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Stocks performed solidly in the third quarter, as the Federal Reserve announced more stimulus measures for the U.S. economy, and efforts to ease the crisis in the euro zone were stepped up. The Dow Jones Industrial Average managed to post a 2.6% gain for the month of September, and 4.3% for the quarter. The S&P 500 Composite gained 2.4% for the month, and 5.8% for the quarter. The Russell 2000 and the NASDAQ Composite posted 3.1% and 1.6% advances, respectively, for the shorter period, and 4.9% and 6.2%, respectively, for the longer period. Despite the decent showing, investors were still not overly convinced that they should be in stocks. More than $50 billion was funneled from U.S. stock funds into bond mutual funds and exchange-traded funds, according to the Wall Street Journal, as investors sought ways to protect their investments.

The uptick in stocks augured well for convertibles. Premiums over conversion value shrank somewhat, allowing for greater participation in the advances of the underlying common stocks. In part, on a total-return basis, the Value Line Convertibles Survey All Convertibles Total Return Index posted a 4.7% gain for the quarter, following a slight decline (0.6%) in the previous quarter, and was up 13.3% year to date. Meanwhile, our Especially Recommended Convertibles, as a group, posted a 3.0% gain, up from the 4.1% drop in the second quarter, and a 7.3% gain for the nine-month period. Recommended rank 1 convertibles were up 4.3%, reversing a second-quarter drop, and they were up 7.9% for the nine months ended September 30th.

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 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: Occasionally, illiquid issues are included in our Especially Recommended list because previously liquid issues can become illiquid, via conversion or repurchase by companies, and, therefore, difficult to trade. We suggest avoiding such issues even though they are listed.]

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 over 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 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 for the Third Quarter

During the third quarter, the groups performed as expected. That is, convertibles in the Above-Average Volatility group gained more than those in the Modest Volatility group, and convertibles in the Modest Volatility group outperformed those in the Low Volatility group. Convertibles in the Above-Average Group gained 4.1% for the quarter. Those in the Modest Volatility Group rose 3.4%, and those in the Low Volatility group gained 2.8%. The High Risk group, which contained three warrants, fell 4.2% during this timeframe. For the nine months ended September 29, 2012, the performances were mixed. The Above-Average Volatility convertibles lost 1.0%. Convertibles in the Modest Volatility group gained 14.5%, while those in the Low Volatility group posted a 6.7% gain.

Performance Results of Recommended Convertibles and Warrants Ranked 1 for the Third Quarter

Our Especially Recommended Rank 1 convertibles portfolio (including warrants) posted a 4.3% gain for the quarter. Meanwhile, all convertibles and warrants ranked 1 in our Survey posted a return of 3.9%.

Looking at the Especially Recommended convertibles that were ranked 1 during the third quarter in each volatility group, those in the Above-Average Profit Potential group gained 29.1%, thanks to the stellar performance of Sunrise Senior Living’s 5% notes due 2041. (The company had earlier agreed to be purchased by Health Care REIT.) The Modest Profit Potential group returned a gain of 5.1%, and the Low Profit Potential group, a gain of 2.6%. The warrant category lost 1.9%.

Conclusion

The defensive nature of convertibles is evident when equities are in a downward spiral. However, 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 stocks,  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. But, as we depend on outside sources for quotes 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 convertible market. Since we began measuring our performance over 35 years ago, our especially recommended convertibles have returned about 17.1% annually.

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