ERI Convertibles Up 6.9% in First Quarter 2011
In a period that saw many ups and downs, Wall Street recorded its best first-quarter performance (in percentage terms) in 12 years. The Dow Jones Industrial Average gained 6.4%, but not without some volatility driven by political unrest in North Africa and the Middle East, the earthquake/tsunami/nuclear disaster in Japan, and the ongoing European debt crisis. These issues caused unsettling situations for investors. Still, the Value Line (Arithmetic) Index* rose 6.7%; the NASDAQ Composite, gained 4.8%; and the S&P 500, ticked up 5.4%. The Russell 2000 Index, which is comprised mainly of small-company stocks, was the best performer of the broader benchmarks, rising a hefty 7.6%.
Stock market volatility and unsettling world events created value for convertible debt issues, as investors sought safer havens for their hard-earned dollars. In addition to safety, convertibles generally offer greater income, while often providing favorable participation in the movements of their underlying common stocks. Our All Convertibles Total Return Index posted a 6.5% gain in the first quarter, in response to a 6.7% gain in the Value Line (Arithmetic) Index*. Convertibles recommended for purchase during the first quarter rose 6.9%, trailing only the Russell 2000 Index.
Each week, our proprietary model assigns ranks--from 1 (Highest) to 5 (Lowest)--to all convertibles and warrants in our universe whose underlying common stocks are ranked by either The Value Line Investment Survey or its sister publication, The Value Investment Survey Small and MidCap Edition. It is from the list of Rank 1 convertibles produced by our model that we cull our recommended issues. These issues are then categorized in groups according to their relative volatility (our measure of risk in convertibles). For the quarter, all Ranked 1 convertibles (excluding warrants) rose 7.2%.
Because so few of the 65 warrants in our survey are issued by companies covered by of the Value Line Investment Surveys and, therefore, are not ranked, recommended warrants are rare. However, there were two recommended warrants this quarter, and they registered a combined gain of 17.4%.
Performance of the Volatility Groups
Especially Recommended convertibles are further 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 about 1,700 stocks, and the approximately 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, and with above-average profit potential. The Modest Volatility (moderate profit potential) group has convertibles in which Relative Volatility is between 65% and 90%, and the Low Volatility (modest profit potential) group has convertibles where the Relative Volatility is 60% and below. (Note: Relative Volatility is reported in increments of 5%.)
In the case of Rank 1 convertibles, risk group performances in the first quarter were as expected. Recommended Rank 1 convertibles in the Above Average Volatility group gained 15.8%; those in the Modest Volatility group posted a 6.0% gain; and those in the Low Volatility group rose 4.1%.
Because a recommended security remains on our list when its rank falls to 2, we also measured the performance of these issues along with Rank 1 convertibles. Unlike the recommended Rank 1 risk groups, however, risk group performances of Rank 1 and 2 convertibles combined were mixed. Convertibles in the Above-Average Volatility group returned 12.2%, while those in the Low Volatility group gained 6.9%. The Modest Volatility group posted a 4.3% gain.
Our performance results underscore the defensive nature of our portfolio. Bear in mind, however, that these results serve only as an indication of how an investor would fare following our recommendations at the quoted trading levels. Our prices are not actual prices, since we do not trade these securities. And, our pricing dates lag our publication dates, so investors will invariably receive a different price quotation at the point of purchase. Furthermore, commission costs and other expenses are not taken into consideration for our calculations. Therefore, modeling your portfolio to match ours would more than likely offset some of the potential gain.
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, and its investment value, as well as some inaccuracy in pricing the convertible) has proven effective over many 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 convertibles market.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.