Loading the player...

Over the years, one thing has become clear about legendary investor Warren Buffett. He prefers preferred stock

Whatever his reasons for investment, Buffett has always opted for preferred stock in companies. This holds as true for his $5 billion investment in a beleaguered Goldman Sachs Group Inc. (GS) desperate for capital during the financial crisis as for his more recent investments in Bank of America Corp. (BAC) or Kraft Heinz Co. (KHC) (from which he made a tidy profit this week). 

So, what is it about preferred stock that makes it attractive to Buffett? 

The Two Advantages Of Preferred Stock 

To answer that question, it is important to understand the nature of preferred stocks. 

In their makeup, preferred stocks are much like bonds. They provide yields at certain pre-fixed rates and at regular intervals. They are also inversely proportional to interest rates. However, their returns are higher as compared to bonds because they do not have maturity dates. As a result, the amount of risk associated with preferred stocks is much higher as compared to bonds.  

There are two advantages to preferred stock. The first is its seniority in capital structure: it lies between debt and common stock. Put simply, debt holders and preferred stock owners are paid off before common stock holders, in case the company liquidates.

The second is cumulative dividendAs the name implies, cumulative dividend refers to the accumulation of dividends, if the company misses a payment. To be sure, this does not imply that dividends are guaranteed. But, preferred stock holders receive a sum of missed payments, if the company misses a promised dividend payment. 

For smart investors like Warren Buffett, they have become even more attractive in recent times. Interest rates are historically low and a global economic swoon has reduced avenues for investing. Along with corporate bonds, preferred stocks are a great way to multiple returns on invested capital. What's more, they also offer tax breaks on certain kinds of dividend income for investors.

A Shrewd Investment In Goldman Sachs 

Warren Buffett's shrewd investment in Goldman Sachs is an excellent example of their benefits. In 2008, Buffett invested $5 billion in Goldman Sachs and received warrants (or, contracts to buy stock directly from the firm) worth $5 billion at $115 a share. Goldman's stock was hovering in the $125 per share range on the day that the deal was announced. Thus, Buffett was offered the stock at a heavy discount.   
In 2011, Goldman redeemed Buffet's investment at a 10% premium. At that time, Buffett revisited his warrants with Goldman Sachs and bought 13.2 million shares of the company. At that time, the company's stock was hovering around $163 per share. He sold the stock for a tidy profit in 2013. In all, Buffett made a profit of approximately $2 billion from his investments in Goldman. 

One could argue that this amount was Buffett's compensation for taking an extraordinary risk during fraught times. But Buffett had thought through the extent of his risk-taking. As he put it in an interview: "If I didn't think the government was going to act (to pass the $700 billion bailout), I would not be doing anything this week. It would be a mistake buying anything right now." 

He employed a similar strategy at Bank of America in 2011. He bought $5 billion worth of BoA preferred stock and received warrants to buy 700 million shares of the company for $5 billion anytime before September 2021. As the folks at Motley Fool calculated, the purchase price for BoA stock for Buffett roughly works out to $7.14 per share. That is more than a 50% discount to the bank's closing price of $14.86 yesterday. 

 

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.