Having dealt with common stocks in several previous examples, Benjamin Graham tackled convertible issues and warrants in chapter 16 of “The Intelligent Investor.”
Confused about these securities? You’re not alone; Jason Zweig led off his commentary to the chapter with these words:
“Although convertible bonds are called 'bonds,' they behave like stocks, work like options, and are cloaked in obscurity.”
While convertibles are unlikely to be top of mind for investors in 2018, who knows what will become important when the current bull market ends? Therefore, it’s worth grappling with the issues in this chapter because, as the old adage goes, “The more things change, the more they stay the same.”
Graham examined with three types of securities: convertible bonds, preferred stocks and stock options (also called warrants). While there are individual differences, they share one important trait: They can be converted to common stocks, subject to various conditions.
Convertible bonds
These are first described as offering advantages to both the investor and the corporation that issued them. Specifically, the investor gets the protection of a bond as well as an opportunity to participate if the price of the common stock goes up substantially. The mechanism involved is a right to convert bonds into common stocks at a certain price at a certain time; this is somewhat similar to a stock option.
For the issuing company, convertibles provide an opportunity to raise capital at a modest interest rate (or dividend in the case of preferred stock). In addition, if the company succeeds and its valuation increases, the company may buy it back.
Graham pointed out a problem with this so-called bargain for both sides. Both sides give up something, even if that something is hard to define:
“On this subject there are a number of tricky arguments to be advanced both pro and con. The safest conclusion that can be reached is that convertible issues are like any other form of security, in that their form itself guarantees neither attractiveness nor unattractiveness. That question will depend on all the facts surrounding the individual issue.”
For example, one of those facts is the stage of the market. Buying a convertible near the end of a bull market usually will not work because the price of the stock will likely drift or drop lower. Graham concludes that while convertibles theoretically confer advantages, “... we clearly see that other things are not equal in practice and that the addition of the conversion privilege often—perhaps generally—betrays an absence of genuine investment quality for the issue.”
Convertible preferred stocks
Similarly, Graham saw little advantage in convertible preferred stocks, even though they carry less risk than common stocks. He noted that investors often buy these securities, despite a lack of confidence in the common shares. In his view, investors are being tempted by a perceived ideal combination of a prior claim plus a conversion privilege at a price close to the current market. Statistics, he said, indicate this is most likely to produce a pitfall.
Convertibles of both kinds frequently thrust a behavioral dilemma onto investors. If the price of the common stocks goes up “considerably,” then the issue may be called. That forces a decision of whether to sell out or to convert into common stocks.
To make matters worse, Graham cited an old Wall Street maxim, “Never convert a convertible bond.” Once investors convert, they lose their strategic combination of being a priority claimant and a chance to make a profit. As a result, investors become speculators (and that’s never a good thing in Graham’s world).
Stock options (warrants)
There is no holding Graham back on this subject:
“Let us mince no words at the outset. We consider the recent development of stock-option warrants as a near fraud, an existing menace, and a potential disaster. They have created huge aggregate dollar “values” out of thin air. They have no excuse for existence except to the extent that they mislead speculators and investors.”
Jason Zweig, in his commentary to the chapter, was not a believer either. He made this case against covered calls (an option combined with a common stock):
“You’ve put a floor under your losses, but you’ve also slapped a ceiling over your gains. For individual investors, covering your downside is never worth surrendering most of your upside.”
Graham didn’t like stock options/warrants from a corporate perspective either:
“Once more we assert that large issues of stock-option warrants serve no purpose, except to fabricate imaginary market values.”
While Graham disliked the corporate practice of issuing warrants, a couple of points need to be raised when discussing stock options. The traded stock options commonly quoted have no direct connection to the issuing company; instead they are created by market makers, and investors/speculators trade them with each other, mainly on the Chicago Board Options Exchange (CBOE).
Second, Graham and Zweig referred to the practices of unsophisticated options buyers and sellers. More sophisticated options users have a host of constructive practices that help them achieve their objectives (see Radioactive Trading, for example).
There is, perhaps, another, personal reason for Graham’s antipathy to convertible securities. In a 2012 GuruFocus article, “Benjamin Graham - 'The Memoirs of the Dean of Wall Street,'” Jose Vasquez explained what happened many years earlier:
“He also specialized in hedges like buying convertible bonds and at the same time shorted the underlying stock in order to have a hedged trades (sic). Hedges played out quite well until the 1929 crash came and he covered most of the short stocks at an initial profit without closing the convertible bonds at the same time. That had bad consequences since the stock market fell for years and being more than 100% leveraged he accumulated 80% of losses.”
Experience, then, also helps us understand not only Graham’s thoughts on convertibles, but also why they too should tread carefully.
(This review is based on the 1973 revised edition of “The Intelligent Investor,” republished in 2003 with chapter-by-chapter commentary by Jason Zweig and a preface by Warren Buffett (Trades, Portfolio) (Trades, Portfolio). For more articles in this series, go here.)
