No Sign of Herd in Preferred Shares

What do I mean by wrong risks? To start, consider stock selection, in which unsuccessful investors are highly dependent on other people's opinions. To that end, they always end up buying the well-known crowd favorites in which the herd is already highly involved. Because they are attracted to bets that feel "safe," they're almost always playing in XYZ for the last 20%, rather than the middle 40%. That stacks the odds against them from the start.

Furthermore, they also tend to be more interested in the news surrounding a company than in the performance of the company's stock. Yet time and time again we see how the market "knows" the news long before it's printed in The Wall Street Journal. For example, when commenting on the financials last June, I wrote how:

Indeed, price action in these securities — the market itself — was broadcasting the credit crunch long before it became a political stump speech or the lead on the evening news.

So while I'm always curious if there is news that accompanies a move in one of my holdings, it usually doesn't change my opinion as to whether I should buy or sell. In my world, the market is the news. The stories are just something to read in the bathtub or while waiting for the train.

Of course, as we always point out, what matters in investing isn't what you trade, but how you trade it. Unsuccessful investors don't just take the wrong risks, but end up taking them in undisciplined and highly dangerous ways.

Although I certainly didn't know Google was poised to drop some 30% (including a 9% loss on Friday) over the next three months, the size of the position almost assured that, eventually, they'd get clocked. It wasn't so much that they picked the wrong stock, which of course they had in herd favorite Google, but that they owned it in a totally reckless and undisciplined way. You'll lose money doing that no matter what you trade.

Always being right is tough regardless if you're trading stock or livestock. A few months ago, I made a bullish call on cattle prices, touting the trade's seemingly attractive price action and unique correlation characteristics. And while the analysis was correct, my timing was wrong: The security fell 15% over the next few weeks. Yet because I held a reasonably small position, less than 3%, and was able to cut the loss, the net effect on my portfolio was minimal.

If there is a trick to trading, it's that the successful players aren't always right about XYZ, but are skillful enough to ensure that the gains from winning trades outweigh the losses from those that don't work out. And when you cut your losers and let your winners run, that usually ends up being the case.

Looking for new ideas? In recent weeks, I've developed an interest in preferred stock, which I last highlighted back in 2005. Within a company's capital structure, preferred stock sits between bonds and common stock. Owners of preferred stock receive dividends that are paid before dividends can be paid to holders of common stock, although they don't get to vote on company matters as common shareholders do.

Back then, I was buying preferreds with floating interest rates, but now believe fixed rates are a better bet. Anybody who thinks preferreds are stogy old grandmother stocks should take a look Ambac Financial Group, 5.95% debentures due 2/28/2103 (AKF), preferred shares of the embattled bond insurance firm that were issued at $25 back in 2003. (The prospectus can be found here). Over the past year, the security has dropped from $25 to $10, before jumping roughly 80% over the past 10 days on rumors of a bank-led bailout.

Preferred shares are affected by interest rates and the perceived credit quality of the issuer, which is why securities such as USB Capital VII, 5.875% Trust Preferred Securities (USB-F) from US Bancorp (USB), JPMorgan Chase Capital XI, 5.875% Capital Securities, Series K (MWR) from JP Morgan, Morgan Stanley Capital Trust III, 6 1/4% Capital Securities from Morgan Stanley (MS) and RenaissanceRe Holdings Ltd., 6.60% Series D Preference Shares (RNR-D) from RenaissanceRe (RNR) have held up better than those from distressed companies.

Maybe it's a trade that fits your risk profile, and maybe it's not. But despite some impressive price action, preferred stock isn't widely touted right now, which from my perspective is a plus. Providing you trade with sensible position size and risk tolerance, it seems like a worthwhile option in the current environment.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in many of the securities mentioned.