PREFERRED
STOCK NEWS
How to Rate
an Unrated Preferred Stock
Over the last
few years we have seen an increase in the
number of new preferred stocks that are
unrated by either Moody’s Investors Service
or S&P. There are a number of reasons that a
company will choose not to have its
preferred stocks rated that have nothing to
do with the company’s wellbeing. But the
uptick in the number of interesting, but
unrated, preferred stocks has left many
preferred stock investors wondering how to
best go about evaluating the
creditworthiness of the issuing company on
their own.
And that’s really the key here – everyone’s
risk tolerance is going to be different and,
in the end, you are the one taking the risk
so it is your comfort level that this
exercise must satisfy. Consequently, it is
important to remember that what I present
here are just ideas – a sample of the types
of things that preferred stock investors
might consider while evaluating the
creditworthiness of a preferred stock
issuer. This is not an exhaustive list by
any means, but should give you something to
augment your own method or provide a way to
approach your due diligence.
Preferred stock
versus common stock evaluations
Preferred
stock investors (income investors) should
not feel discouraged when you find an
interesting security that turns out to be
unrated; after all, those who invest in
common stock (value investors) are used to
the idea of evaluating the issuing company
on their own since common stock shares are
entirely unrated (although there is no
shortage of pundits and media types offering
buy/hold/sell recommendations, even in the
absence of knowing the investor’s risk
tolerance, resources or goals).
However, while there is some overlap, the
question that you, as an income investor,
are trying to answer when performing a
company evaluation is different from that
being sought by value investors.
As an income investor, your primary concern
is the ability of the issuing company to pay
future dividends to you. Preferred stock
dividend amounts and the dates that those
payments must be made are known in advance
for years to come, so the ability to pay is
mostly a matter of how the company manages
its cash flow. Creditworthiness is therefore
the main consideration for income investors.
A value investor’s fortunes, on the other
hand, are determined by how much the
company’s common stock shares increase in
value over time. Any growth in common share
value is primarily driven by the company’s
profitability and its ability to
successfully re-invest those profits,
increasing the company’s value (as measured
by the common stock price). Profitability,
more so than creditworthiness, is therefore
at the top of the list of considerations for
value investors.
No need to become
an expert
Even if you
are not an expert in, or very familiar with,
a certain industry, you can still perform a
meaningful evaluation by comparing your
unrated target company’s key metrics with
those of a rated company from the same
industry. While your target company’s
preferred stocks may be unrated, this
“Best-In-Show” approach allows you to
determine what the rating would probably be.
For example, let’s say that you are
interested in the new series A cumulative
preferred stock offered by industrial REIT
CorInfrastructure (CORR) at 7.375 percent.
This traditional preferred stock trades on
the NYSE under the symbol CORR-A.
In addition to CORR-A, the criteria shown in
Figure 3 give me 18 cumulative,
call-protected preferred stocks offered by
five other industrial REITs – CubeSmart
(CUBE), Monmouth (MNR), Public Storage (PSA),
Stag Industrial (STAG), and Terreno Realty (TRNO).
Preferreds
from CubeSmart and Public Storage offer
Moody’s ratings of Baa3 and A3,
respectively. Preferreds offered by the
other industrial REITs, including CORR-A,
are unrated by either Moody’s or S&P.
By comparing CORR’s key metrics to those of
CubeSmart (at the low end) and Public
Storage (at the high end), you can start to
get a sense for how your target company
would stack up if it were to have its
preferred stocks rated.
CubeSmart’s Baa3 rating is at the bottom of
Moody’s investment grade scale, so if your
comparison leaves you feeling that CORR is
probably a weaker choice than CubeSmart, you
know that you are probably considering a
preferred stock that would be rated as
speculative grade.
