Convertible Preference Shares or Preferred Stock

Preference shares can be classified into the following categories:

• Cumulative
• Non-cumulative
• Participating 
• Non-participating
• Convertible

Convertible Preference Shares

These are convertible into a specified number of common shares based on a conversion ratio that is determined at issuance.

They have the following advantages:

• They allow investors to earn a higher dividend than if they had invested in the company's common shares.
• They offer investors the opportunity to share the profits of the company.
• They allow investors to benefit from a rise in the price of common shares through the conversion option.
• Their price is less volatile than the underlying common shares because their dividend payments are known and more stable.

Convertible preference shares are becoming increasingly common in venture capital and private equity transactions.

Stocks and Bonds

The balance sheet helps us understand the overall financial health of a company.

A major factor in determining financial health is the company's underlying capital structure.

What is the best way to capitalize a company?  Is it equity or debt?  The answer is that it depends, as both debt and equity have their advantages.


Debt

Debt offers the following advantages.

1.   Lenders have no direct claim on future earnings.  Debt can be issued without worries about a claim on earnings.  As long as the interest is paid, the company is fine.

2.  Interest paid on debt can be deducted for tax purposes.

3.  Most payments, whether they are interest or principal payments, are usually predictable, and so a company can plan ahead and budget for them.

4.  Debt does not dilute the owner's interest, and so an owner can issue debt and not worry about a reduced equity stake.

5.  Interest rates are usually lower than the expected return.  If they are not, a change in management can be expected soon.



Debt securities can take a number of different forms, the most common being bonds.

Bonds are obligations secured by a mortgage on company property

Bonds tend to be safer from the investors' standpoint and therefore pay lower interest.

Debentures, in contrast, are unsecured and are issued on the strength of the company's reputation, projected earnings, or growth potential.

Debentures, being far riskier, tend to pay more interest than do their more secure counterparts.




Equity

Equity has the following advantages:

1.  Equity does not raise a company's break-even point.  A company can issue equity and not have to worry about achieving performance benchmarks to fund the equity.

2.  Equity does not increase the risk of insolvency, and so a company can issue equity and not have to worry about any subsequent payments to service that equity.  Equity is essentially capital with unlimited life and so a company can issue equity and not have to worry about when it comes due.

3.  There is no need to pledge assets or offer by personal guarantees when equity is issued.



Equity can take a number of different forms.

A simple form of equity is common stock.

This type of stock offers no limits on the rate of return and can continue to rise in price indefinitely.

There are no fixed terms; the stock is issued and the holder bears the stock.

Preferred stock entitles the holders to receive dividends at a fixed or adjustable rate of return and ranks higher than common stock in a liquidation.

Preferred stock may have anti-dilution rights so that in a subsequent stock offering, preferred stockholders may maintain the same equity stake.

Convertible securities are highly structured in nature and are based on certain parameters.  As the word convertible indicates, they may convert into other securities.

Among the most common are warrants and options.

Warrants and options stand for the right to buy a stated number of shares of common or preferred stock at a specified time for a specified price.

There are also convertible notes and preferred stock, which refer to the right to convert these notes to some common stock when the conversion price is more favourable than the current rate of return.

Approach to Convertible Issues

An illustration on convertible issue

The fine balance between what is given and what is withheld in a standard-type convertible issue is well illustrated by the extensive use of this type of security in the financing of American Telephone & Telegraph Company.

Since 1913 the company has sold at least seven separate issues of convertible bonds, most of them through subscription rights to stockholders.

The convertible bonds had the important advantage to the company of bringing in a much wider class of buyers than would have been available for a stock offering, since the bonds are popular with many financial institutions which possess huge resources but some of which are not permitted to buy stocks.

The interest return on the bonds has generally been less than half the corresponding dividend yield on the stock - a factor which was calculated to offset the prior claim of the bondholders.

Since the company has been able to maintain its dividend without change for many years, the result has been the eventual conversion of all the older convertible issues into stock.  

Thus the buyers of these convertibles have fared well through the years - but not quite so well as if they had bought the capital stock in the first place.

This example establishes the soundness of American Telephone & Telegraph, but not the intrinsic attractiveness of convertible bonds.

To prove them sound in practice we should need to have a number of instances in which the convertible worked out well even though the common stock proved disappointing.  

Such instances are not easy to find.


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Advice by Benjamin Graham on convertibles

Our general attitude toward new convertible issues is thus a mistrustful one.

We mean here, as in other similar observations, that the investor should look more than twice before he buys them.

After such hostile scrutiny he may find some exceptional offerings that are too good to refuse.

The ideal combination, of course, is a strongly secured convertible, exchangeable for a common stock which itself is attractive, and at a price only slightly higher than the current market.  

Every now and then a new offering appears that meets these requirements.

