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Law May Make Investors Prefer Preferred Stock

October 28, 1986|JAMES FLANIGAN

We'll have to wait awhile for the full consequences of tax reform, signed into law by President Reagan last week, to become visible. But already, like an early crocus, a signal of things to come has cropped up in preferred stock, a semi-obscure form of investment security that you'll be hearing more about in the years immediately ahead.

Preferred is the kind of stock in which a company promises you a fixed dividend and usually gives you greater assurances of payment than it needs to do with common stock. Preferred gets its name because a company must pay dividends to preferred holders before it can pay any to owners of common. Also, in a liquidation, preferred holders have priority over common shareholders in the divvying of the company's assets. Preferred holders, however, usually do not have the right to vote on company policies; they are more like debtors than owners.

So much for definition. The reason you are likely to hear more about preferred is that the tax reform law, by eliminating the differential between the tax rates you pay on capital gains and on ordinary income, makes dividends more attractive. That is, this year any gain you make on a stock held for more than six months will be taxed at 20%, while income from dividends will be taxed at your overall income tax rate, which is probably higher. Next year, though, all income will be taxed at the same rate, with 28% the maximum. Dividends thus become more attractive because the competition from capital gains has been eliminated.

Logically you would think that the stock market would now be favoring stocks that pay dividends over those that do not. But no such trend is discernible. The stock of computer maker Digital Equipment, which pays no dividend, has continued to fly high while that of IBM, which pays $4.40 a share in dividends, has been depressed. Why is that? Because common stock trading is dominated these days by institutions--mainly pension funds--that have no tax liability and therefore do not consider taxes in their investment decisions, as individuals must.

Activity Surges

But preferred stock has been going gangbusters both in a specialized market for corporate investors, and in the general stock market, where the preferred stock of Burroughs Corp., the Detroit-based computer maker, has been one of the most active and strongest stocks, trading a phenomenal 3.5 million shares on Monday.

Preferred stock's attractions for corporate treasurers are easy to explain. For one thing, corporations can deduct 85% of dividend income for tax purposes, and under the new law they will still be able to deduct 80%. (The reason for the deduction, explains senior accountant Gayford Hinton of Price Waterhouse, is to avoid even more taxation on dividends than already exists.) But the new tax law makes dividends even more appealing to companies because it takes away so many alternative tax breaks, such as the investment tax credit. Accordingly, the investment banking firm of Salomon Bros. sees companies looking more to investments such as preferred stock for low-tax income.

But, says Anthony Marchese who heads the preferred department at Oppenheimer & Co., the kind of preferred stock the corporations trade--where interest rates are adjusted every 49 days--is not for individuals. The prices make no sense unless you have the corporate dividend deduction.

However, convertible preferred, the kind of preferred stock that assures you income today and a chance for capital appreciation through conversion into common stock tomorrow, is going to get more of a play in the post-tax-reform world.

The Burroughs preferred is an example. It has been actively traded since news got out that Warren Buffett of Omaha, respected as one of America's smartest investors, has bought a lot of it. What did Buffett see? He saw a preferred stock paying a $3.75 a share dividend--equal at the current price to a 7% return--that could be converted into slightly more than half a share of the Burroughs' common. At current prices for preferred and common it makes no sense to convert. But if Burroughs' common stock price improves, the holder of the preferred will have a bargain--a bargain moreover made relatively riskless by the short-term dividend return.

It helps Buffett that he invests through Berkshire Hathaway Inc. and therefore qualifies for the dividend deduction. But, says computer analyst Michael Geran of E. F. Hutton, that fact is incidental to the fact that Buffett was using preferred to hedge against the cloudy short-term outlook for computers in general, and for Burroughs in particular. Others did the same thing recently when they eagerly bought up a convertible issue used by Control Data to restructure its finances.

The meaning is clear: In uncertain times, preferred gives greater assurance of income than does common stock, and also tends to protect principal better because it fluctuates less in a volatile market. You'll be seeing, and hearing, more about it.

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