Using the
Best-In-Show approach allows you to get a
sense of how your target company’s
preferreds would probably be rated. By
starting with this type of comparison, the
rest of your evaluation becomes much easier
to do since you are now looking for
information that will confirm, or not, the
results of your Best-In-Show comparison. Put
another away, you no longer have to figure
out if your target company’s key metrics are
good or bad; you just need to see if they
are better or worse than your Best-In-Show
company.
(Sources: CORR-A prospectus,
sec.gov; preferred stock data,
PreferredStockInvesting.com)
Key metrics – focus
on show-stoppers
Remember that the question preferred stock
investors are trying to answer is: What is
the likelihood that the target company will
be able to meet its future dividend
obligations (its creditworthiness)?
What are the key metrics that answer that
question and where do you find them? Those
who do these types of evaluations for a
living will tell you that the real answer to
that question is that it takes several years
and lots of very fancy computer software
(and even then, they don’t always get it
right as we saw a few years ago). And that
is probably the right answer.
Unfortunately, the more shortcuts you take
here the more risk you are assuming, but the
fact is that very few preferred stock
investors are going to spend more than a few
hours, if that, trying to determine the
creditworthiness of their target company.
To further complicate the task, what may be
an important “key metric” to you may be
entirely unimportant to someone else. So
there is no such thing as a single set of
key metrics that is usable by every
investor; over time, you will need to adjust
the metrics that you use to meet your own
needs.
But once you
develop a list of key metrics that are most
meaningful to you, start with the heavy
hitting show-stoppers first. This will save
you tons of time. There is no need to
analyze more than a few key metrics if you
consider the few that you are using to be
show-stoppers. You do not want to spend
hours evaluating all sorts of metrics only
to find that the target company cannot meet
one of your show-stoppers; do the
show-stoppers first. If your target company
does not have enough cash to meet its
current debt payments, for example, is there
really a need to continue your evaluation?
Standard metrics
Key metrics
come in two flavors - standard metrics and
industry-specific metrics.
Standard metrics are those that are
meaningful regardless of the industry your
target company is in. Space does not allow
me to present an exhaustive list here nor
the definitions or formulas but more detail
is easy to find by clicking on the metric
name here or doing a Google search.
Remember, metrics that speak to the
company’s ability to pay your preferred
stock dividends, especially those that speak
to cash management and utilization, is what
is important. Here are some examples of
standard metrics:
Free Cash Flow: How much cash does the
company keep after meeting its obligations,
including existing debt payments and
preferred stock dividends? See the Statement
of Cash Flows.
Operating Cash Flow: Similar to Free
Cash Flow, Operating Cash Flow tells you if
the company’s operations (cash received from
customers less cash paid out to suppliers)
generate a net positive amount of cash. See
the Statement of Cash Flows.
Quick Ratio: Similar to Current Ratio
(below) but only counts cash and assets that
can be quickly converted to cash (such as
the company’s accounts receivable). See the
Balance Sheet.
Net Income: Is the company profitable?
Net income is not applicable to property
REITs (see Funds From Operations below). See
the Income Statement.
Current Ratio: Is the value of the
company’s assets greater than the value of
its liabilities? This standard metric is one
of many that speaks to the company’s overall
health. If the company would be unable to
sell its assets in order to meet its
liabilities, the company is over-leveraged.
If that’s the case, they are probably unable
to secure loans (still want to buy their
preferred stock?). See the Balance Sheet.
The Statement
of Cash Flows, Balance Sheet and Income
Statement can be found on the company’s
website along with other SEC filings that
are required for publicly traded companies.
Also,
Payout Ratio (the percentage of earnings
paid out to shareholders as common stock
dividends) has some appeal. Since preferred
stock dividends are always paid before
common stock dividends, the company’s
ability to pay its common stock dividends
can serve as an “earlier warning system” to
preferred stock investors. But note that
Payout Ratio is not meaningful for REITs
since their Payout Ratio is set by law
(REITs must pay at least 90 percent of their
taxable income to preferred and common stock
shareholders).