By the nature of the securities markets, however, you are more likely to find such an opportunity in some older issue which has developed into a favorable position rather than in a new flotation.

(If a new issue is a really strong one, it is not likely to have a good conversion privilege.)


Benjamin Graham
The Intelligent Investor

Margin of Safety Concept in Bonds and Preferred Stocks (Fixed Value Investments)

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.”  Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion. Let us try now, briefly, to trace that idea in a connected argument.

All experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds and preferred stocks. 

For example, a railroad should have earned its total fixed charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. 

• This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income. 
• (The margin above charges may be stated in other ways — for example, in the percentage by which revenues or profits may decline before the balance after interest disappears—but the underlying idea remains the same.)
• The bond investor does not expect future average earnings to work out the same as in the past; if he were sure of that, the margin demanded might be small. 
• Nor does he rely to any controlling extent on his judgment as to whether future earnings will be materially better or poorer than in the past, if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record. 
• Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. 
• If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.

The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt. (A similar calculation may be made for a preferred-stock issue.) 

• If the business owes $10 million and is fairly worth $30 million, there is room for a shrinkage of two-thirds in value—at least theoretically—before the bondholders will suffer loss. 
• The amount of this extra value, or “cushion,” above the debt may be approximated by using the average market price of the junior stock issues over a period of years. 
• Since average stock prices are generally related to average earning power, the margin of “enterprise value” over debt and the margin of earnings over charges will in most cases yield similar results.

So much for the margin-of-safety concept as applied to “fixed value investments.” Can it be carried over into the field of common stocks? Yes, but with some necessary modifications.

Ref:  The Intelligent Investor by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment




Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stockss
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks
• 
  

Rule No. 1: Do Not Lose Money. How Warren Buffett avoids yearly losses in his entire portfolio?

Avoiding losses is probably the most important tool for long-term success in investing. No investor, even Buffett, can avoid periodic losses on individual stocks. Even, if you resigned yourself to buying only at incredibly cheap prices, occasional mistakes will still occur. What differentiates Buffett from nearly all other investors is his ability to avoid yearly losses in his entire portfolio.






How Warren Buffett avoids yearly losses in his entire portfolio?


Warren Buffett would rather not place his faith in the hands of investors and traders. The methods he uses to lock in yearly gains take the market out of the equation.

He reckons that if he can guarantee himself returns, even in poor markets, he will ultimately be way ahead of the game. 
To learn more, we should focus on how Buffett best avoids losses.

These include:

Timing the market. He is not concerned about the day-to-day fluctuations in the stock market. However, Buffett - whether by accident or calculation - must be recognized as one of the most astute market timers in history.

Convertibles. Some of Buffett's most lucrative investments in the late 1980s and early 1990s involved convertibles, which are hybrid securities that possess features of a stock and an income-producing security such as a bond or preferred stock.

Options. On a number of occsions, Buffett has expressed his disdain for derivative securities such as futures and options contracts. Because these securities are bets on shorter-term price movements within a market, they fall under the definition of "gambling" rather than of "investing." If Warren Buffett does dabble in options, and few doubt he could dabble successfully, he does so quietly. He once acknowledged writing put options on Coca-Cola's stock; at the time he was thinking of adding to his stake in the soft-drink company.

#Arbitrage. Not only did Buffett continue to beat the major market averages, but he suffered few single-year declines along the way. That second accomplishment is, by far, the more remarkable. Buffett's scorecard shows that he has increased the book value of Berkshire Hathaway's stock 35 consecutive years. In only 4 years, did the S&P 500 Index beat the growth of Berkshire's equity. Right from the start of his investment management career, Buffett resorted extensively to takeover arbitrage (the trading of securities involved in mergers) to keep his portfolio results positive. In poor market years, arbitrage activities have greatly enhanced Buffett's performance and keep returns positive. In strong markets, Buffett has exploited the profit opportunities of mergers to exceed the returns of the indexes.Benjamin Graham, Buffett's mentor, had made arbitrage one of the keystones of his teachings and money management activities at Graham-Newman between 1926 and 1956. Graham's clients were informed that some of their money would be deployed in shorter term situations to exploit irrational price discrepancies. These situations included reorganizations, liquidations, hedges involving convertible bonds and preferred stocks, and takeovers.


----

There are only 3 ways an investor can attain a long-term, loss-free track record:

1. Buy short-term Treasury bills and bonds and hold them to maturity, thereby locking in 4 to 6 percent average annual gains.

2. Concentrate on private-market investments by buying properties that consistently generate higher profits and that can sell for greater prices each year.

