The Value Line Convertibles Survey

3rd Quarter Performance of Especially Recommended Convertibles

Things fell apart on the economic scene during the month of September. The Dow Jones Industrial Average lost over 6%, the S&P 500 Index 9.2%, the NASDAQ Composite 12%, and the Russell 2000 Index 8%. Portfolios holding convertible securities fared better than those dedicated to stocks. The Value Line Convertibles Survey All Convertible Index fell only 7.8%.

The unprecedented $700 billion bailout plan to rescue the U.S. financial system was signed into law on Friday, October 3rd, but failed to stem the hemorrhage on Wall Street because of a lack of confidence in the U.S. (and global) economy, and a morbid fear of a prolong recession. Other factors contributing to the dismal nine-month performance include worsening condition in the housing market and the ever-worrisome credit crunch, leading to a lack of credit from lending institutions. Still, though some private capital has been activated (Warren Buffett’s investment of $3 billion to shore up General Electric), the gloomy financial crisis still hangs overhead. At the end of the ninemonth period (ended September 30th), all the major equity indexes were in double-digit decline: the DJIA fell over 18%; the S&P 500, almost 21%; the NASDAQ Composite, more than 21%; the Russell 2000, 11%; and the Value Line Arithmetic Index, 15%.

The start of the final quarter promises no difference, at least not for now. And, investors registered their grave concerns about the economy on the first trading day after the signing, sinking the Dow Jones Industrial Average below the 10,000 mark for the first time since October 2004. The market’s setback has engulfed all sectors. Homebuilders, banks, financial services firms, print media, energy, coal, metal, and materials have all being affected by the market’s downturn. Needless to say, investors are turning to safer grounds, buying bonds, government securities, and other less risky instruments. While convertibles derive most of their value from their respective underlying stocks, and the creditworthiness of the issuing company, this asset class, by nature, has weathered the storm better than the stocks have.

A major reason investors hold convertibles is to insulate their portfolios against this kind of equity market volatility. Investing in convertibles provides income in the form of preferred dividends and/or coupon income while awaiting a turnaround in the equity markets. Indeed, our All Convertible Index was down only 9.8% for the nine-month period, compared to the losses in the major indexes. Convertibles did what was expected; they held up better than stocks in a declining market. As we wait for brighter days, we think convertibles will give investors a good hedge on the market.

For the third quarter, our Especially Recommended Rank 1 Convertibles gained 1.7%, despite an overall decline in their underlying common stocks. For the longer period, the index was down a mere 0.5%. Meanwhile, our larger group of rank 1 convertibles lost 5.0% for the quarter, and 6.9% for the nine months. Our boarder-based All Especially Recommended Convertibles group lost 2.8% for the shorter period, and dropped 5.2% for the longer period.

Methodology of Choosing Convertibles for Our Especially Recommended List

For each pricing period, our proprietary model assigns a rank, 1 (Highest) through 5 (Lowest), to convertibles whose underlying stock is ranked by either The Value Line Investment Survey or its sister publication, The Value Line Investment Survey Small and MidCap Edition. From the list of rank 1 convertibles (see page 5), we select issues that meet and/or surpass certain required criteria to be purchase recommendations. To be included in our Especially Recommended list, a convertible, besides being ranked 1 (highest), must possess the following attributes:

1.A current yield advantage over its underlying stock, except in cases of zero coupon bonds or warrants.

2.Must be favorably leveraged. This means that it is 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.

3.Should have some degree of call protection intact, or not considered a likely call candidate.

4.Easily traded. That is, the issue must be liquid to permit easy trading.

Note: Illiquid issues are sometimes included on our Especially Recommended list, or previously liquid issues can become illiquid, and therefore difficult to trade due to conversion or repurchase by the issuing company. Still, although illiquid issues are listed on our Especially Recommended table, we suggest investors avoid them because of the difficulty in trading them.

Performance Results

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 that stock is in relation to the median stock in The Value Line Investment Survey universe of over 3,500 stocks. Our High Risk group consists of warrants only, and has the highest profit potential, and also the highest risk of losing. 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%, and the Low Volatility (modest profit potential) group has convertibles whose Relative Volatility is 60% and below.

For the quarter, the expected performance of liquid rank 1 convertibles in the various risk groups was mixed. The Above- Average Profit Potential group lost 4.6%; the Modest Profit Potential group gained 2.8%; and the Low Profit Potential group rose 1.7%, underscoring the defensive nature of convertibles. Over the ninemonth haul, however, the order of performance was reversed. The Above-Average Profit Potential group lost 21.7%; the Modest Profit Potential group, 1.1%; and the Low Profit Potential group, 4.4%. The warrant category (High Risk) was down 42.3%. (Note: There was no recommended issue in this group for the September period.)

As we generally advise our subscribers to purchase our rank 1 recommendations, hold when the rank drops to a 2, and sell if the rank falls further (to 3), we also calculated the performance of our portfolio of rank 1 and 2 recommended issues. Here again, our expectations were not met. The best performer was the Low Profit Potential group which lost only 1.7% for the quarter, and 4.4% after nine months. The Modest Profit Potential group lost 5.4% for the shorter period, and 1.1% over the longer stretch. The biggest loser was the Above- Average Profit Potential group which fell 17% in the quarter, and 21.7% for the three quarters together. See these quarterly performance results on page 35 (Figure 2).

Liquid vs. Illiquid Issues

Although we carefully select our especially recommended issues, invariably we include relatively illiquid and/or difficult-to-trade issues because of their attractiveness. Furthermore, liquid issues often become illiquid due to partial redemption, early conversion, or repurchase by the company. Rarely, however, do illiquid issues offer a true performance advantage, even if this 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. 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 have pursued this asset class, Figure 3 on page 34 compares the returns of both liquid and illiquid issues, and combined as a group.

Conclusion

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, and its investment value) 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.

George S. Graham,
Editor