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Sweet! Buffett's Bank of America Deal; BAC, BRK.A

September 05, 2011 | About:
John P. Hussman, Ph.D.

Charles Rotblut

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.

AAII Sentiment Survey

This week’s AAII Sentiment Survey results:

Bullish: 38.6%, up 2.2 points

Neutral: 29.0%, up 6.4 points

Bearish: 32.3%, down 8.6 points


[b]Long-term averages:

Bullish: 39%

Neutral: 31%

Bearish: 30%

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.

[b]About The Author
- Charles Rotblut, CFA is the VP for American Association of Individual Investors & AAII Journal Editor. Charles is also the author of Better Good than Lucky (W&A Publishing/Trader's Press). (Author archive at EconMatters here.)


The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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