3. Own publicly traded securities and minimise your exposure to price fluctuations by devoting some of the portfolio to unconventional "sure things (arbitrages).# "




Also read:

Focus on how Buffett best avoids losses

http://myinvestingnotes.blogspot.com/2009/09/list-your-top-5-rules-for-success-in.html

The Benefits and Drawbacks of Preferred Stock Investing

The Benefits and Drawbacks of Preferred Stock Investing
BY STOCK RESEARCH PRO • MAY 8TH, 2009

Some companies issue two types of stock: common and preferred stock. While each offers a portion of ownership in the company, there are significant differences between the two. Preferred stock is often seen as a hybrid instrument; a mix between a stock and a bond. Although preferred stock is an equity security, it has many characteristics that are similar to a debt instrument.

Why Companies Offer Preferred Stock
For the issuing company, preferred stock can be easier to market than common stock as most holders of preferred shares tend to be bond institutional investors. This is due to tax law that enables U.S. corporations that pay income taxes to exclude a large portion (70%) of their dividend income from taxable income. Additionally, if cash flow problems arise for the issuing company, they may suspend dividend payments to preferred shareholders.

Even so, the amount of preferred stock issued by a company usually represents a very small percentage of its funding (compared to common stock and debt).

Unique Features of Preferred Stock
The following is a list of common characteristics of preferred stock:
Redeemable: A preferred stock is said to be redeemable or “callable” in that the company that issues the shares reserves the right to redeem them at a pre-determined price and its own discretion.
Participating: This feature enables preferred share holders to participate in the dividends to common shareholders, usually at a pre-determined rate.
Convertible: The convertible option provides preferred shareholders with the option of converting preferred stock to common stock.
Cumulative: Under the cumulative feature, if the company fails to pay its dividend to preferred shareholders, it must make up the dividend before any dividends can be paid to common shareholders.

The Benefits of Preferred Stock Investing for Individuals
The fact that individuals do not enjoy the same tax advantages as corporations should not preclude them from considering investment in preferred stock. Some of the benefits of preferred stock investing for individual investors include:
• Greater price stability and payment priority (of both dividends and liquation proceeds) than common stock holders
• Greater liquidity than many bond holdings
• Relatively low investment per share

The Potential Downside to Investing in Preferred Stock
The “callability” and limited upside potential are the two negative factors most often referenced for preferred stock. Additionally, preferred shareholders do not receive voting rights and, like bond holders, are exposed to interest rate changes.


http://www.stockresearchpro.com/the-benefits-and-drawbacks-of-preferred-stock-investing

Bullbear Stock Investing Notes
http://myinvestingnotes.blogspot.com/

What the Par Value of a Stock Means

What the Par Value of a Stock Means

Par value, sometimes referred to as face value, is the nominal value assigned to an underlying security. Par value acts very differently depending on whether the underlying security is a debt instrument, such as a bond, or an equity instrument, such as common stock. Par value will play little role in the market price of most common stocks but can be an important component of preferred stocks.

Function

1. Par value is a factor of the legal value of the corporation issuing the common stock. The legal value of the corporation is determined by multiplying the par value by the number of shares of company stock that are outstanding. The par value represents the minimum price the company may pay to buy back its stock from investors. The par value is assigned by the issuing company and is typically quite low--1 cent or less per share.

Features

2. Stocks may be sold at whatever price the market will bear as long as the price is equal to or above the stock's par value. Stock may not be sold below its par value. The par value of stock is assigned by the company when it forms; however, the par value may be altered by the company as the needs of the company change over time, subject to state regulation.

Considerations

3. Not all states require companies to assign a par value to their stocks. Stocks issued without par values are referred to as zero-par value stocks or no-par stocks. The legal value of the companies that issue such stock is determined by the total amount received by the company from the initial sale of company stock.

Identification

4. The par value of a company's stock is typically printed on each stock certificate. A stock certificate of a zero-par stock may include a statement indicating the stock has no par value or it may not have any reference to par value. Investors may determine the par value of a company's stock by contacting the company's investor relations department.

Significance

1. Par value has little significance in determining the market value of common stock. Par value has much more significance when the underlying security is preferred stock that requires the payment of a specific dividend because in these instruments par value value represents the amount the company must repay to the investor at maturity. Par value for preferred stock becomes an important facet in calculating the interest rate on dividend payments, market values and yields.

http://www.ehow.com/about_6332199_par-value-stock-means.html

Why Hold Cash?

Liquidity brings opportunities.

Do not rush to invest in stocks as soon as you have additional cash available for investing.  Be patient and wait for good investment opportunities.

Holding cash or cash equivalents is not just for safety; it can help you earn more on your investments by enabling you to take advantage of opportunities that arise with brief windows in which to strike.  

From this perspective, keeping some cash or investments in liquid, low-risk securities may prove to be a high-return proposition in the long run.  

In some cases, it might be helpful to invest in convertible preferred stocks or convertible bonds, as long as you stay with established firms the way Buffett does.