Industry-specific
metrics
Industry-specific metrics are those that
apply to companies from specific industries.
Preferred stocks tend to be issued by
companies from certain industries, so
building your list of industry-specific
metrics is not as onerous as it might sound.
And if you focus on building a list of
industry-specific metrics that you consider
to be show-stoppers, you only need a few of
these.
Here are some
examples of industry-specific metrics:
Property REITs
(pREITs):
Funds from Operations (FFO - take net
income and add gains/losses from selling
properties and depreciation back in),
occupancy rate (the properties owned by most
investment grade REITs typically have an
occupancy rate that is at least 90 percent).
Mortgage REITs
(mREITs): mREITs do not own property. mREITs
make money by using low-cost funds to buy
securities that pay a higher return, the
spread being referred to as
Net Interest Margin.
Insurance
companies: The success of these businesses
revolves around their ability to
statistically forecast the probability of a
claim against a specifically configured
policy. The “Combined
Ratio” metric measures the difference
between premium revenue collected and paid
out.
Commodity-dependent: The fortunes of several
industries are closely linked to the market
price of a specific commodity. Examples
include silicon for solar panels and
electronics, platinum for catalytic
converters in cars and crude oil for
upstream producers. This last group offers a
wide variety of preferred stocks. The
estimated value of their reserves allows the
company to take on debt to fund their
production operations. In the upstream oil
business, those assets are revalued twice
per year by creditors with the next
revaluation coming up this April. For
commodity-dependent industries, the
commodity’s value drives the company’s
ability to secure credit and continue
operations.
Compare your
standard and industry-specific metrics to
the same metrics from your Best-In-Show
company. There are literally dozens of these
types of financial metrics but these will
get you started. You’ll have to determine
the degree to which they are show-stoppers,
considering your personal goals, resources
and risk tolerance. But if the target
company compares poorly with your
Best-In-Show company on such metrics, your
warning lights should start flashing.
(Sources:
metric definitions,
wikipedia.org,
reit.com,
riskheads.org)
Quarterly
conference call transcripts are invaluable
Most of these
industry-specific metrics are presented in
the company’s quarterly and annual reports
available on their website. These metrics
are commonly presented and discussed during
the quarterly conference calls that company
executives have with Wall Street analysts as
well.
In fact, one
of the quickest ways to build a list of
show-stopper industry-specific metrics that
are meaningful to preferred stock investors
is to read those transcripts.
Seeking Alpha provides access to these
transcripts (current and past) on each
company’s detail page (you may need to
register a free username on Seeking Alpha).
Just type in the common stock symbol in the
search field at the top of this website and
click on the Transcripts tab (example:
Public Storage).
Other tips
Financial
metrics can be dramatically affected, one
way of the other, by special one-time events
(such as an acquisition, natural or manmade
disaster or a change of ownership). Such
events will be discussed during the
quarterly conference calls and also
explained in the footnotes that accompany
the company’s financial statements. A weak
key metric may be caused by a one-time event
so be sure to watch for those.
The company
detail page at Seeking Alpha,
Yahoo Finance and many others also
provides recent news stories about the
company that can be very helpful and will
often describe disruptive events that can
affect your metrics.
Also, the
prospectus of your target’s preferred stock
will include a section on risks and other
significant company initiatives that can
have a direct bearing on their ability to
pay future dividends, so be sure to read
over those items as well. For example, the
prospectus for CORR-A provides a table
of contents on the second page. To see
significant company initiatives, click on
“Prospectus Supplement Summary” and read
about the company on page S-1. Risks are
described under Risk Factors on page S-10.
While it will
never be as good as genuine clairvoyance,
identifying your Best-In-Show companies then
using a few show-stopper key metrics for
comparison, especially after you fine-tune
them as you gain experience, will allow you
to make a more informed judgment regarding
the likelihood of your target company’s
ability to pay your preferred stock
dividends.
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