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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 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 ranking 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 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 rise more than they would fall. 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. Below is a sample of such convertibles.

 

Recent

<-----Leverage----->

Cv

<------Common------>

Convertible Securities

Price

+50%

-50%

Prem (%)

Price

Yield(%)

 

Wintrust Financial $50.00 C    

$1,079.41

30

-24

19

$37.27

0.5

 

Dollar Financial 3s2028        

116.99

30

-16

17

$19.35

 NIL

 

Encore Cap'l Grp 3s2017 (144A) 

112.41

30

-19

17

$30.44

 NIL

 

Kaman Corp 3.25s2017 (144A)    

124.31

30

-24

17

$36.21

1.5

 

TiVo 4s2016 (144A)             

138.40

30

-23

15

$13.38

 NIL

 

Amer Eq Invmnt 3.5s2015 (144A) 

123.52

35

-17

14

$13.53

0.9

 

Vector Group 3.875s2026        

103.75

30

-13

14

$15.37

10.4

 

Omnicare 3.75s2042             

107.96

35

-25

13

$39.56

0.3

 

Fidelity Natl Fin 4.25s2018    

133.93

30

-19

14

$25.25

1.9

 

Mindspeed Tech 6.75s2017 (144A)

138.58

35

-25

11

$4.87

 NIL

 

* Prices as of 2/1/2013

 

Highlight on Selected Convertibles:

DFC Global Corp. (formerly Dollar Financial) (DLLR) provides financial services to under-banked consumers. It offers cash checking, short-term or longer-term consumer loans, money order and money transfer products, legal document processing services, electronic tax filing, bill payment, debit cards, foreign currency exchange, photo ID, and prepaid local and long-distance phone services. At June 30, 2012, the company's global store network consisted of 1,399 stores, including 1,345 company-owned, conducting business primarily under the names Money Mart, Money Shop, Loan Mart, Money Corner, Insta-Cheques, and The Check Cashing Store in Canada, the United Kingdom, the United States, and the Republic of Ireland.

The 2013 fiscal second quarter ended December 31, 2012. For that period, results were flat year over year. However, for the six-month period, sales of $540 million were slight higher (2.8% greater than the previous year, but earnings soared 28% to $0.78 a share, up from $0.61 in the first half of fiscal 2012.

The common is ranked for above average performance over the next six to 12 months, but its volatility is above the market’s (Beta is 1.30). That said, the company’s 3% convertible note due 2028 may be a safer bet on this company.

The convertible offers a 2.6% current yield advantage over the common, and is poised to share in as much as 60% of any gains in the common. On the downside, the note’s exposure is limited to 32%.

Wintrust Financial (WFTC), through its fifteen wholly owned banking subsidiaries, provides community-oriented, personal and commercial banking services to customers located in the Chicago metropolitan area and in southeastern Wisconsin. The company operates primarily through three business segments; Community Banking, Specialty Finance, and Wealth Management Services.

The bank continued to impress its investors with solid a performance in 2012. Share earnings came in at $2.29, up 37% from 2011. And Value Line sees share net reaching as much as $3.00 over the 2015-2017 pull.

Beside being favorably leveraged, the Wintrust Financial Series C convertible preferred offers a 4.1% current yield advantage over the underlying common, at a lower risk level.

Vector Group, Ltd. (VGR), through its subsidiaries, engages in the manufacturing and sale of cigarettes in the United States. The company’s Liggett Group LLC unit produces cigarettes in approximately 136 combinations of length, style, and packaging. The Vector Tobacco subsidiary engages in research relating to reduced-risk cigarette products. And the New Valley LLC engages in the real estate business and operates a residential brokerage company in the New York metropolitan area.

The latest financial results available are those of the third quarter in 2011. The period ended September 30, 2012, and for the nine months ended then, sales totaled $807 million, which were $33 million (or about 4%) lower than the same time a year earlier. And share earnings showed the effect. Although results in the third period were impressive, up 50% year over year, the nine-month total of $0.16 a share was 59% less than the previous year.

However, the company is financially sound and stable. And common stock dividends have been on the rise since 2003, which is as far back as Value Line’s analysis goes. Currently, the dividend yield is over 10.4%, and that is a big attraction for stock portfolios. If your portfolio is restricted from purchasing common stocks, however, then consider the company’s 3.875% convertible notes due 2026 offer as an alternative to be materially exposed the company’s prospects.

The convertible offers a 28% participation in the common if the common advances by 25% or more. In addition, the convertible offer excellent downside protection will support the value of the convertible if the company declines.

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