Fortunes have been made from preference shares this year.
I'm coming to the conclusion that the biggest investing mistake I've made this year has been not buying a few preference shares. You don't have to spend long on some of the Fool's discussion boards to see that it's been possible to earn some serious money. Life-changing money, in at least one case.
Many novice investors are wary of preference shares. They prefer to stick with what they know -- the so-called 'ordinary' shares that we all know and buy. Preference shares have different ticker codes, carry different prices, and reward investors in different ways.
In investing, sticking to what you know is usually good counsel. But in the case of preference shares, this year it's been well worth breaking that rule, and taking the time and trouble to find out a little more about them.
What are preference shares?
I'm not going to waste time repeating the information contained in the detailed explanations of preference shares that my Foolish colleagues Padraig O'Hannelly and Sam Thewlis provided earlier this year.
Sam's article explains the difference between ordinary shares and preference shares, while Padraig's article provides more detail, and explains how private investors like you and me can go about buying preference shares.
In essence, though, the three key points are these:
- Preference shares pay a fixed dividend, known in advance when you buy the shares, in a manner similar to the coupon interest on a bond.
- As creditors, holders of preference shares rank ahead of ordinary shareholders -- hence the word 'preference'.
- If a company fails for any reason to pay a dividend on a preference share, the missing amount is often 'rolled over'.
In summary, I agree with Padraig's assessment of preference shares: they can be thought of as a cross between corporate bonds and ordinary shares, and in certain circumstances are attractive to both the company and the investor.
Banking bonus
And for investors, those certain circumstances have been the last twelve months. Banks, it turned out -- as well as some building societies and former building societies -- issued lots of preference shares when times were good. In many cases, they're still trading today, even when the business that issued them (like Natwest and Bristol & West Building Society) no longer exists as a separate entity.
In the credit crunch, the price of banking preference shares fell, just as the price of banks' ordinary shares fell. But, as banks were obliged to continue paying out on preference shares, even when they had scrapped their dividends on ordinary shares, this wasn't entirely rational. At best, it represented a view that the underlying bank might go bust.
For income investors prepared to take a long hard look at the real risks involved, the result was an opportunity to lock in a mouth-watering yield. Those looking for capital gains weren't disappointed, either. Many Fools made a lot of money when the market marked the price of preference shares sharply up again, after realising that banks weren't going to collapse overnight, and that the dividend payouts on preference shares would continue to roll in.
Second helpings
Similar gains are on offer today, in the wake of the most recent rights issues announced by Lloyds Banking Group (LSE: LLOY) and Royal Bank of Scotland (LSE: RBS).
As I explained at the time of the rights issues, the issues surrounding preference shares are complex, and there's been much debate over on the Fool's banking sector board as to the most profitable way to exploit the various opportunities available. Suffice to say, there's more than one way to riches, and -- as usual -- Fools are very generously pooling their combined knowledge.
My advice: take a look, and decide for yourself. As I've said, I think my own investing regret for 2009 will be not pursuing preference shares more seriously myself.
More from Malcolm Wheatley:
Malcolm holds shares in Lloyds Banking Group.
