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I'm reading the Intelligent Investor, and quote:

A modest amount of bonds or preferred stock, however, is not necessarily a disadvantage to the common, nor is the moderate use of seasonal bank credit. (Incidentally, a top-heavy structure—too little common stock in relation to bonds and preferred—may under favorable conditions make for a huge speculative profit in the common. This is the factor known as “leverage.”)

When the company has way lot more preferred stock than common stock, why is there a potential for huge speculative profit in the common stock?

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  • @keshlam The Intelligent Investor is a legendary classic by Benjamin Graham (Warren Buffett's mentor), who died decades ago. There is much to learn from the book if one puts in the effort to understand it.
    – nanoman
    Dec 11, 2022 at 21:56
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    Thanks. Perhaps Graham was an expert investor, but writer... apparently not so much.
    – keshlam
    Dec 11, 2022 at 22:40

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Preferred shares, somewhat like bonds, do not change in value so much with the fortunes of the company, because they carry largely fixed payments (dividends playing the role of bond interest). There is some risk of default if the company does poorly, but no huge upside if the company does well. They are considered conservative investments.

Common shares, by contrast, represent an investment in the true economic value of the company. On the downside, common shares will become worthless before the company gets to the point of not being able to pay its bondholders and preferred shareholders. Conversely, common shares will undergo the lion's share of the appreciation if the company's profits grow rapidly.

The relevance of "leverage" may be clearer if we start from the more familiar case of bonds (debt). If a company has $10 billion in assets (marked to market, not book value), $9 billion in debt to bondholders, and $1 billion in equity of common shareholders (market capitalization), then this is a case of "top-heavy structure", corresponding to 10:1 leverage.

These common shares are high-risk, high-return. If the economic value of the company's assets increases by only 10% to $11 billion, then the market value of the common shares increases by 100% from $1 billion to $2 billion (the debt is not immediately affected and remains at $9 billion). This is the "huge speculative profit". It is similar to an individual investor buying stock on margin, but here the company itself is leveraged.

Preferred shares may be less familiar, but are like a "junior", slightly riskier version of bonds and play a similar role in creating leverage.

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