Insights: Finance

Published in: April 1, 2000

Published March/April 2000

FINANCE Gaining Converts Investing in convertible securities is like having your cake and eating it, too by Mario Gabelli Theoretically, the ideal investment offers limited downside risk and unlimited upside potential--the investment equivalent of having your cake and eating it, too. But, is there such an investment vehicle? Surprisingly, the answer is yes. It's called a convertible security and it's available in markets throughout the world.   Convertible securities ("converts") are bonds or preferred stocks that can be converted into a fixed number of common stock shares of the issuing company. Converts combine the capital appreciation potential of equities with the higher income and safety of fixed-income instruments. In their landmark book, Security Analysis, Benjamin Graham and Thomas Dodd describe convertibles as "the most attractive of all [securities] in point of form, since they permit the combination of maximum safety with the chance of unlimited appreciation in value."   The global convertible securities market is large, diverse and liquid. To put this in perspective, with a capitalization of more than $400 billion, the global convert market is bigger than the equities markets of Sweden, Australia or Hong Kong. The Japanese convertible securities market is the largest, with a capitalization of approximately $160 billion, or 38 percent of the global market. The United States is second, with a market cap of about $130 billion, or around 31 percent, followed by Europe, with about 24 percent. The remaining 7 percent comes from emerging market nations.   Europe is the fastest-growing segment of the market. Companies are using converts in the restructuring process that is changing the corporate landscape in Europe. Parent companies spinning off subsidiaries and large corporate stockholders reducing equities positions are issuing convertible securities that can be exchanged for the common stock of the companies being spun off or sold. Capital gains taxes are deferred until the convertible privilege is exercisable--generally five years after it is issued.     RISK/REWARD CHARACTERISTICS   The chart demonstrates convertible securities' unique risk/reward characteristics. Following the stock price line on the chart, you will note that as the underlying common stock declines in price, the price of the convertible falls as well. However, as the common stock continues to decline, the convertible's price stabilizes along the line designated in the chart as the bond floor. In essence, the convertible begins trading like a bond, supported by its now even higher yield.   Conversely, as the common stock begins to rise in price, the convertible's price also rises. When the common stock appreciates well beyond the point that the convertible can be exchanged for common stock at a profit, the convertible will rise in lockstep with the common. At this stage, the convertible's yield no longer provides the same degree of downside protection should the common stock reverse course and head lower; however, its upside potential is now equal to that of the underlying common stock. In short, the convertible is now trading just like a stock.   These attractive risk/reward characteristics have been clearly demonstrated in the marketplace. For example, over the past 25 years, U.S. convertibles have provided about 86 percent of the return of the S&P 500 with about two-thirds the risk. We believe selective convertible securities investors can build portfolios with two-thirds of the upside potential of equities and only one-third of the downside risk.     THE THREE FACES OF CONVERTIBLE SECURITIES   All convertible securities are generally created equal--issued at about a 25 percent premium to conversion parity (the common stock for which the convert can be exchanged must appreciate 25 percent before the convertible bond holder can make a profit by converting into the common). To compensate investors for sacrificing a portion of the upside potential of the underlying common (that 25 percent premium), the convertible issue has a materially higher yield than the common stock.   As is also illustrated in the chart, on the open market, converts take on very different identities determined by the performance of the underlying common stock. If the common stock declines substantially, the conversion privilege loses value and, in some cases, may become almost worthless. Of course, as the price of the common and convert declines, the yield on the convert increases substantially. These "busted" convertibles can provide junk bond-type yields often with less credit risk. If the underlying common remains within hailing distance of its conversion price, the convertible issue is referred to as "balanced." These converts continue to enjoy a substantial yield advantage over common shares and retain capital appreciation potential. If the underlying common shares soar, putting convertible shareholders "in the money," the convert will trade like the underlying common stock. We call these "butane" converts. Following are some examples.     BUSTED: MARK IV   Mark IV, with $2 billion in sales, produces power and fluid transfer products used in the automotive and other industries. With the stock at $18.50 and 47 million shares outstanding (plus $930 million in net debt), the company has a total enterprise value of $1.8 billion. The stock trades just over six times 12-month trailing EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), an attractive valuation. On a 10 times multiple, the enterprise value would rise to $2.8 billion, or $60 per share. A catalyst is in place with chairman and CEO Sal Alfiero restructuring the existing business, expanding via acquisition into Europe and buying back stock. Presently, the 4.75 percent convertible bonds due 2004 trade at $830 with a 5.7 percent current yield and 49 percent premium. Should the stock rise by 25 percent, to $23.125 over the next year, the bonds would likely trade at $940 for a total rate of return of 19 percent. On the other hand, should the stock fall by 25 percent, the bonds would likely hold their bond floor of $830. A win-win strategy.     BALANCED: VIVENDI   Vivendi is a Paris-based conglomerate with three main business segments: utilities, communications and construction. With operations in about 90 countries and sales more than $32 billion, Vivendi provides water services to 80 million customers worldwide. In France, Vivendi has interests in telecommunications, pay-TV, the Internet and media. Following its purchase of France's largest film producer, Pathe, it will also have a significant stake in U.K. pay-TV operator BSkyB. At 80 Euros per share, Vivendi common stock is attractive on a sum of the parts analysis that values the company at over 95 Euros. Vivendi's 1.5 percent convertible due 2005 was issued in April 1999 to help finance its purchase of US Filter. Currently, the bond trades at a 12 percent premium and provides a 1.5 percent current yield. Given a plus or minus 25 percent change in the stock price over the next year, we estimate the bond will participate in about 70 percent of any upside movement, with less than 20 percent of the downside risk.     BUTANE: TELEFONICA   Telefonica is Spain's incumbent telecommunications operator, offering a full range of fixed and mobile telephone services. The company also has significant assets in Latin America. On a sum of the parts valuation, Telefonica sells at a 20 percent discount to its break-up value. What will unlock this value? The company's chairman, Juan Villalonga, has already taken measures to reorganize the company by spinning off parts of its business. We believe the market will value the sum of these parts higher than it currently appraises the whole.   In August 1997, Telefonica issued an A+-rated $525 million convert yielding 2 percent and maturing in 2002. Telefonica common stock has performed quite well since the convert was issued, and over the past year, the convert has outperformed the common--putting it firmly in our "butane" category. We believe the common and the convert will continue to rise.     OUR APPROACH   At Gabelli Funds Inc., we've been investing in convertibles for more than 20 years. We have two mutual funds--the closed-end Gabelli Convertible Securities Fund and the open-end Gabelli Global Convertible Securities Fund. We also invest in converts in our privately managed equities accounts, particularly for those clients with lower risk profiles. My partner, Hartwell Woodson III, helps provide the day-to-day insights into what we buy and sell. Of equal note, he is writing his thoughts in Gabelli University Press's second book, Win-Win Investing, Your Guide to Global Convertible Securities.   Our interest in convertibles is a natural outgrowth of our stock-picking discipline. When we research stocks, we always check to see if there is an opportunistically priced convertible available that, because of its higher yield, will "pay us to wait" for the value of the underlying common to surface.   I think convertibles are appropriate for virtually every investor. Whether you are primarily an equities investor looking to boost income from your portfolio and reduce downside risk, or primarily a fixed-income investor seeking more capital appreciation potential, convertible securities fit the bill.   Mario J. Gabelli is the founder and chairman of Gabelli Funds Inc., a Rye, New York-based financial services company. He appears regularly on CNN and CNBC.

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