Preferred shares vs. common shares: which is your best investment?

What are preferred shares? And What is better: investing in preferred shares or common shares? What are the rights to preferred shares? What happens to the shares if the company goes bankrupt? These are some of the questions we’ll be answering in this article.

What are common shares?

Common shares are ownership titles, which are traded on the market, and after their acquisition, the owner of them is the owner of the company in the proportional part that represents said share of the social capital of the same.

Common shares, unlike many other financial assets, do not have an expiration date, so the owner of them, will own them until they sell them, pass them on as inheritance or the company ends its activity.

What rights do common shares grant?

These are the following rights enjoyed by a common shareholder:

• Right to dividends: The shareholder has the right to participate in the profits generated by the company, either via dividend distribution or via an increase in the company’s market capitalization.
• Claim right in case of bankruptcy: When a bankruptcy proceeding is initiated, the common shareholder has the right to recover their contribution once all debts have been liquidated and preferred shareholders have been compensated. Therefore, they run the risk of not recovering their money, which has often happened in asset liquidations of companies.
• Political rights: The shareholder has the right to attend general meetings and vote to elect the Board of Directors, with a voting weight according to the percentage of social capital they own. It should be noted that common shares are usually the only asset with voting rights.
• Limited liability: The shareholder does not have joint liability in case of bankruptcy or default; they simply respond for the part of the capital contributed, and that will be their only risk.

What are preferred shares?

The preferred shares are shares established by the company with different characteristics, which vary depending on what the company decides. Before acquiring this type of asset, one must specifically know the characteristics of the preferred shares.

This type of share does not grant the shareholder voting rights or a capital quota, but it does give priority when collecting dividends or liquidations, as we will see below.

What benefits do preferred shares have compared to ordinary shares?

When investing in preferred shares, the investor acquires a series of advantages or benefits that are not available to ordinary shareholders, such as political rights or the priority collection of dividends, as we will see below

Priority in the collection of dividends from preferred shares

One of the main advantages of preferred shares is that they usually have priority for the collection of dividends over ordinary shares. In the event that everything goes well for the company, both types of shares will collect their dividends. But if things do not go so well and the company cannot pay the full amount of the planned dividend, it may be that the preferred shares collect their dividends and the ordinary ones are reduced, or perhaps they do not collect anything. The dividend on the preferred shares may depend on several factors, among them:

• The amount invested.
• The evolution of the company’s results.
• From the dividend of ordinary shares.

Speaking of dividends, you might be interested in our list of the best dividend-yielding stocks of 2023.

In case of bankruptcy, what would happen to the preferred shares?

Another advantage of preferred shares is that in the event of company bankruptcy, preferred shares have a collection preference over ordinary shares, once all the company’s assets have been liquidated, through a bankruptcy proceeding and all debts have been liquidated.

Disadvantages of preferred shares compared to ordinary shares

Just as there are advantages, the investor in preferred shares also has a series of disadvantages compared to ordinary shareholders.

Why do preferred shares have a different price?

Preferred shares are less liquid than ordinary shares, mainly for three reasons:

• There are fewer preferred shares in circulation compared to ordinary shares.
• The shareholders are usually institutional investors.
• The owners of preferred shares are usually long-term investors.
• Also, because they are not traded on the market (that is, through a stock broker), you will usually have to go to the company itself. They are provided by banking institutions, energy companies, or institutional organizations.

All these facts make them very scarce, and therefore, they have much more stable and slightly higher prices than ordinary shares (which are more abundant, are traded on the market, and therefore are more volatile).

After all, shares with the right to collect in advance are more quoted, especially, in times when the economic solvency of a company is in question. However, preferred shares are assets with slightly less risk.

The possible loss of dividends

According to the General Accounting Plan, there are certain situations in which dividends cannot be distributed. These are:

• Provide the Legal Reserve of 20% of the share capital.
• Net Worth must be equal to or greater than the Share Capital.
• Available Reserves equal to or greater than Research and Development expenses.
• In case of losses, it is the General Meeting that must decide whether or not to offset the negative results of previous years. In any case, if the losses from previous years make the net worth of the company less than the share capital, any possible profit will necessarily go to offset these losses.

However, when we talk about preferred shares, sometimes the amount of dividends to be collected is predefined and subject to the obtaining of profits. However, in the event of negative results, the dividends to which you have the right to collect can accumulate for future years where profits are obtained.

Your best bet at retaining profits would be to stake your money with the dividend kings.

Political rights of preferred shares

Normally, in preferred shares, the shareholder has no political rights, that is, they cannot vote at shareholder meetings. This may, for a small investor, be unimportant, but many investors prefer to have the ability to influence the company’s decisions, for example, in the event that the company launches a takeover bid or there are fights for control of a company among investors, these political rights have a lot of meaning and make the shares that possess them worth more than those that do not.

Preferred shares vs. bonds: sensitivity to interest rates.

On many occasions, preferred shares are redeemable at the company’s discretion. However, the preferred shared rights agreement often stipulates the conditions on which they can be redeemed. Being redeemable means that the company can buy the preferred shares whenever it wants, at the same price at which they were sold.

On many occasions, it is common to describe preferred shares, as a mix between shares and bonds, Since the owner has a title to the company (share), but no political rights over it, it simply comes down to collecting its dividend (bond).

From this, it can be deduced that the attractiveness of preferred shares is strongly related to the interest rates paid by bonds. For example, in an environment of rising interest rates by central banks, public debt bonds, will tend to offer higher returns to their borrowers. If a preferred share (without political rights), is not able to at least offer that same return, it would be expected that investment in them would be reduced towards safer assets, that are at least as profitable as the bonds themselves.

How to invest in preferred shares: Shares and ETFs

Next, we are going to see what alternatives exist to investing in preferred shares, since although the most intuitive, comfortable, and profitable way is through ETFs, there are other alternatives.

Invest in individual preferred shares

The first option is to invest in preferred shares of specific entities. It is not the most recommended as it requires going to the company in which we are interested in investing, and the time and informational costs are high. Thus, these types of shares are usually issued by financial institutions, telecommunications providers, public services, and energy companies.

Investing in preferred stock ETFs

The second option is to invest in ETFs, or exchange-traded funds, that are built based on a portfolio of preferred shares.

Since we have invested in a fund and at no time were we going to have a political right, these exchange-traded funds can be an alternative, not only more profitable but also safer since if any of the companies that compose it were to go bankrupt, as it liquidated its assets, it should attend to its situation with the fund before any other standard shareholder?

An example of an ETF that invests in preferred shares is:

• Invesco Preferred Shares UCITS (ISIN: IE00BDT8V027)

The choice between common shares or preferred shares

If you have to choose between a company that has common shares or preferred shares, the common ones are usually more attractive, due to their political rights and because they are not redeemable.

Although preferred shares have different characteristics, there may be cases where preferred shares are more interesting than common ones. However, you should always study all the legal implications of acquiring them.

Comparative table between common shares and preferred shares

* Common shares do have the right to payment in case of liquidation of the listed company, however, the fact that they are the last to receive the money, once all creditors have been paid, as well as, the preferred shareholders, means that on many occasions they have not been able to recover their invested capital, or at least a part of it.

** The right to dividend payment is superior in the case of preferred shares, hence their name. Something especially important if things start to go wrong.

In conclusion, the main difference between preferred shares and common shares is the possibility of getting paid earlier in the case of the former (especially in bad financial situations), while common shares carry certain political rights. How about you? Which do you prefer?

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