Sunday, January 2, 2011

We're On a Crazy Carousel

The passage of still another year reminds me of Jacquel Brel's brilliant waltz from the late 1960's musical review: Jacques Brel Is Alive and Well and Living in Paris. It is a song that begins slowly, sanely, gathering tempo as it culminates breathlessly at the end. I was playing that song during the anticlimax of Y2K.

We're on a carousel / A crazy carousel / And now we go around / Again we go around / And now we spin around / We're high above the ground / And down again around / And up again around / So high above the ground / We feel we've got to yell / We're on a carousel / A crazy carousel

My "blogger friend" Mark over at Fund My Mutual Fund, whom I've referenced before in these virtual pages, has been writing, strategizing, constantly working towards the goal of starting his own mutual fund. He is pursuing the golden ring on this carousel of life, following his dream, and this year he will finally realize it. His New Year's message revealed many of the details that led to this culminating moment and I applaud him for his tenacity.

Decades earlier, like Mark, I followed my own dream, carving out a niche in the publishing world, one that fascinates me to this day, but at one time in my life I had considered a career change and perhaps if the Internet existed then, I might have followed a different path. It wasn't that I had a falling out with my interest in publishing, but I too had become enamored by "the markets" and fancied myself an "investor."

My interest started out by investing in some of the Nifty Fifty ( many of which crashed and burned under their own overvalued weight in the poor economic, high inflationary years of the 1970's), and then with the help of VisiCalc (the precursor of Lotus 1-2-3, in turn the precursor of Excel) and my first computer (an Apple II), came up with what I thought was a "bullet proof" system of investing in convertible debentures. I even marketed a VisiCalc template ("Converticalc") to analyze them. Well, as we all sooner or later recognize, there is no infallible system, and making investing an avocation can be as dangerous as being your own surgeon, so now I rely on people like Mark and, I am not ashamed to admit (in this era of "fast money"), I'm also a buy-and-holder, investing in selected dividend aristocrats selling at reasonable price/earnings to growth ratios. But Mark's New Year's message reminds me that things might have turned out differently if I followed my other dream to its logical conclusion.

The program drew interest at the time and there was even some discussion with a major brokerage house about starting a mutual fund based on it. By today's computer standards the program is laughable, but mind you this was nearly thirty years ago. A new publication, Financial & Investment Software Review, which was dedicated to "microcomputerized investing" carried my article on investing in "converts" in its Summer, 1983 issue. I wish I could just give a link to the article, but I have to paste it below in its entity as it doesn't exist anywhere on the Web. Actually, the concepts haven't changed that much -- as far as straight investing in Convertibles is concerned -- but the nature of these instruments have changed with the advent of computer driven arbitrage. They are not for the faint of heart.

So, this is now water under the proverbial bridge for me, but things could have turned out differently if my interest in investing finally outweighed my passion for the publishing business. Follow your dream in 2011 and watch for the launch of Mark's "Paladin Long-Short Fund."

Evaluating Convertible Debentures by Robert Hagelstein (Financial & Investment Software Review, Summer, 1983, Volume 1, No. 3)

Convertible debentures are an unusual investment opportunity but largely have been overlooked because of the complexities in evaluating them and because of the relative illiquidity of the marketplace. During the last several years, however, convertible debentures have been issued by a growing number of companies and in larger numbers, significantly improving their liquidity. This factor, in combination with the widespread availability of the microcomputer for analysis, makes convertible debentures suitable for most portfolios. Much of the following discussion of convertibles has been adapted from the manual that accompanies CONVERTICALC , a VISICALC® template that was developed for the evaluation of convertible debentures.

Convertible debentures are debt instruments that are convertible into common stock. They share the most attractive aspects of both kinds of investments, the appreciation prospects of equity with the high current income of a bond. In addition, the debt characteristic of the convertible creates an investment floor, a point at which the convertible will not decline, even if, theoretically, the common declines to nearly no value (assuming bankruptcy is not the cause of the decline).

