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Convertibles are made up of two parts: a fixed-income portion (which is bond-like) and a warrant (a call option on the underlying common stock). Thus, the value of a convertible depends on the sum of both parts. The bond value is the value of the convertible at maturity, without the warrant feature, discounted to the present value. This depends on many variables such as the size of the coupon, the company’s investment quality and financial strength, as well as the amount of time to maturity. The warrant portion gets its value from the activities of the underlying common stock; the more the stock advances, the higher the value of the warrant, and vice versa.

Common stocks ranked 1 or 2 by our sister publications, The Value Line Investment Survey and he Value Line Investment Survey Small and MidCap Edition, are deemed to have the potential to outperform market averages in the upcoming six to 12 months. Convertibles are assigned ranks based on the attractiveness of their total return potential. The rank of the underlying common stock contributes significantly to the ranking of the convertible, as it pertains to the warrant portion of the security. So, if the underlying stock is ranked for above-average performance, the convertible’s potential total return is likely to be above average. That said, because convertibles are a hybrid instrument between a bond and a stock, they generally do not share fully in gains in the stock. On the other hand, convertibles generally offer income above that available from the common and often a relatively lower level of risk.

As the conversion value approaches the price of the convertible, the premium at which the convertible trades tends to gradually disappear. The lower the premium over conversion value, the greater is the convertible’s participation in the upside of the underlying stock. Convertibles trading above par generally tend to have the lowest premium over conversion value. And the smaller the premium, the more likely the convertible will mirror the activities of the underlying stock. Thus, convertibles with low premiums over conversion value enable portfolios to reap the returns of the underlying common stock, at much less risk, and in the process, gather income that is usually higher than that available from the stock.

We screened our database for favorably leveraged convertibles, trading at premiums over conversion value of 20% or less, and whose underlying common stocks are ranked for above-average performance. These convertibles display greater sensitivity to their respective underlying common stocks, and have the potential to rise more than they would fall, if the stock rises or falls 25%. Such convertibles can allow investors to increase income and reduce risk, as compared to holding just the underlying stocks, while achieving performance that, at times, could be roughly similar to owning the underlying stock.

 

Recent

Leverage

Conv Curr

Conv

Conv

<------Common------>

Convertible Securities

Price

+25%

-25%

Yld(%)

YTM(%)

Prem(%)

Price

Yld(%)

 AGCO Corp 1.25s2036            

138.43

18

-14

0.9

 NMF 

7

$52.69

 NIL

Tenet Healthcare $70.00 (Mand.)

$903.08

13

-7

7.8

 PFD 

14

$5.58

 NIL

 Smithfield Foods 4s2013        

118.53

13

-10

3.4

 NMF 

17

$22.91

 NIL

 Newell Rubbermaid 5.5s2014     

217.88

30

-20

2.5

 NMF 

-3

$19.30

1.0

 Gilead Sciences 0.625s2013     

143.87

23

-17

0.4

 NMF 

2

$53.73

 NIL

 PDL BioPharma 2.875s2015        

107.75

17

-12

2.7

0.3

7

$6.49

9.2

Vector Group 3.875s2026        

113.99

18

-7

3.4

2.7

7

$18.02

8.9

United Rentals $3.25           

$53.00

16

-12

6.1

 PFD 

13

$40.76

 NIL

 Saks 2s2024                    

104.42

14

-6

1.9

1.6

15

$10.82

 NIL

 AngloGold Ashanti $3.00        

$50.61

14

-12

5.9

 PFD 

20

$45.93

0.4

* Prices as of 9/8/2011

Highlighted Convertibles:

AGCO Corp. (AGCO) makes agricultural equipment. The company sells tractors, combines, hay tools, forage equipment, sprayers, and implements under such brand names as AGCO, AgcoAllis, AgcoStar, Challenger, Farmhand, Fendt, Fieldstar, Gleaner, Glencoe, Hesston, Lor*Al, Massey Ferguson, New Idea, RoGator, SisuDiesel, Soilteq, Spra-Coupe, Sunflower, Terra-Gator, Tye, Valtra, and White & Willmar.

According to Value Line, the top-ranking company is on its way to a good earnings performance ahead. Demand for tractors and combines, which together generate about 75% of sales, remains strong. At the end of the third quarter (September 30, 2011), sales totaled $6.26 billion, up 32% from the same point in 2010. Earnings per share soared 215% to $3.03 from $1.41. Still, the stock’s high volatility (Beta is 1.50) is a deterrent to risk-averse investors.

The company’s 1.25% convertible note due 2036 is, by nature, less volatile. In addition, it pays an income (interest) while the common is dividendless. Its participation in the activities of the underlying common stock is as much as 72% of any gains, while on the downside the drop in the convertible would be limited to only 56% of any decline in the common.

Tenet Healthcare (THC) owns and/or operates 49 acute care hospitals, with 13,428 beds, in 11 states, with concentrations in California, Texas, and Florida. It also operates specialty care facilities. Occupancy rate in 2010 was about 50.4%. Revenues of $9.2 billion were generated by inpatient service, 64.4%; outpatient service, 31.5%; managed care 4.8%; and the balance came by way of uninsured patients.

According to Value Line’s analysis, the recovery potential of the stock is attractive, as Obamacare policies come into effect soon. However, the stock’s volatility is above the market’s (with a beta of 1.20). The stock is expected to trade in the $8- to $16-a-share range over the 2014-2016 pull, and share earnings could reach as much as $0.80. As an alternative to this volatile stock, we encourage investors to take a look the company’s 7% mandatory convertible preferred stock. The preferred is more price-stable than the common, and has an attractive 7.8% current yield advantage over the common.

With a liquidation value of $1,000 per share, the preferred dividend income is $70 a year. Plus, it is expected to share in as much as 13% of a 25% rise in the common, while on the downside, its participation is limited to 7% if the common falls 25% or more.

Vector Group, Ltd. (VGR), through its subsidiaries, engages in the manufacturing and sale of cigarettes in the United States. The company’s Liggett Group LLC unit produces cigarettes in approximately 136 combinations of length, style, and packaging. The Vector Tobacco subsidiary engages in research relating to reduced-risk cigarette products. And the New Valley LLC engages in the real estate business and operates a residential brokerage company in the New York metropolitan area.

The latest financial results available are those of the third quarter in 2011. The period ended September 30, 2011, and for the nine months ended then, sales totaled $840 million, which were $55 million (or 7%) higher than the same period a year earlier. Earnings per were a bit more impressive coming in at 0.64% a share compared to $0.53 in the previous year.

A financially-sound and stable company, common stock holders have received increasing stock dividend every year since 2003, which is as far back as Value Line’s analyst goes. Currently, the dividend yield is over 9%, and that is a big attraction for stock portfolios. However, if your portfolio is restricted from purchasing common stocks, then you should consider the company’s 3.875% convertible notes due 2026 offer as an alternative to be materially exposed the company’s prospects.

The convertible offers an 18% participation in the common if the common advances by 25% or more. In addition, the convertible offer excellent downside protection should there be a significant decline in the common. Also, bear in mind that common dividends are generally to the first to go should the company face financial difficulties.

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