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Amid a global rally, the U.S. equity benchmarks were off to a blistering start in the first quarter. Gains in these indexes were attributed to the surprising turn in economic conditions, both here and abroad. The U.S. economy seems to have found a stable footing, and Greece’s debt crisis was calmly “settled.” Investors embraced riskier assets such as small-capitalization stocks and “junk” bonds. Companies with questionable credit ratings issued almost $76 billion in bonds in the first quarter, which was the most issued since 1980, at least. Meanwhile, small-cap stocks had their best first quarter since 2006.

During the period, the Dow Jones Industrial rose 8.1%, gaining 994 points to register its largest point start increase to any year, while many other indexes experienced levels that exceeded year-end estimates. The broader-based S&P 500 Index was up 12% to 1408.47, the Russell 2000 also climbed 12% to 830.3, and the Nasdaq Composite gained almost 19% to 3091.6. Value Line’s Arithmetic and Geometric Indexes rose 13.8% and 12.4%, respectively. Still, the picture could turn gloomy, as seen in 2010 and 2011 when stocks got off to strong starts only to falter later in the those years. Headwinds include the fact that oil prices continue to climb, a result of the growing tension in the Middle East, the European credit crisis seemingly ready to raise its ugly head again.

The exodus of capital from safer investments into more-risky global assets curtailed the value of convertibles in the first quarter. While some lower-volatility convertibles had good performances, stocks underlying our recommended convertibles outpaced the debt issues 18% to 8.6%. But overall, our convertible universe, as a group, did better than their underlying common stocks. The Value Line All Convertibles Total Return Index rose 8.7% for the period, while the underlying stocks gained 7.3% (not including dividends).

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: 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 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

During the period, group performances were in the order expected. Convertibles in the Above-Average Volatility group posted a gain of 11.9%, those in the Moderate Volatility group, 11.7%, and the Low Volatility group, 7.9%. The High Risk group, which contains only warrants, returned a gain of 33.5%.

Performance Results of Recommended Ranked 1 Convertibles and Warrants

Our Especially Recommended Rank 1 convertibles portfolio (including warrants) posted an 8.3% gain. Without warrants, the convertibles portfolio gained 8.0% in the quarter. Meanwhile, convertibles ranked 1 (recommended or not) in our database posted a return of 9.3%.

Looking at the Especially Recommended list by volatility groups, the Above-Average Profit Potential group suffered a loss of 1.6%, while the Modest Profit Potential group and the Low Profit Potential group gained 14.4% and 7.6%, respectively. The High Risk group (warrants) posted a gain of 24.2%.

Conclusion

Convertibles are defensive in nature, and that is evident in a downward spiraling equity environment. However, in up-trending equity markets they tend to lag the performance of their underlying stocks. Over the longer term, however, 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 quotes on these convertibles, the quoted 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. 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 30 years ago, our recommended convertibles have returned about 17.3% (annualized).

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