The Safest, Strongest Rally You’ve Never Heard of

When it comes to investing, there’s an old saying: “No one rings a bell and tells you when it’s time to buy.” This is especially true in cases where a pretty strong rally has already been underway for quite some time. After all, who wants to buy a richly-valued stock that’s already up more than 300% in this volatile environment?

Well, this particular group of stocks defies this logic quite well. And investors who take a ride on this rally will likely see cash flowing in a big way.

Here’s what you need to know…

Since the market lows of March 2009, this group of securities has climbed more than 24.5% annually, with a few having returned more than 300%. 

These stellar results come from what investors might consider one of the most boring investments around: preferred stocks.

#-ad_banner-#A preferred stock is a hybrid security that relates to the equity and debt portion of a company’s capital structure. Typically, they are senior to the company’s common stock (thus “preferred”) and get their share of the company’s earnings first. These securities pay a fixed dividend that can often be more than the common stock, but are usually junior to the company’s bonds and bank debt (meaning funds go to the preferred stock payout after bank debt and bond payments). 

Preferred stocks have bond-like qualities, but trade at a smaller face value, often sporting a par value of about $25 a share. Like bonds, when shares of a preferred stock trade above the par value, it means they are trading at a “premium.” Naturally, when preferreds are trading below par, they are trading at a discount. 

While common stocks may have underperformed in recent years, preferreds look quite healthy. Hartford-based life insurer Phoenix Cos. (NYSE: PNX) for instance, has seen its preferred shares (NYSE: PFX) rocket from post-Lehman Brothers lows of roughly $7 to almost $24 a share. Throwing in the stock’s 2% dividend yield (or a 26.7% yield, if you bought at the low), that’s at a three-year total return of about 300%.

Gauging the health of preferreds…
Money managers and individual investors alike have been using the iShares S&P Preferred Stock Index Exchange Traded Fund (NYSE: PFF) as a proxy for buying individual preferred stocks. As an exchange-traded fund (ETF), PFF provides them with decent diversification and the same dividend yield as that of a preferred stock (the fund currently yields 5.8%). 

The other day, as I watched PFF approach a 52-week high, the premium price (although the ETF really doesn’t have a par price, per se) piqued my curiosity. As I mentioned, preferred stocks have been a fantastic investment since March 2009, but are they still worth your money?  I decided to look under the hood… 

First, what I suspected: Of the 250-plus holdings in PFF, about 71 % trade at a premium. This explains the ETF price being close to its 52-week high. Another obvious indication of the ETF’s high performance was that most holdings were high-quality names with reliable cash flows, sported premium valuations and prices that consistently improved since 2008. 

In addition, about 27% of the holdings were trading at discounts,  — preferreds of European financials such as Spanish bank Banco Santander (NYSE: SAN), Dutch insurer ING Groep NV (NYSE: ING) and the Royal Bank of Scotland (NYSE: RBS). On U.S. shores, student lender SLM Corp., affectionately known as SallieMae (NYSE: SLM), as well as the battered but rising automaker General Motors (NYSE: GM) were also trading below par.

Now here’s the shocker: Only about 2.5% of the fund’s holdings trade at par. Frankly, I was shocked that nearly one-third of the basket displayed some attractive value and that such a small fraction of the preferreds traded at their fair value

Reading the tea leaves…
The most interesting piece of information I gleaned from this exercise has to do with the U.S. financial sector. While the sector still walks on thin ice as far as the economy and regulatory environment are concerned, confidence in its health is much stronger than three or four years ago. The evidence is in the preferreds of the mega banks: J.P Morgan Chase (NYSE: JPM), Citigroup Inc. (NYSE: C), Wells Fargo (NYSE: WFC) and Bank of America (NYSE: BAC), which trade at decent premiums to par. 

Risks to consider: Be prepared to play some defense. If the European crisis bubbles over into the U.S. financial system then prices of bank common and preferred shares will come under fire. Brace yourself for volatility.

Action to take –> Shares of PFF look pretty richly valued. If you already hold shares, then it’s OK to hang on to them, unless you’re itching to raise cash. Better yet, if some sort of “black swan” event happens that puts the global economy into panic mode, causing stocks to plummet, then this might be the perfect time to strike. Preferreds would likely take a hit in this scenario, sending valuations back to reasonable (or better yet, discount) levels — giving you a great entry point before investors realize their overreaction in dumping these safe investments.