Dear Member,

The deal Warren Buffett made with Bank of America (BAC) was sweeter than many investors may have realized. A special class of 6% Cumulative Perpetual Preferred Stock is being issued to his Berkshire Hathaway (BRK-A and BRK-B) along with a warrant to purchase 700,000,000 shares of common stock.

There are two parts to this deal that have benefits not available to the public. I’ll start with the warrant. A warrant is a contract to buy shares directly from the issuing company at a specified price. The key words here are “from the issuing company.” The shares set aside for Berkshire Hathaway’s warrant would be dilutive to existing Bank of America common stockholders if the contract were exercised. An option, conversely, is a contract between investors covering existing shares. An options contract has no impact on the number of shares outstanding (it is not dilutive if exercised), a significant difference.

As stated above, the preferred stock purchased by Berkshire Hathaway is cumulative. This means that if a dividend is not paid, the balance accrues until Buffett’s company is paid for all past due dividends. All of Bank of America’s publicly traded stock is non-cumulative. If a dividend is not authorized for a certain period, no balance accrues. The preferred shareholders simply do not receive a dividend for that period.

Non-cumulative preferred stock gives a company more flexibility in managing its cash flow. It also puts a key component of what makes preferred stocks attractive, income flow, at higher risk. Preferred stock compensates investors for diminished voting rights by giving them priority over common shareholders for dividends and typically by paying higher comparative yields.

Cumulative preferred stock buffers the risk of a skipped dividend payment by allowing past due dividends to accrue. It does not guarantee that shareholders will receive the missed dividends in the future, but rather confers the right to accrue a balance. Dividends, both current and past due, must be paid to cumulative preferred shareholders before owners of the common stock can receive dividends: hence the term “preferred.” Most, but not all, preferred stocks pay cumulative dividends.

Preferred shares have historically provided diversification benefits relative to bonds and common stocks, though their prices can be impacted by changes in interest rates and earnings. Potentially offsetting the diversification benefits is industry concentration. This is particularly the case for those of you who own common shares of financial companies. More than 80% of the holdings in SPDR Wells Fargo Preferred Stock (PSK) and the iShares S&P U.S. Preferred Stock Index (PFF) exchange-traded funds come from the financial sector. Given the reliance on cash flow to fund dividends, be careful not to overlap common stock holdings with preferred stock holdings.

More on Preferred Stock

As is the case with any asset class, a thorough understanding of preferred stocks is required before investing. Callability and credit rating are among the factors investors need to consider. John Deysher provided a comprehensive overview of preferred stocks last year in the AAII Journal.

Quantum Online has a complete listing of preferred stocks. (The site requires a free registration to use.)

Do you go outside of stocks and bonds for income? Do you own preferred stock, MLPs, UITs or annuities? Tell us on the AAII.com Discussion Boards.

September AAII Journal Now Online

The September AAII Journal is now on AAII.com. (Print copies will be in the mail soon.)

This month’s feature article, Retirement Spending on Planet Vulcan: Longevity Risk and Withdrawal Rates, looks at how much retirees should withdraw from their savings given uncertain lifespans. It tackles the problem from an interesting angle: finding the optimum withdrawal rate for spending it all.

Other articles include, but are not limited to:

• Aging and Investing: The Risk of Cognitive Impairment — an interview with David Laibson of Harvard University.
• A Cautionary Note About Robert Shiller’s CAPE — the oft-cited ratio may be overvaluing stocks.
• The Top ETFs Over Three Years Represent an Eclectic Group — a look at the best-performing exchange-traded funds

The Week Ahead

The markets will be closed on Monday, in observance of Labor Day.

No S&P 500 members are scheduled to report next week.

The week’s first economic report will be the ISM’s non-manufacturing (aka “services”) index. Wednesday will feature the Federal Reserve’s latest Beige Book. July international trade data will be published on Thursday. Friday will feature July wholesale trade.

No Federal Reserve officials are currently scheduled to speak.

September has historically been the worst-performing month of the year for stocks, according to the Stock Trader’s Almanac. Even during pre-presidential election years, large-cap stocks have declined, though the average loss has been modest. The one exception is small-cap stocks, with the Russell 2000 averaging a 0.1% gain in September during pre-election years.

AAII Sentiment Survey

The latest AAII Sentiment Survey reveals that bullish sentiment among individual investors has exceeded bearish sentiment for the first time since the end of July. The percentage of individual investors who expect stock prices to rise over the next six months continued its slow upward climb, up 2.2% to a six-week high of 38.6%. The historical average is 39%.

Neutral sentiment, expectations that stock prices will be essentially unchanged over the next six months, increased 6.4 percentage points to 29.0%. Even with the strong upward bump this week, neutral sentiment has been below its historical average of 31% for seven consecutive weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, dropped by 8.6 percentage points to 32.3%. While this is the 25th time in 28 weeks that pessimism has been above its historical average of 30%, the 8.6 percentage point drop is the largest single-week decline in bearish sentiment since December 23, 2010.

All of the sentiment readings are now within a few percentage points of their long-term averages.

This week’s special question asked AAII members how much, if any, margin of error they were factoring into third- and fourth-quarter earnings estimates. Many respondents thought analyst forecasts were between 5% and 20% too high. Others thought the profit projections would be pretty close to the actual results. Some individual investors thought the estimates would end up being wrong, but were unsure by how much.

Here is a sampling of the responses:

• “I believe they are 10% to 15% too high. Analysts will soon start revising forecasts down.”
• “The earnings forecasts have been too optimistic and are not taking into account the recent downtrend.”
• “I don’t usually put a percentage on the error, but I always assume earnings estimates are on the high end.”
• “Analysts will be wrong for sure, but I’m not smart enough to know which way.”
• “Typically, analysts miss actual earnings 70% of the time. I don’t pay much attention to earnings estimates any more.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

AAII Asset Allocation Survey

AAII’s Asset Allocation Survey reveals that individual investors took a more defensive stance during August, increasing their portfolio allocations to cash and bonds while decreasing allocations to stock holdings. Stock and stock fund allocations dropped to an 11-month low. AAII members allocated 55.3% of their portfolios to stocks and stock funds last month, a decrease of 7.1 percentage points from July and well below the historical average of 60%.

Bond and bond fund allocations increased 3.3 percentage points to 21.6%. This is the highest allocation to fixed-income securities and funds since November 2010. Bond and bond fund allocations have now been above their historical average of 15% for 27 consecutive months.

Cash allocations climbed 3.8 percentage points to 23.1%. Even with such a strong increase in the allocation to cash, this was the 21st time in the past 23 months that cash allocations have been below their historical average of 25%.

Last month’s special question asked AAII members what their rationale was for allocating to cash. Responses mostly centered around one of three reasons: saving for future stock purchases, preserving capital or saving for future expenses. Many AAII members said they were waiting for stocks to reach bargain prices. Several members set aside cash to cover required minimum distributions from IRAs and other expenses. Others expressed uncertainty about the economy and stock prices.

Here is a sampling of the responses:

• “Dry powder for the eventual return to an uptrend.”
• “I’m holding cash both as an emergency fund and to invest when I find a good opportunity.”
• “I want to have two years of required minimum withdrawals in cash.”
• “The fluctuating market makes it scary to be totally invested.”
• “I like the security of cash now. When I feel the politicians are serious about improving the economy, I will add to my equity holdings.”

Take the survey:
http://www.aaii.com/assetallocationsurvey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor

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