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Convertible Preferred Stocks

Investing in the stock markets poses a huge risk and is definitely not for investors who do not do their homework properly. Unlike the fixed income market, returns from stocks are highly erratic and volatile.

Hence regulatory bodies like SEC make it mandatory for companies who raise funds through the capital markets to publish risk factors, which are related macro economic, industry, and company specific in nature.

However, it is impossible for a common investor to peruse through tons of documents of smaller font and try to gauge his/her risks. Hence, if you are a first time investor, always seek advice from a qualified financial advisor before investing.

Just remember that a bad investment might lead to disastrous results however for a patient and careful investor the opportunity for capital appreciation is equally high.

If you are among those investors who have had a bad experience or are vary of investing in stocks then probably you might consider investing in convertible preferred stocks. Convertible preferred is a type of security which owes its flexibility to the modern financial markets. It is particularly attractive to those investors who are looking for capital appreciation (high growth) in the stock market and at the same time a steady income from the same instrument. Before we go ahead, lets first understand what a preferred stock is.

Just like common stock, preferred stock is another form of security issued by corporation to raise capital. They trade on exchanges too and can be purchased in the secondary market. Preferred stock has the characteristics of both the regular common stock and a bond. Each share of preferred stock is normally paid a guaranteed sum by the issuing corporation. There are many types of preferred stock, some of them are:

1) Participating preferred stock.

2) Adjustable rate preferred

3) convertible preferred stocks

The above list is not exhaustive and there are other types of preferred stock. For simplicity sake, lets focus on the third type, the convertible preferred stocks.

As the name suggests, convertible preferred can be converted into common stock at the behest of the holder or the issuing corporation.

Consider this example:

Greg has purchased 100 convertible preferred shares from a biotechnology company "ABC" at a price of $100 a share. Following are the characteristics of the instrument:

Interest rate of 5% per annum

Conversion ratio of 5

Thus, his total value is 100 * $100 = $10,000

Now Greg is assured to receive a fixed payment of $5 per share annually in the form of dividend.

Greg also has the option to convert his preferred stock into common stock and he would receive 5 common shares for every convertible preferred stocks he holds. Since Greg holds 100 convertible preferred shares, he would be entitled to receive 500 (100*5 = 500) common stock upon conversion.

The conversion ratio also shows what price the common stock should be trading so that it is profitable for the preferred share holder.

Lets say Company ABCs common stock which is listed on NASDAQ and is trading at a price of $15 per share.

If Greg were to convert his preferred stock into common he would get 5 common shares for each preferred stock he holds. Since the common stock is trading at $15 per share, the total value of the common stock would be 500 * $15 = $7500

Now why would Greg decide to convert his preferred stock into common stock and forego his annual dividend too! Therefore, he decides to hold on to his preferred stock. A year later, Company ABC's has declared phenomenal results and its stock price shot up to $25 per share.

If Greg were to convert his convertible shares into common shares now, he would still get 400 shares and his value would now be $12,500 (400 * $25)

That means, the common stock of ABC should be trading above $20 so that Greg can make money upon conversion (100/5 = $20)

Since converting his preferred shares would be more profitable for Greg, he decides to convert all his preferred stock into common stock.

That was an example, but if there was a real Greg and ABC was a real company, Greg would be laughing all the way to the bank because that was a neat profit of $2,500.

Again, the example above is a simple one. In reality many complexities exist including tax issues.

For example, company ABC could have a clause wherein it could force conversion after the common shares reaching a threshold point or force partial conversion, etc.

So before investing, the first thing an investor needs to check for is the conversion rate. Sometimes, companies can take investors for a ride by setting unrealistic conversion ratios. This was experienced by many investors after the period following the dot com bubble. Prior to the dot com bubble, internet companies were trading on very high valuations (read share prices) thus enabling the companies to set high conversion ratios. However, post 2000 when the share prices of most internet companies were trading at all time lows; holders of convertible securities were left with securities which were practically worthless.

A major advantage of holding convertible preferred stock is that the holder will get priority ahead of common share holders in the event of company liquidation.

A major disadvantage is that holders do not have voting rights unlike common shareholders who have the right to vote in the day to day affairs of the company. (Some preferred stock do have limited voting rights however it depends from company to company)

Venture capital investors usually prefer to invest through convertible preferred stocks instead of common stock. It enables them to exit the company through an IPO (Initial Public Offering) or secondary offering.

So, if you are among those investors who definitely want to invest in common stocks but never seem to get your timing right. Then convertible preferred stocks are the right kind of investment for you, which offer the best of both worlds.

P.S Always consult a financial advisor who might be in a better position to gauge your risk taking abilities!

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