Convertible Issues and Warrants (MG Book Club Chapter 16)

Convertible Issues and Warrants

This is the sixteenth discussion of the ModernGraham Book Club’s reading of The Intelligent Investor by Benjamin Graham (affiliate link).  In last week’s discussion, we discussed the fifteenth chapter, which explored Graham’s requirements for Enterprising Investors.  This week we will discuss the sixteenth chapter, which is titled “Convertible Issues and Warrants.”  I encourage you to purchase the book (preferably by clicking the link to Amazon, because a purchase through that link will help support the club) and join in with us as we read through a chapter each week; however, even if you don’t have the book I think you will find our discussions to be very useful in your own understanding of value investing, and you can still bring a lot to the discussion from your own experiences as an investor.  Whether this is the first day you’ve ever been interested in investing, or you have decades of experience with the stock market, we’d love to hear your thoughts in the comments below!

Please feel free to leave a comment on this post with your own responses to the questions, along with any other thoughts you have, and return throughout the next couple of days to see what others have said. If you find something that has been said by another commentator interesting, feel free to respond to them with another comment.  We’ve had some great discussions throughout the book club, so keep it up!

ModernGraham’s Comments

Ben

Those of us who have received a formal education in finance, have likely been taught that bonds are generally preferable over equities when it comes to risk level.  After all, bonds have higher priority on the credit/bankruptcy scale.  But then we also know that historically bonds have had a smaller rate of return than equities over the long-run, so schools tend to teach that we should diversify between the two asset classes in order to maximize the benefits of both.  The question that comes up in this chapter is where do convertible bonds come into the equation?  Dynamically, convertible bonds are a blending of both the traditional bond and the common stock holding.  An investor could theoretically purchase a convertible bond when the company’s liquidity may be presenting a higher risk level in order to protect his investment from the risk of default, and then convert the bond into stock at some point in the future when the company’s prospects are stronger.  In this Chapter, Graham outlines a number of reasons why this approach is not favorable for Intelligent Investors.

Heather

For a corporation, convertible bonds are attractive as they allow the corporation the ability to offer a lower return rate than traditional bonds and when converted their debt is eliminated. For investors, convertible bonds allow them to have the safety of a bond, with the same potential for success as a stock. Convertible bonds then, in theory, sound like the ideal choice for both corporations and investors. However, as shown through chapter 16, there is much more to convertible bonds that greatly diminishes their appeal.

First, the main issue is when to convert or as Graham mentions on page 409, “Never convert a convertible bond.” Once a bond has been converted into common stock, the investor loses the advantage of the convertible bond in the first place and is at the same amount of risk as everyone else. Graham notes that many people who buy convertible bonds are unlikely to have bought the common stock at all, which means that after the conversion they are left with a stock that they didn’t consider worth buying in the first place. Additionally, convertible bonds are prone to be converted based on emotion as the holder of a convertible bond is going to be more inclined to convert after the stock has already risen in value. This means they are inevitably cut out of gains and more likely to experience losses.

Secondly, convertible bonds can result in a diluted share price as they introduce a large number of new shares to the market. The adds an amount of uncertainty to the convertible bond as it is difficult to apply the tests Graham lays out in the last two chapters.

Discussion Questions

Please leave a comment below and feel free to answer any of these questions, or just give your general thoughts.

1. What quote from this chapter do you think best summarizes the point Graham is making?
2. How do you generally feel about convertible bonds?
3. Where do you think they could fit into an Intelligent Investor’s portfolio?
4. What did you think of the chapter overall?

Next Week’s Discussion: Chapter Sixteen

Chapter Title - Four Extremely Instructive Case Histories

When reading the next chapter, try to think about how the concepts Graham presents in the chapter could apply to your own investments, whether you consider yourself a Defensive Investor or an Enterprising Investor.

What are some other ways to participate?

If you are a blogger, you can give your thoughts in a post on your own site, link to the discussion here on ModernGraham, and I will be sure to let our readers know that the conversation is going on over at your site as well.

In addition, you can use the hashtag #MGBookClub in social media to talk about the book on Twitter or Facebook!