The Stock That Bank Bulls Should Prefer

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Last week, Warren Buffett injected a huge amount of confidence into the financial sector with Berkshire Hathaway's (NYS: BRK.B) $5 billion investment in Bank of America (NYS: BAC) . Yet if you're thinking about diving into the same sort of specialized bet that Buffett made, think again, because the terms you'd get won't be what B of A gave the Oracle of Omaha.

Understanding preferred stock
Buffett made his investment in B of A by buying preferred stock. Compared to ordinary common stock, preferred stock has two key advantages: It's entitled to receive its dividends in full before common shareholders get anything, and, in the event of bankruptcy, preferred shareholders are in line ahead of common shareholders if there are any assets remaining once bondholders get paid off.

But preferred stock has a big downside compared to common stock: Its upside is limited. Typically, companies that issue preferred stock have the right to repurchase the shares for a fixed price after a specified time. For instance, Berkshire gave B of A the right to buy back preferred shares at a 5% premium. With many preferred stocks, though, the issuer can buy back shares without paying a premium -- and sometimes at a discount to the current market price.

That buyback right puts a ceiling on how high preferred stock prices can go. That in turn is the reason bank bulls shouldn't be in any hurry to buy preferred shares.

Don't follow Buffett
It's true that preferred shares offer some attractive yields right now. Wells Fargo (NYS: WFC) , JPMorgan Chase (NYS: JPM) , and Citigroup (NYS: C) have preferred issues that yield roughly 7%. That's well in excess of the 2% to 3% dividends you can get on JPMorgan and Wells Fargo common shares -- let alone the 0.1% that Citi pays right now.

But what buying regular preferred stock doesn't give you is the equity kicker that Buffett received on the B of A investment. Essentially, the warrants Berkshire received to buy 700 million shares at $7.14 per share gave the company the upside that the preferred shares lack -- an upside that's already worth $875 million in intrinsic value at yesterday's closing price, even discounting the time value of the 10-year warrants.

Now because the warrants that Berkshire got aren't publicly traded, we don't know exactly what they're worth. But thanks to TARP, we do know what some similar warrants are worth: Warrants to buy B of A shares at $13.30 that expire in January 2019 will cost you about $4 per share as of yesterday.

Obviously, a warrant to pay $7.14 will be worth more than one to pay $13.30. So even if you bought plain vanilla B of A preferred shares that yield more than 6%, they wouldn't give you an equity kicker and you'd have to pay substantially more than the Oracle for warrants worse than the ones Berkshire received.

Stick with simplicity
As strange as it may seem, those who pick preferred shares over common stock aren't really all that bullish. Essentially, when you buy preferred stock, you're betting that the upside on the common is less than the extra yield you get from owning the preferred. Yet you also have to think that things aren't so dire for financials that they'll go out of business, potentially leaving you with a complete loss.

By contrast, buying common shares may not give you much yield, especially with B of A paying almost no dividend and Morgan Stanley (NYS: MS) and Goldman Sachs (NYS: GS) yielding just over 1%. But with potentially unlimited upside, the risk/return trade-off looks a whole lot more attractive if you're bullish on the sector overall.

What to prefer
Preferred stock sounds like something everyone should gravitate toward. But once you know the ins and outs of how preferred shares work, you'll realize that if you really want to make a bullish bet on a company, the regular shares you already know and love usually do the job much more efficiently.

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At the time this article was published Fool contributorDan Caplingerprefers smart investments. You can follow him on Twitter here. He owns shares of Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway, Citigroup, Bank of America, JPMorgan Chase, and Wells Fargo, and has created a ratio put spread position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool'sdisclosure policyhas no stated preference on blondes, brunettes, redheads, blue hair dye, or male pattern baldness.

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