Despite the focus on convertible debentures in this article, there are also convertible preferred issues that may be of interest to the investor. A drawback to this convertible security is preferred stock has no maturity date at which time one can expect to receive par value for the investment. Nonetheless, many of the evaluation techniques discussed below can be applied to these convertibles should the investor wish to include such issues in an investment portfolio.

Corporations issue convertible bonds as an inexpensive means of raising capital. In effect, a convertible offering is an equity offering in the future, allowing the corporation to issue a debt instrument with a coupon rate much lower than prevailing rates. Until recently, convertibles were mostly the exclusive province of corporations with lower debt ratings. Persistent high interest rates have changed this; even Kodak and IBM have issued or filed to issue convertible securities.

There are several publications that follow convertible debentures, each providing essential information needed to evaluate them: the number of shares into which each debenture is convertible (the "conversion ratio"), the coupon and maturity date, the quality rating as a debt issue, the amount of debentures outstanding, and the identification of the issuer and the issue into which it is convertible (some are convertible into the common stock of companies other that that of the issuer). These publications include Standard & Poor's Bond Guide, Moody's Bond Record, and the Value Line Convertibles Service. They also provide some of the computations used to analyze convertibles, particularly Value Line.

CONVERTICALC not only gives the critical formulas for evaluating convertibles, but it also provides the data on approximately one-hundred of the most actively traded issues on the NYSE and AMEX exchanges. The user can add or substitute other issues, replicating the evaluation formulas.

Nevertheless, there is no computer program that can forecast the direction of security prices. There are a host of intangibles affecting investors' perceptions of value, many of these relating to investor psychology rather than to fundamental values. CONVERTICALC is intended to be an investment aid and does not offer any prescribed buy/sell decisions, It endeavors to supply information to evaluate convertible debentures in relation to one another and in relation to the underlying common stock.

As convertible debentures can be exchanged into the underlying common stock, at the option of the holder, the appreciation prospects of the common is crucial to evaluating its corresponding convertible, Traders convinced that the common will move substantially higher within a short period of time, are normally better off buying the common than the convertible. Longer term investors, particularly conservative ones to whom current income is important, may find the convertible to be the better choice. In both cases, however, the first step in making a buy decision is determining whether the common stock is desirable.

Convertibles selling at a large discount from par may be especially attractive to long-term investors. Such issues enable one to "lock" into a virtually guaranteed capital gain, even if the underlying common stock should fail to appreciate during the period. Another consideration is the convertible's bid and asked price. This spread will normally be small for issues actively traded on the NYSE or AMEX. It can be considerable for issues with a relatively small float and for those traded over-the-counter.

Most convertible are "callable" by the issuer, requiring the holder to either sell at the call price or convert into common stock. It is not unusual for convertibles to be called once the issue is selling at substantially more than par. Usually, convertibles are callable at prices higher than par during the first few years after issuance, declining to par as the date of maturity approaches. Many are callable at par long before maturity. For this reason Moody's Bond Record is an invaluable companion for investors considering buying convertibles: current call terms are specified.

A key element in evaluating convertibles is the issue's "conversion premium." This premium represents the percentage at which the convertible is selling over its "conversion value" (the number of shares into which one debenture is convertible multiplied by the current price of the common stock). The lower the premium, the more likely the convertible will move in relation to the underlying common stock while the higher the premium the more likely the convertible will move in relation to interest rates. Convertibles with low premiums, having relatively high yields and fast "payback" periods (see below), are generally the best buys (if, of course, the common stock merits a buy). Such convertibles will appreciate with the common stock and provide greater yields than the common stock, giving the investor the best of two worlds: capital gains and lower downside risk.

