Make Money Like Warren Buffett

They may be obscure to some investors, but on average, preferred shares have been paying dividends more than double the average bond fund yield this year.They’re also yielding nearly four times more than the average common stock dividend. And this fall the great Oracle of Omaha even used them to invest in two beaten-down companies, Goldman Sachs (GS) and General Electric (GE). In a market like this, they’re definitely worth a look.

Preferred shares are a hybrid security: Like a share of common stock, they represent ownership in a company. But they trade like a bond, often with much lower price swings, both up and down, than common shares. And clearly, they often pay higher dividends. But look closely: Prices can still fall, and companies can cut their dividends. Worse, when a company goes under, preferred-shareholders must line up behind bondholders. Indeed, investors in Fannie Mae and Freddie Mac preferred stock got wiped out when the government took over the firms.

Warren Buffett, of course, was able to extract special demands when he sank $8 billion into the preferred shares of Goldman Sachs and General Electric. “Mere mortals do not have access to the deals that Buffett does,” says Mohnish Pabrai, manager of a hedge fund that uses Buffett-like strategies. Instead, invest in the firms Buffett bought but didn’t demand an extra pound of flesh from. Among them: Wells Fargo (WFC) and Bank of America (BAC). Wells’s planned acquisition of Wachovia is finally final, and the bank is well capitalized and well run, says Doug Rao, portfolio manager of the Marsico Flexible Capital fund. Some of its preferred shares are yielding 8 percent. Bank of America’s acquisition of Merrill Lynch gives it the high-quality investment bank CEO Ken Lewis has always wanted. Some preferred shares yield 9 percent.

Real estate investment trusts are also well represented among preferred-stock issuers. While not a Buffett holding, Vornado Realty Trust (VNO), a REIT that focuses on office buildings, has preferred stock that yields 13 percent. Another route: closed-end mutual funds like the Delaware Investments Dividend and Income (DDF), which yields 11.6 percent. The fund has been buying preferred shares of General Motors (GM) and Amgen (AMGN).

But even Buffett can make a misstep. Payments on the $358 million in U.S. Air preferred shares bought in 1989 were temporarily halted. He later admitted that his analysis was “both superficial and wrong.”