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Despite the uncertainties of global economic conditions last year—a downgrade in the U.S. credit rating, political gridlock in Washington, Europe’s lingering debt crisis, as well as falling home prices, and higher oil quotations--the Dow Jones Industrial Average managed to end the year up 5.6%, thanks to a 12% increase in the fourth quarter. The broader-based S&P 500 Index closed unchanged for the year, while the NASDAQ and the Russell 2000 Index lost just 1.8% and 5.4%, respectively.

As per usual, investors, faced with economic and political uncertainty throughout the year, turned to safer haven in high-quality bonds and gold, as well as convertible bonds and preferred stock. But the drag on stocks during the months between June and November resulted in disappointing results for convertible investors. In fact, the average convertible showed better results in the fourth quarter (up 2.6%) after two consecutive negative quarters. The index ended the year down 3.9%, compared with a gain of more than 17% in 2010. The Value Line Arithmetic Index* lost 6% in 2011.

Our Especially Recommended convertibles fared somewhat better, gaining 7.3% for the fourth quarter and finishing the year up 4.6%. All Rank 1 convertibles, as a group, gained a small 1.2% in the final quarter, but finished up 2011 with a loss of 2.5%. Meanwhile, Especially Recommended rank 1 convertibles rose 10.0% in the fourth quarter, and 6.2% for the year.

As the underlying common stocks lost value, so did warrants recommended during the year. For the fourth quarter, they lost almost 11%, and for the year, they shed about 46%.

Our Methodology for Selecting Recommended Convertibles

Each pricing period, our proprietary model assigns a rank, 1 (Highest) through 5 (Lowest), to convertibles whose underlying stock is ranked by either The Value Investment Survey or its sister publication, The Value Line Investment Survey Small and MidCap Edition. From the list of Rank 1 convertibles, we cull issues that meet or surpass certain required criteria to be recommended for purchase. To be selected, an issue, besides being ranked 1, must possess the following attributes:

1. A current yield advantage over its underlying stock, except in cases of zero coupon bonds or warrants.
2. Favorable leverage, meaning that the security is expected to participate to a greater degree in an increase in the underlying common's price than in a decline of similar magnitude.
3. Some degree of call protection, or is not a likely call candidate for redemption.
4. Fairly liquid for easy trading.

Note: Illiquid issues are sometimes listed on our Especially Recommended table because previously liquid issues can become illiquid, and, therefore, difficult to trade. Too, as holders convert or companies repurchase outstanding notes, issues that were once considered liquid become illiquid. Still, although illiquid issues are listed on our Especially Recommended table, we suggest investors avoid them.

Recommended convertibles are categorized into four different risk groups based on Relative Volatility--an internal indicator of the level of risk in holding a convertible vis-à-vis its underlying common stock. The relative volatility of the stock is a measure of how risky that stock is in relation to the median stock in The Value Line Investment Survey universe of more than 1,700 stocks, and the over 1,800 stocks in The Value Line Investment Survey Small and MidCap Edition. Our High Risk group consists of warrants only, and has the highest profit potential. The Above Average Volatility group carries convertibles with Relative Volatility of 95% and above, with above-average profit potential. The Modest Volatility (moderate profit potential) group has convertibles whose Relative Volatility is between 65% and 90%, and the Low Volatility (modest profit potential) group has convertibles whose Relative Volatility is 60% and below. Higher returns are expected from convertibles in the Above-Average Volatility group than those in the Modest Volatility group. So too are convertibles in the Modest Volatility group expected to outperform convertibles in the Low Volatility group.

Performance Results of Recommended Convertibles and Warrants Ranked 1 and 2

Group performances were mixed in the fourth quarter and for the year. For the short period, convertibles in the Above-Average Volatility group posted a gain of 7.8%, those in the Moderate Volatility group, 3.5%, and the Low Volatility group, 8.0%. For the year, the Above-Average group lost 9.6%, while the Modest and Low groups posted gains of 0.1% and 7.0%, respectively. Warrants lost 10.9% in the fourth quarter, and finished the year down 45.6%.

Performance Results of Recommended Ranked 1 Convertibles and Warrants

Our Especially Recommended Rank 1 convertibles portfolio (including warrants) posted a gain of 9.7% for the fourth quarter, and 2.9% for the full year; Rank 1 warrants gained 23.1% in 2010. Without warrants, the convertibles portfolio gained 10.0% in the fourth quarter, and 6.2% for the full year compared to 19.1% in 2010. Meanwhile, all convertibles ranked 1 in our Survey, as a group, posted a return of 1.2% for the quarter, but lost 2.5% for the year. In 2010, the group posted a gain of 21.3%.

By volatility groups, the Above-Average Profit Potential group performed the best posting a gain of 20.1% for the quarter, and 4.0% for the year; the Modest Profit Potential group, 4.1%, and 1.9%, respectively; and the Low Profit Potential group, 10.3% and 8.3%, respectively. The group with warrants lost a mere 0.4% for the quarter, and 38.4% for the full year.

Conclusion

Convertibles are defensive in nature, which becomes evident when their underlying common stocks are caught in a downward spiral. Downward trending equity markets reduce a convertible’s value, but a convertible tends to fall less then its supporting common stock. The Value Line (Arithmetic) Index*, as well as the broader-based Russell Composite 2000 and NASDAQ, all suffered greater losses than the average convertible in 2011.

Our results serve only as an indication of how investors would fare following our recommendations at the quoted trading levels. As we depend on outside sources for quotations on these convertibles, these prices may not be available when investors act on our recommendations. Moreover, commission costs and other expenses are not taken into consideration in our calculations.

While past results are no guarantee of future performance, Value Line's Convertible Ranking System has proven effective over the years. We remain confident that our proprietary model will continue to discriminate effectively among our universe of convertible securities, giving subscribers an edge in the convertible market.

At the time that this article was written, the author did not have any positions in any of the companies mentioned.