16. Convertible Issues and Warrants

Convertible bonds and preferred stocks have come into fashion at the time this edition was published, and stock-option warrants (long-term rights to buy at specified prices) have become more numerous, and are being handled on the major exchanges.

From the perspective of the investor, there are two key concerns: how they rank as investment opportunities and how their existence affects the value of related common-stock issues.

Convertible bonds and preferred stocks are claimed to be advantageous to the investor, in giving them the security and dependability of a band, plus the opportunity to benefit from a substantial increase in the value of common stock. The value to the issuer is in its ability to "repay" bonds with stocks from its treasury (which effectively cost the firm nothing) for investors who choose to convert their holdings. The consideration can be "much trickier" in practice, given the terms of a given security, the stability of the firm in question, and the performance in the market.

However, by analyzing the convertible issues in existence, it becomes clear that they are bound to yield unsatisfactory results as a whole: the option to convert is used to improve the appeal of a security that is unattractive, either as a result of the firm's performance and credit rating or the interest yield issued as compared to the market rate, and the number of shares offered for conversation is generally set at a level where the instrument is unlikely to be converted.

Looking at 42 convertible issues in 1947, during which time there were a significant number, there was no single instance in which the price of the stock increased an average of 30%, and no single issue had any increase in price or even maintained its value over the same course of years. A control group of 37 "straight" issues from the same year showed 7 maintained or increased in value, and of those that decreased, the average decline was only about 9%. The conclusion to be drawn from this analysis is that convertible issues are in themselves less desirable than nonconvertible securities of the same kinds.

However, it is conceded that a convertible issue is generally safer than the common stock of the same company - though this becomes an uneven comparison, as bonds are generally less risky than stocks and are measured by different criteria: an investor would be well advised to separate his funds for bonds and stocks and choose companies in either category, rather than choosing a given company and making a stock-or-bond decision for investing in it.

Another dilemma for the holder of a convertible issue is determining when to convert an issue: should the price of shares rise to the point that redeeming the bond becomes attractive, should the investor convert immediately, or continue to hold the bond while waiting for the stock to rise to a higher price. Depending on the interest rate of the bond and the number of years to maturity, it may require a stock to rise to provide at least 25% more than the present value of bond interest, which is more certain. And naturally, this is if the investor restricts himself to pure mathematical logic and does not succumb to the "mental anguish" that arises from fear of making a bad guess.

The author notes that the common maxim on Wall Street is to "never convert a convertible bond," because the investor loses the certainty of future interest and the potential for greater earnings if the stock continues to rise would be immediately voided. If the advice is never to convert a bond that is convertible, it would seem the wiser option simply to buy a straight bond that can never be converted anyway.

All of this considered, the author's general attitude about convertible issues is admittedly mistrustful. There is the potential for this form of investment to be rationally assessed as preferable to specific buyers under specific market conditions - but for most buyers in most conditions, they offer little advantage and worse prospects than other forms of investment.

Effect of Convertible Issues on Common Stock

While the potential holder of a convertible issue has one set of risks, a far greater risk is taken on by the holder of common shares in any firm that deals in convertible securities.

In the event that the price of the stock should rise to the point where holders of these instruments would seek to exercise the option to convert, shares are released to the market, diluting the value of existing shares. In such instances, the investor must reevaluate his investment decision in light of the potential for this dilution to occur, which will ultimately have a negative impact on any measure of value pertaining to the price and number of shares outstanding.

This potential should give pause to the holder of such a stock, but is also a matter of concern for prospective buyers, which drive down the price of a stock according to their pessimism about the prospect of dilution.

Indicated Switches from Common into Preferred Stocks

The comparison between the prospects of common and preferred stocks have inverted throughout history: at some times, the potential earnings of common stocks have been better than those of preferred stocks, and at other times, preferred stocks promised better return than common ones.

As such, some investors consider swapping their holdings from common to preferred stock, or vice versa, choosing to hold the type of shares that held the most promise at any given time. Such practices ignore the fundamental differences between the two securities: preferred stock is not analogous to common stock, but to bonds.

Perhaps the only valid consideration of switching between the two is when a considerable premium or bargain is offered - that is, when converting preferred shares to common stock offers the ability to acquire the common stock on the open market, or vice-versa.

Stock-Option Warrants

"Let us mince no words," the author writes. "We consider the recent development of stock-option warrants as a near fraud, and existing menace, and a potential disaster. ... They should be prohibited by law, or at least strictly limited."

Originally, stock-option warrants issued by a firm were attached to a bond issue, inherent in the conversion privilege. In this instance, the investor who held a bond would give something of value to the firm (namely, freedom from the debt owed) in exchange for the stock. Where options are divorced from bonds, the firm sells an option to buy, in exchange for nothing at all.

This is universally detrimental to investors. Those who purchase warrants are unlikely to be able to redeem them at a rate that would exceed the cost of purchasing the warrant - in effect, paying a fee in exchange for something the seller expects to be completely worthless. Investing in such issues is tantamount to gambling where there is little chance of success.

It is seen as a good deal for the selling company because the firm receives an immediate payment for a good it may never have to deliver. The downside of this is that, if the stock rises in price, the options will be exercised, and the company will be compelled to issues shares from its treasury, diluting the value of existing shares, and will find that it has received from them a considerably lower price than could have been had by merely selling additional common shares when the need for capital arises.

(EN: The author's dim view in general seems to consider options written by the company directly, and does not mention the writing of options contracts by brokerage houses or individual investors, which seems to be the more common practice in the modern market. However, I would expect that the cautions to buyer and seller alike remain identical)

Practical Postscript

The author considers warrants in general, whether tied to a convertible issue or sold independently, to be an exceedingly bad idea. And yet, the periodic instance of a warrant in which an investor made an astronomical profit attract much attention among the greediest of speculators.

The example is given of Tri-Continental corporation's warrants which were originally sold at 1/32 of a dollar during the depths of the 1929 depression, and rose to a rate of $75.75 some years later, yielding a return of 242,000%. Even in the current market, one can find instance of warrants that will more than double in value in the course of a single year.

In theory, the practice of trading in options can be conducted in much the same manner as trading in stocks: they depend on the prediction of the future value of stock prices by buyers and sellers - but given the extreme degree of risk, it is even less practical as a method of either investment by the individual or fund-raising by a corporation.