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Europe’s debt crisis has continued to take its toll on the global economies, including that of the United States. The month of June was a boon for most market indexes after it looked as if some kind of resolution to European debt worries had been agreed upon. However, the uptick was gradually eroded in the ensuing two months, and the major indexes ended the quarter in negative territory. The Dow Jones Industrial Average registered a 2.5% loss; the S&P 500 decreased 3.3%; and the NASDAQ suffered a 3.8% decline. Meanwhile, the Value Line (Arithmetic) Index lost 5.6%.

As expected, equity losses among convertibles were cushioned by interest or dividend income and investment value. The Value Line Convertibles Survey All Convertibles Total Return Index lost 0.6%, while the Recommended Convertibles, as a group, suffered a 4.1% drop. Recommended Rank 1 Convertibles were down 4.2%, while all convertibles ranked 1 showed a slight 0.1% gain. The All Convertibles Total Return Index remained positive for the six-month period, up 8.2%.

Our Methodology for Selecting Recommended Convertibles

Each pricing period, our proprietary model assigns a rank of 1 (Highest) through 5 (Lowest), to convertibles whose underlying stock is ranked by either The Value Line 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 it is expected to participate to a greater degree in an increase in the underlying common's price than in a decline.
  3. Some degree of call protection, or 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 are, 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 approximately 1,700 stocks, and more than 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 Volatilities are between 65% and 90%, and the Low Volatility (modest profit potential) group has convertibles whose Relative Volatilities are 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

During the second quarter, group performances were in no particular order of expectation. Convertibles in the Above-Average Volatility group lost 15%, those in the Modest Volatility group lost 0.9%, and the Low Volatility group registered a 3.8% drop. The High Risk group, which contains only warrants, was the only group with a positive return of 4.8%.

Performance Results of Recommended Ranked 1 Convertibles and Warrants

Our Especially Recommended Rank 1 convertibles portfolio (including warrants) posted a 4.2% loss. Meanwhile, all convertibles ranked 1 in our survey posted a return of 0.1%.

Looking at the Especially Recommended convertibles that were ran 1 during the quarter in each volatility group, those in the Above-Average Profit Potential group suffered a loss of 14.2%, while the Modest Profit Potential group showed a gain of 1.5%, and the Low Profit Potential group, a loss of 4.4%. The only Rank 1 warrant in the High Risk group posted a loss of 1.5%.

Conclusion

Convertibles are defensive in nature, which becomes evident when equities are in a downward spiral. But in up-trending equity markets, they tend to lag the performance of their underlying stocks. However, over the longer term, convertibles tend to perform just as well as, or sometimes even better than, their underlying common stock at a reduced risk level. 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, the quoted prices may not be available when an investor acts on our recommendations. Moreover, commission costs and other expenses are not taken into consideration in our calculations. So, 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 convertibles market. Since we began measuring our performance over 30 years ago, our recommended convertibles have returned about 17.5% (annualized).

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.