The housing market, higher oil prices, and the mire in which financial companies have been plunged as a result of the subprime mortgage mess took their toll on the economy in the final quarter of 2007. All major equity indexes suffered losses in the period. The Dow Jones Industrial Average was down 3.8%, the S & P 500 declined 3.2%, the Russell 2000 decreased 4.2%, and the Nasdaq Composite fell 1.0%. This resulted in a flight to safety as investors searched for guaranteed income with far less exposure to risk.
After a somewhat sluggish year for new convertibles, the primary market opened in December with corporations gaining $17.6 billion in proceeds from the issuance of new convertible securities. With over $95 billion in new issues, 2007 was the second best year for new convertibles since 2001, when $106.4 billion was sold. Despite this flow of new issues, convertibles waned in the final quarter, though outperforming common stocks as expected. Overall, our recommended convertibles suffered losses during the December quarter, but managed to post positive results for the year. Especially Recommended rank 1 convertibles were up 9.5% for the year, and our All Especially Recommended convertibles gained 3.3%. Our All Convertibles Total Return index lost 1.1%% for the shorter period, but gained 4.8% for 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. To be selected, a convertible must be ranked 1 (highest), and offers a current yield advantage over its underlying stock, except in cases of zero coupon bonds or warrants. In addition, selected convertibles must display 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. Furthermore, selected convertibles should have some degree of call protection intact, or should not be a likely call candidate, and are fairly easy to trade. Still, illiquid issues are included on our Especially Recommended list, and 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.
For the fourth and final quarter of 2007, which includes pricing dates between September 28 and December 28, our All Especially Recommended rank 1 convertibles lost just 1/10th of a percent, and all the rank 1 convertibles, as a group, gained 1.1%. For the full year, the All Especially Recommended Index gained 9.5%, and the rank 1 convertibles group gained 7.4%. Our All Convertibles Total Return Index lost -1.1% for the quarter, but gained 4.8% 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 mixed. For the quarter, rank 1 convertibles in the Low Volatility?Modest Profit Potential group showed the best performance with a gain of 1%, and turned out to be the year?s winner with a 12.7% gain. Convertibles in the Above Average Profit Potential and the Moderate Profit Potential groups suffered declines of 5.5% and 4.3%, respectively for the shorter period. For the full year, the Above Average group lost 6.6%, and the Moderate Potential group gained 1.4%. There were no liquid recommendations in the High Risk during the year. These results are posted in Figure 1 on page 34.
Since we advise investors to purchase recommended issues when they are 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 best performing group for the quarter and the year contained convertibles with the lowest risk (or highest price stability). The Low Volatility?Modest Modest Profit Potential group outperformed the higher groups showing a slight gain in the highly volatile fourth quarter and a gain of 10.9% for the year. The Above Average Profit Potential group lost 5.9%% for the quarter, but finished the year on the plus side with a 2.7% gain. The Moderate Profit Potential group lost 6.0% for the quarter and 3.4% for the year, by far the worst performer. During the year, The High Risk (warrants) category recorded a lost of over 60% for the one issue we recommended in the first quarter of the year. See the quarterly performance results for the combined rank 1 and rank 2 convertibles over the years since 2000 on page 35 (Figure 2).
Liquid vs. Illiquid Issues
Even though we carefully select the convertibles we recommend, we sometimes include relatively illiquid issues?those that are difficult to trade because of an inadequate amount of the issue outstanding, or issues not readily traded. Moreover, 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 purinclude relatively illiquid issues?those that are difficult to trade because of an inadequate amount of the issue outstanding, or issues not readily traded. Moreover, 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.
Our performance results underscore the defensive nature of our portfolio. The 6.6% lost from rank 1 convertibles in the aboveaverage group, where above average profit was expected, could not match the 12.7% gained by rank 1 convertibles in the Low Volatility?Modest Profit Potential group. 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, the 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.