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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, and 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 The Value Line Investment Survey Small and MidCap Edition, are deemed to have the potential to outperform the 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 rank 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 the 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 increase 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

Convertible

<---   Common   --->

 

Convertible Securities

Price

+50%

-50%

Curr Yld(%)

Prem (%)

Price

Yield(%)

Industry

GT Solar (UBS AG) $1.6875      

$35.23

40

-35

4.8

9

$11.51

 NIL

Electr

Lions Gate 3.625s2025          

96.88

30

-9

3.7

14

$6.99

 NIL

Rec  

TRW Automotive 3.5s2015 (144A) 

153.90

35

-30

2.3

17

$38.73

 NIL

CarOEM

Tenet Healthcare $70.00 (Mand.)

$869.02

30

-12

8.1

17

$5.20

 NIL

Med Sv

AGCO Corp 1.25s2036             

123.28

30

-19

1.0

18

$42.59

 NIL

Mchnry

Coinstar 4s2014                

134.93

30

-22

3.0

19

$45.50

 NIL

Ind Sv

Tech Data 2.75s2026            

101.20

30

0

2.7

19

$45.98

 NIL

Cmptrs

Oil State Int'l 2.375s2025     

199.03

50

-40

1.2

0

$63.23

 NIL

OlfdSv

Alliance Data 4.75s2014        

196.25

50

-35

2.4

1

$92.10

 NIL

InfoSv

Newmont Mining 3s2012          

144.00

50

-30

2.1

1

$65.66

0.9

GldSil

* Prices as of 9/8/2011

 

Highlighted Convertibles:

Coinstar, Inc. (CSTR), based in Bellevue, Washington, is a multinational company offering a range of ''4th Wall'' solutions for retailers' storefronts. The company’s core automated retail businesses include the well-known Redbox self-service DVD rental and Coinstar self-service coin-counting devices. It currently has around 33,300 DVD kiosks and 18,900 coin-counting kiosks, located predominantly in supermarkets, drug stores, mass merchants, financial institutions, convenience stores, and restaurants nationwide.

Coinstar performed well in the first two quarters of the year, bringing in over $859 billion in sales, up 29% from the same period last year. Share earnings more than doubled to $1.44 on a year over year basis. However, the departure of the Redbox division head and investors’ fear of revenue weakness put downward pressure on the stock. In our view, this created an entry point for patient investors as the stock is expected to trade in the $85- to $130-a share price range over the pull to 2014-2016.

For the patient investor, the company’s 4% convertible notes due 2014 may offer better investment prospects. The convertible offers a 3.0% current yield advantage over the common, which pays no dividends. The 19% premium over conversion value would allow the convertible to share in as much as 60% of any gains in the underlying common stock. On the other hand, if the stock declines, the convertible is only expected to contribute 44%.

Tech Data (TECD) is a leading distributor of microcomputer-related hardware and software products to value-added resellers and computer retailers throughout the Americas, Europe, and the Middle East. The company distributes more than 150,000 products for over 500 vendors, including Hewlett-Packard (HPQ - Free Hewlett-Packard Stock Report, Apple (AAPL), Cisco (CSCO - Free Cisco Systems Stock Report), IBM (IBM - Free IBM Stock Report, Intel (INTC - Free Intel Stock Report, Microsoft (MSFT - Free Microsoft Stock Report, NEC, and Seagate (STX); and sells to over 125,000 customers.

Tech Data’s upward sales momentum is broad based. The company racked up sales of about $6.45 billion in the July quarter, bringing its half-year total to $12.8 billion, up 15% on year-over-year comparison. Share earnings were just as impressive, with profit rising 34% to $1.10 a share in the shorter period, and 25% to $2.13 in the longer period.

In the meantime, the company has hired new members of its salesforce in an effort to target small- and mid-sized businesses. Too, it has added new products and services and acquired five distributors in Europe. Earnings projections for the year are set to reach over $5.00 a share from sales of about $26.5 billion. Still, this high soaring stock does not pay dividends. The company’s 2.75% convertible notes due 2025, which are more stable, provide income and can serve as a hedge against the common.

The convertible note is less volatile than the stock and it pays income, something common shareholders do not get at this point. Furthermore, with the modest 19% premium over conversion value, the convertible has the potential to share in 60% of any gains in the common, with virtually no downside risk.

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.

Tenet successfully fought off a takeover bid by Community Health Systems (CYH), even with a $7.25-a-share offer in April. Investors’ reactions, however, indicated their disagreement with Tenet’s management and the stock price declined. Value Line analyst Eric Manning is bullish on the industry and believes the stock will make a comeback as the fundamentals have gradually improved since the end of the recession. Also, the new healthcare legislation should decrease the number of uninsured patients at THC’s facilities.

The recovery potential of the stock is attractive, especially with the possibility of a higher bid from another potential acquirer. However, the stock is somewhat volatile, with a beta of 1.15. It 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. The company’s 7% mandatory convertible preferred stock, which more price-stable than the common, is an attractive alternative to the common.

With a liquidation value of $1,000 per share, the preferred dividend income is $70 a year, plus it is expected to rise 60% as high as the common. On the downside, its participation is limited to 24%.

 

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