Preferred Shares Make Sense

By Will Ashworth | May 11, 2010 AAA

Warren Buffett was asked at his annual meeting May 1 why Berkshire Hathaway (NYSE: BRK.A) invested $300 million in 15% senior unsecured notes in Harley Davidson (NYSE: HOG) at the height of the credit crisis instead of buying the equivalent in stock. He responded that the motorcycle manufacturer wasn't going to go out of business, so he knew he'd get paid, but he had less certainty in the direction of its stock. As a result, Buffett's company will receive $45 million in interest income until February 2014. That looks pretty enticing now that the markets have come back to earth. While it's nearly impossible for regular investors to access lucrative deals such as the one above, it is possible to find preferred shares and other investments providing stable income and reasonable long-term returns.

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Long-Term Stock Returns

Vanguard founder John Bogle's book "The Little Book Of Common Sense Investing" suggests that the total return for stocks over the next 10 years will be 7%. If this is true, then Buffett's decision to take the 15% is incredibly smart despite Harley Davidson stock being up 20.2% year-to-date on top of 50.9% in 2009. While Harley's recent returns are exceptional, its long-term results are mediocre. Its 10-year average annual return is -0.2%. That won't fund much retirement. Should its stock revert to previous form, Buffett makes out like a bandit. If not, Berkshire shareholders simply earn a great rate of interest - one that's hard to come by in today's low-interest environment.

You Can Do The Same

Originally, I was going to write an article about Amerco (Nasdaq: UHAL), the parent company of U-Haul, along with other moving and storage companies. Then I came across Buffett's Harley Davidson answer. I quickly realized the real subject should be to highlight preferred share investments that make sense. One of them just happens to be Amerco, which has an 8.5% preferred stock that pays $2.13 a share annually while its five-year annual average return is just 2.3% and its current stock price sits 51% off the five-year high. Its financial future is assured, but less so is its stock price. Conservative investors should like this play.

Some Additional Options

In a recent article I wrote about Fenimore Asset Management, I highlighted property and casualty company Markel (NYSE: MKL) as one of its top holdings. Markel happens to have a 7.5% unsecured senior debenture due in 2046 but redeemable as early as August 2011. Fenimore investors are good value investors. If they like the company, you can be sure your debentures will be safe. Another option is Ameriprise Financial (NYSE: AMP), which has a 7.75% senior note that matures in 2039. I picked the financial planner back in August 2009, suggesting its stock would get back to $60 in two to three years. Nothing's changed that would alter my opinion. It's a good company, and the note is an excellent way to hedge your bet. A final alternative is to buy the PowerShares Preferred Portfolio ETF (NYSE: PGX), which tracks the Bank of America Merrill Lynch Core Fixed Rate Preferred Securities Index. It currently yields 7.2%. This might be your best bet if interest rates begin to rise and share prices begin to drop. At least then, you can leave the heavy trading to the professionals.

Bottom Line

If you need your investment portfolio in the next five years to fund your retirement, you don't want to put a significant portion in preferred share investments because when the tide turns and prices drop, if you need to cash in some of your chips, you'll likely have less than expected. On the other hand, if you don't need the funds and can invest longer term, Warren Buffett is leading the way. (Offering both income and relative security, these uncommon shares may work for you. To learn more, see A Primer On Preferred Stocks.)

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