As the conversion premium is intrinsic to evaluating convertible values, the CONVERTICALC disk includes a section sorted by conversion premium. Generally, those convertibles carrying premiums of less than 5% will follow nearly all of the underlying common stock's rise. However, some of these same issues may be equally vulnerable to a substantial decline of the common while others may follow only half the common's decline. The potential magnitude of a convertible's downside risk relates to its yield in relation to those paid by non-convertibles of similar quality. Obviously, convertibles with yields to maturity approaching those prevailing for straight debt issues that would decline the least even if the underlying common stock should decline (see the discussion of the "investment premium" below).

It is possible to quantify the potential price relationship between an underlying common stock and a convertible debenture, plotting what is known as the "convertible curve" on a x/y axis graph. An awareness, however, of a convertible's conversion and investment premiums generally obviates the need to maintain such graphs.
Then, there is the concept of "payback period," the amount of time it will take to recover the conversion premium from the additional yield provided by the convertible over the common stock, This is important when considering whether one buys the convertible or the underlying common, When a convertible has a relatively long payback period and the premium is not excessive the common stock yields nearly the same as the convertible. If the dividend is relatively secure, the common stock may be a better value than the convertible,

The concept of "investment premium" can be as important to one's investment decision as the conversion premium, The former represents the percentage a convertible debenture is selling above its investment value (as if it is devoid of its convertibility feature). In order to ascertain this percentage, it is necessary to identify the debt quality of the convertible being considered. Access to Moody's or Standard & Poor's bond publications will provide a bond rating for the issue, For this reason, it is necessary for the investor to know the yield to maturity of the convertible being considered. Even if the investor is not looking for high current yield, yield to maturity is the basis for comparing convertible to straight bonds, CONVERTICALC provides an approximate yield to maturity calculation.

Quantifying the investment premium is a method of judging the potential "floor" for the price of a convertible, a means of establishing the magnitude of the investment risk, A convertible with virtually no investment premium is selling at its investment value. Such issues are more likely to be more sensitive to changes in interest rates than movement of the underlying common stock This is also a characteristic of convertibles with high conversion premiums. Therefore, generally, the investment premium and the conversion premium will tend to be the reciprocal of the other, high investment premiums following low conversion premiums and vice versa, Sometimes one can find convertibles with relatively low investment AND conversion premiums, These are the undervalued issues that should be sought by the investor; they have nearly the same upside potential as the common stock with very little downside risk if the common stock should decline (assuming static interest rates).

The investment premium may be quantified by using a hand-held calculator or the remaining memory available on the VISICALC matrix. After the bond rating for the convertible issue being evaluated has been ascertained, and the prevailing yield for equivalent non-convertible debt issues has been established, a bond table would reveal at what price the convertible would have to sell to yield the prevailing rate. Then, by subtracting the current price from the price at which it would have to sell to yield the prevailing rate and dividing the remainder by the current price, the investment premium can be calculated. Common sense can generally substitute for an actual calculation. In comparing a number of convertibles chosen on the basis of relatively low conversion premiums, ones of roughly the same investment grade, those with the highest yields to maturity have the lowest investment premiums.

Convertibles should not only be analyzed against one another and against the underlying common stock; they should also be evaluated against themselves over a period of time. Maintaining a file on a regular basis and recording changes in the key convertible evaluation components - conversion premium, yield, and payback period - enables the investor to "plot" bands of values. Market volatility, earnings growth, interest rate movements will profoundly affect these statistics. By observing these movements as computed by CONVERTICALC, the investor can decide when the common is overpriced in relation to the convertible or vice versa. One may want to sell a convertible whose conversion and investment premiums have become too excessive and switch into one with lower premiums and/or a higher yield. By observing diligent portfolio management the investor can maximize return and minimize risk.
"Evaluating Convertible Debentures" © 1983 by Robert Hagelstein. CONVERTICALC, is a VISICALC® template formatted for 64 K APPLE II® DOS 3.3. APPLE® is a registered trademark of Apple Computer, Inc. VISICALC® is a registered trademark of VISICORP''.