power & Light Preferred, which he noted, yielded 15%, was awash with cash, and whose earnings were rising again.
 
His bet proved to be highly profitable, as his preferred stocks doubled and tripled in value during the next few years.  

If you want to follow Keynes’s [and Buffett’s] idea of buying preferred stocks, I recommend that you buy the John Hancock Preferred Income Fund (NYSE: HPI), a closed-end fund that uses a value-oriented approach to invest in preferred stocks and other fixed-income securities which are rated investment grade by Moody’s or Standard & Poor’s.

The fund currently pays a monthly income of 15.5 cents a share for a current yield of 12.8%. If the economy recovers, as I expect it to do in 2009, you could make a substantial capital gain, plus the dividend yield.

When I first recommended it in [December], it was selling at a discount to net asset value. Since then, the discount has disappeared and it’s now selling at a 16% premium over its NAV ($12.90). [At Friday’s closing price below $15,] it’s gotten a little ahead of itself. Wait for the price to come down a bit before buying more. 

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