Benjamin Graham

Chapter 16 – Convertible Issues and Warrants

Summary and Discussion – Chapter 16 – Convertible Issues and Warrants
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created July 16th, 2014
Last updated July 23rd, 2014
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

Convertible preferred shares, convertible bonds, and warrants are all examples of “convertible issues”. In this short chapter, Graham poses two basic questions: A) Do convertible issues make good investments, and B) What effect do their have on the value of common shares? [1]

What are convertible issues?

In the simplest terms, a convertible issue is a financial instrument which can be converted into the common shares of its issuing corporation at a predetermined time and price. Such issues come in a variety of shapes and sizes but this feature—their ability to be converted into common shares—is consistent across all their forms. Examples of convertible issues include convertible preferred shares, convertible bonds and debentures, stock warrants, and stock rights.

The “Elevator Pitch”

What’s so great about convertible issues? From the perspective of the issuing corporation, convertible issues can be attractive as fundraising tools, based on the fact that their conversion feature often allows the issuer to pay a lower dividend yield (in the case of preferred shares) or interest rate (in the case of bonds and debentures) than would be the case with a non-convertible issue. Furthermore, even if purchasers elect to convert the issue into common shares, this may in fact benefit the issuer by effectively retiring part of their senior debt and replacing it with equity—thereby superficially improving the company’s debt/equity ratios. From the standpoint of the investor, convertible issues offer the potential for capital appreciation in addition fixed income. Convertibles, therefore, can be viewed as “the best of both worlds” for both parties. [2]

The Catch

The problem, of course, is that convertible issues can just as easily be viewed as the worst of both worlds, offering—from the investor’s perspective—less income than non-convertible fixed-income issues and less potential for capital appreciation than common shares. Ultimately, it is impossible to pass a judgment on convertible issues based on generalities alone. As Graham puts it, “convertible issues are like any other form of security, in that their form itself guarantees neither attractiveness nor unattractiveness. That question will depend on all the facts surrounding the individual issue.” [3]

Notes of Caution

Puts yourself into the mindset of a corporation considering whether or not to issue convertible securities. As discussed above, the attractiveness of convertible shares, from the issuer’s perspective, stems from the fact that convertible issues generally carry lower interest/dividend payments for investors. In principle, these payments should be inversely related to the perceived attractiveness of the corporation’s common shares. It stands to reason, therefore, that companies’ management are more likely to issue convertible securities during periods in which there is strong market demand for their common shares, based on the premise that during such periods investors will be willing to tolerate especially low interest/dividend payments in exchange for the right to participate in the expected capital appreciation of the common stock. For this reason, Graham encourages investors to be skeptical regarding convertible issues which are sold during periods of pronounced market optimism:

“[C]onvertible issues floated during the latter part of a bull market are bound to yield unsatisfactory results as a whole. (It is as such optimistic periods, unfortunately, that most of the convertible financing has been done in the past.) The poor consequences must be inevitable, from the timing itself, since a wide decline in the stock market must invariably make the conversion privilege much less attractive…” [4]

There is another risk associated with convertible issues, which is that they may tempt investors to venture into speculative territory into which they would otherwise not enter. Although purchasing a convertible issue from Company A is likely to be safer than purchasing that company’s common shares, there is no guarantee that Company A is worth investing in in the first place, regardless of the medium used to invest. [5] As a rule of thumb, one would be wise to avoid investing in businesses through convertible issues unless that businesses is one in which you would be happy to invest through common shares. Needless to say, this raises the further question of why, under such conditions, one would not simply opt to be a common shareholder.

Equity Dilution due to Convertible Issues

Common shareholders of any corporation must be aware of the dilutive effect which convertible issues may have on their holdings. To estimate the full potential impact which a corporation’s outstanding convertible issues may have on its shares, Graham recommends calculating EPS with the assumption that all outstanding convertible issues will in fact be converted into common shares. [6] These days, this practice is aided by the listing of diluted EPS on the statement of comprehensive income (income statement).

Although somewhat tangential to the immediate topic of this chapter, readers wishing to get a hands-on feel for the effects of equity dilution can do so through this excellent simulator.

 

Footnotes

[1] 403.
[2] 404.
[3] 404.
[4] 404.
[5] 404.
[6] 411.

 

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