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The year 2008 is finally behind us. It is now time to regroup and rebalance portfolios as we move into 2009, trying to regain some of the losses incurred in 2008. All the major equity indexes were down considerably last year, as if we needed a reminder. The Dow Jones Industrial Average lost about 34%, the S&P 500 Index was down 38%, the NASDAQ Composite fell 24%, and the Russell 2000 Index dropped 35%. Value Line’s All Convertibles Total Return Index fell 28.8%. As resilient as convertibles have historically been, they too suffered badly as stocks decreased by unprecedented amounts. At this point, many investors are wondering how they can capitalize on the current economic trough with a profitable strategy involving convertibles. This concern, however, will be discussed at length in a future narrative. Meanwhile…  


The convertible new issue market virtually dried up during the final quarter of 2008 as corporations stayed on the sidelines waiting for some sign that the worst was over and a possible growth (or rather recovery) scenario was finally emerging. Although we see little sign of this at present, it appears investors are keen to turn the page on 2008 and, so far this year, have optimistically bid up stocks in the face of bad economic news. The Dow Jones Average is already up 2.7%, the S&P 500 has risen 3.5%, and the NASDAQ has climbed 4.8%. The Value Line Arithmetic Index has gained 7.3% since the beginning of the year.


Selecting Convertibles for Inclusion on Our Especially Recommended List


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 (on page 5), we select issues that meet and/or surpass certain stringent criteria required to be recommended for purchase. In addition to being ranked 1, in order to be selected, a convertible must offer a current yield advantage over its underlying stock, except in cases of zero coupon bonds or warrants; have favorable leverage (this means that they are expected to participate to a greater degree in an increase in the underlying common’s price than in a decrease in the stock’s price); have some degree of call protection intact, or should not be a likely call candidate; and fairly easy to trade. Sometimes, however, we include illiquid issues because issues that are liquid when recommended can become illiquid and therefore difficult to trade. Although illiquid issues are listed on our Especially Recommended table, we suggest investors avoid them.


Performance Results


For the fourth and final quarter of 2008, our ranked 1 Especially Recommended convertibles lost 11.7%, and all the rank 1 convertibles, as a group, lost 13%. For the full year, our Especially Recommended Rank 1 Convertibles dropped 12.1%, and the rank 1 convertibles group lost 19%. Our All Convertibles Total Return Index lost 21% for the quarter, and 28.8% for the full year.


Our Especially Recommended convertibles are categorized into four risk groups based on their 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 the stock is in relation to the median stock in The Value Line Investment Survey universe of over 3,500 stocks. The High Risk group consists of only warrants 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%. The Low Volatility (modest profit potential) group has convertibles whose Relative Volatility is 60% and below. Performance in these groups was in reverse order. For the quarter, rank 1 convertibles in the Low Volatility—Modest Profit Potential group showed the best performance losing only 11.2%, and 10.6% for the full year. Convertibles in the Moderate Profit Potential group declined 15.8% for the shorter period, and 24.9% for the year. The Above- Average Profit Potential group lost 19.2% for the quarter, and 28% for the year. There were no liquid recommendations in the High Risk during the year. These results are posted in Figure 1 on page 34.


Since our policy is to purchase issues ranked 1, hold when the rank drops to a 2, and sell if the rank falls further (to 3), we also evaluated the performance of our entire portfolio of recommended issues. Again, the groups performances were in reverse order with the most defensive group falling only 3% for the quarter and 7.2% for the year. The Above-Average Profit Potential group and the Moderate Profit Potential group both lost 19.2% for the quarter, but lost 36.7% and 20.1%, respectively, for the year. The High Risk group (the warrant group) lost 42.3% for the year. See the quarterly performance results for the combined rank 1 and rank 2 convertibles over the years since 2004 in Figure 2 on page 35.


Liquid vs. Illiquid Issues


Even though we carefully select convertibles we recommend, inevitably illiquid issues (those that are difficult to trade because of an inadequate amount of the issue outstanding, or issues not readily traded) are included. And, liquid issues sometimes do become illiquid due to partial redemption, early conversion, or repurchase. Rarely, however, do illiquid issues offer a true performance advantage, even if it appears so by results. In cases where the actual trading price and volume on a convertible are unavailable (which is often the case with illiquid issues), performance results will reflect price quotes that represent the midpoint between the bid/ask spread, and illiquid issues often trade at wide bid/asked spreads. If an investor buys an issue at the asked price and sells it at the bid, such wide spreads will dramatically reduce the profit potential these issues appear to possess on paper. Still, for those investors who might be interested in pursuing illiquid issues, Figure 3 on page 34 compares the fourth-quarter returns of both liquid and illiquid issues and combined as a group.  


Conclusion


Our performance results underscore the defensive nature of our portfolio. These results serve only as an indication of how investors would fare following our recommendations at the quoted trading levels. Invariably, some convertibles are inaccurately quoted, and prices do change at the point of purchase, which would have an impact on the performance results of individual portfolios, plus commission costs and other expenses are not taken into consideration. Furthermore, constant maintenance of such a model portfolio like ours would more than likely offset some of the perceived gains. While past results are no guarantee of future performance, Value Line’s convertible ranking system (which weighs such key factors as the attractiveness of the underlying stock, the convertible’s yield advantage over the common, its investment value, as well as some inaccuracy in pricing the convertible) has proven effective over the years. We are confident that our proprietary model will continue to discriminate effectively among our universe of convertible securities, giving subscribers/investors an edge in the convertible market.