Chapter 16: Convertible Issues and Warrants

**Quick update** Thanks for reading, I’ve compiled this entire series into an electronic copy that you can take offline → here

Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, Graham explains what the investor should understand about convertible bonds and preferred stocks. He opens by defining stock-option warrants as : long term rights to buy common shares at stipulated prices. Graham is not fond of warrants, or companies that use them but he keeps his conversation focused on convertible issues first. Here’s the list of preceding posts if you’d like to get caught up:

• Intro and Chapter 1 , Chapter 2, Chapter 3, Chapter 4, Chapter 5, Chapter 6, Chapter 7, Chapter 8, Chapter 9, Chapter 10, Chapter 11, Chapter 12, Chapter 13, Chapter 14, Chapter 15

On Convertibles

Graham seeks to teach the investor:

1. How convertibles rank as investment opportunities and risks.
2. How their existence affects the value of the related common stock issues.

First, why would convertibles even be good for the investor? Ideally a convertible allows the investor the protection of a bond or preferred stock, plus the opportunity to participate in any substantial rise in the value of the common stock. The issuer in this case can raise capital at a moderate interest or preferred dividend cost, if the prosperity intended is realized, they can then get rid of the senior obligation by converting it to common stock. While this is the theory behind convertibles, Graham points out the flaws:

• In exchange for the conversion privilege, the investor usually gives up something like quality, yield or both.
• The company that issues gets money at a lower cost by calling in the debt, converting to common, but because of that, it then surrenders part of the common shareholder’s claim to future enhancement

Therefore , the “best of both world” concept of convertibles is terribly oversimplified and often does not coincide with how things usually are.

Graham remarks: “ We do know, however, that the group of convertible issues floated during the latter part of a bull market are bound to yield unsatisfactory results as a whole. It is during these times that companies tend to issue their convertibles for financing, much to the detriment of the investor. Zweig buttresses Graham’s comments: “ as Graham warns, convertible securities always come out of the woodwork near the end of a bull market — largely because even poor-quality companies then have stock returns high enough to make the conversion feature seem attractive.”

Further elaborating on the purchase of convertibles, Graham indicates that while buying convertible preferred stock instead of straight common is logical, many in the past have bought convertible preferred when they never would have bought common in the first place. While that can work out, more often than not, it turns into a pitfall. Again, we harp on the concept of buying in as an owner, if we were never going to buy the common in the first place, why on earth would we want to hold preferred?

Generally speaking, Wall Street’s advice is to never convert a convertible for if you do, you lose your edge of having a prior claimant to interest plus a chance for an attractive profit. Graham’s thoughts on convertibles is that if an investor wants to hold them, then he’d better take a second look. The ideal combination, according to Graham is: “strongly secured convertible , exchangeable for common stock, which itself is attractive, and at a price that is only slightly higher than the current market.”

Graham moves his attention to how convertibles significantly influence common stock. Particularly, he uses examples of use of convertibles for M&A activity, while often M&A transactions boost the share price, when done so with convertibles, there is actual dilution of current and future earnings on common stock that flows arithmetically from the new conversion rights.We can quantify the dilutions by taking the recent earnings, and calculating the adjusted earnings per share , if all convertible shares and bonds were actually converted. While this isn't’ usually off-putting it can be a real danger and should be taking into consideration.

While Graham does remark on warrants and their use, he generally takes another pecimistic attitude toward them. He believes the rare upside that is presented when warrants are involved require more energy and competencies than the scope of the text. I think it’s important again here to see that much of the warrant / option conversation goes against Graham’s primary objective of keeping the Intelligent Investor focused on being an owner. Fortunately, warrants are not used nearly as much anymore and really are not going to be an impactful part of our conversation

The Commentary:

Zweig starts with : “ Although convertible bonds are called “bonds”, they behave like stocks, work like options and are cloaked in obscurity.” . He basically states that since convertibles function more like stocks than bonds, they may well be considered the worst of both worlds for a bond investor. He remarks that: “ convertibles usually zig when most bonds zag.” For conservative investors with most, or all of their assets in bonds, adding a diversified bundle of converts is a sensible way to seek stock-like returns without having to take the scary step of investing in stocks directly. He remarks further that while Graham wasn’t a fan of them, since “Graham’s day” , “converts” are now making medium-term , 7–10 years , with halfbeing investment grade and many issues carrying call-protection (assurance against early redemption). These make converts much less risky than they once were. While this seems a positive for convertibles , Zweig reminds us that trading in small lots of convertible bonds is expensive, and diversification is impractical unless you have well over $100,000 to invest in this section alone (2002). He recommends if an investor wants to get into convertibles, that he choose to do so through low-cost convertible bond fund. Essentially, Zweig and Graham remain on the same page, “you can best shield yourself against losses not by buying one of these quickly convertible contraptions, but by intelligently diversifying your entire portfolio across cash, bonds, and U.S and Foreign stocks.”

As I continue to work through the chapters, my goal is to post on each chapter’s central tenets. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.

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-David