After a dismal first half of 2010, the stock market surged in the second half. At June 30, 2010, all major indexes were in negative territory. The Dow was down over 6%, the S&P 500 had a 7% deficit, and the Russell 2000 was lower by 2.5%. Faced with economic and political uncertainty throughout the year, many investors sought safer havens in high-quality bonds and gold, as well as convertible bonds and preferred stock. The average convertible returned about 2% (including income) in this half-year stretch. After the August lull, the indexes moved into high gear. The second half was a reverse image of the first, as investors saw a different picture on the horizon, and stock indexes soared to their highest levels since 2008. Indeed, the Dow Jones Industrial Average ended the year with an 11.4% gain, the S&P 500 was up almost 13%; the NASDAQ Composite rose 16.9%; and the Russell 2000 increased by 25.3%. Many investors remained cautious, though, and stayed with bonds for more-assured income and safety.

Although convertibles tend to lag their underlying stocks in an upbeat market, that was not the case this time. In fact, convertibles in our universe outperformed all major indexes except one, the NASDAQ Composite. The average convertible rose over 17% in 2010, thanks to 7.9% and 6.6% gains in the third and fourth quarters, respectively. Our Especially Recommended convertibles, as a portfolio, gained 19.8%. If the performance of the single warrant that was recommended during the fourth quarter is included, that number jumps to 43.1%. Especially Recommended Rank 1 convertibles rose 7.5% in the fourth quarter, and finished the year up 19.1%. All Rank 1 convertibles, as a group, gained 5.3% in the final interim, and 21.3% for the full year.

Our Especially Recommended Rank 1 convertibles portfolio including the sole warrant gained 8.6% for the quarter, and ended the year up 23.1%. Meanwhile, all Rank 1 convertibles in our Survey returned 5.3% for the quarter, and 21.3% for the year.

By nature, convertibles are defensive instruments by virtue of their higher investment quality and income, among other variables. Still, a sustained upward trend in equities can transform these instruments into a class that is nearly as aggressive as their underlying common stocks, particularly if the common is trading above the conversion trigger price. The above performance results speak for themselves. Bear in mind, however, that these results serve only as an indication of how investors would fare following our recommendations at the quoted trading levels. As we depend on outside pricing sources for quotations on these convertibles, the prices may not be the same when investors act on our recommendations. Indeed, our pricing dates lag our publication dates. Moreover, commission costs and other expenses are not taken into consideration for our calculations.

While past results are no guarantee of future performance, Value Line's Convertible Ranking System has proven effective over the past 30-plus years. In fact, our recommendations have been monitored by Mark Hulbert of Hulbert Financial Digest, and in a commentary from September 2009, he highlighted our selections as one of the better performers. We remain confident that our proprietary model will continue to discriminate effectively among our universe of convertible securities, giving subscribers an edge in this market.