Intelligent Investor Ch.16 - Convertible Issues and Warrants

Convertible Issues and Warrants

Stock-option warrants are long-term rights to buy common stocks at a specific price. Convertible issues are issues of a bond that can be converted into common stocks. 

Convertible issues rank much more important than the warrants, as the investor receives the protection of a bond or preferred stock, plus the opportunity to participate in any rise in the value of the common stock. It is as well good for the issuing company, who may not need to pay back the bond if the investor exchanges them into common stocks.

According to Graham, 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!

The convertible preferred is safer than the common stock of the same company, i.e. the risk is smaller of an eventual loss. But if you expect an eventual loss, it would not be an intelligent investment, to begin with. 

The best way to test the soundness of a convertible issue is during a decline stock market, as otherwise, you could have bought the common.  In a declining stock market, normally bonds perform better, including convertibles! In many cases where the purchasers converted their bonds into stocks and held the stock through the decline, they lost all the strategic aspects of having a convertible. From that perspective you can summarize it in 4 words:

"Never convert a convertible bond"

Once you convert you have lost the combination of the receiver of interest plus the possibility for an attractive profit! 

So what is the best combination for a convertible?  -A strongly secured convertible, exchangeable for common stock at a price only slightly higher than the current market!

So why are companies issuing these convertibles and not just bonds and common stocks?  -The advantage is that convertibles bring in a much wider class of buyers, as many institutions were permitted to buy bonds but not common stocks and normally the interest return has been roughly around half of the dividend yield for the common stocks.

Keep in mind that convertibles will dilute the current earnings per share if exercised!

Stock-Option Warrants

Graham writes directly in the beginning "They should be prohibited by law, or at least strictly limited to a minor part of the total capitalization of a company".

In the beginning, they were attached to a bond and were unimportant in amount. But they were grossly overused or misused and today you rarely find them at all.
Today you find stock-options instead!