Finding Bargains Among 'Wrecked Convertibles'

• ByTim Melvin, RealMoney.com Contributor
• On 2:58 pm EST, Monday November 10, 2008

I am fortunate to have a lot of friends and associates who are much more astute observers of the market than I will ever be. I am doubly fortunate that many of them share their observations with me.

On Friday morning I got an email form a good friend in New York City who, in spite of being between the rivers, is an accomplished practioner and observer of the stock market game. It was a simple attachment of a chart of year-to-date returns from various hedge fund strategies. I was surprised to see that the worst performer of all was the convertible arbitrage category. One could opine that this group got hurt by the temporary ban on short-selling, but the negative 50% return in 2008 seems excessive to me. Digging a little deeper, I found that this strategy lost more than 30% in October alone.

I have noticed over the years that there is a certain ecology to asset classes and strategies. Someone finds an edge and begins to outperform his or her peers. This attracts attention, and like a forest clogged by too many trees, the sheer number of investors using the method chokes off returns. An overgrown forest will have underbrush killed off by lack of sunlight and competition for nutrients from the excess of trees and plants. A hedge fund strategy will have way too many people chasing far too few good trades and too much leverage used to squeeze every dome out of thinning margins.

Eventually, the fire comes along, and when it does, the strategy explodes. All the money that flowed in during the previous good times runs for the exit. Just as the forest grows fastest in the aftermath of a fire, opportunities grow in the investment category.

Typically, convertible arbitrage involves buying a convertible preferred stock and selling short the underlying common stock on the basis of the conversion ratio and the stock's trading relationship to the underlying.

A few years ago, James Altucher developed a much easier hedging strategy. He looks for deep out-of-the-money convertibles and simply sells half as many shares of common as he bought preferred. That seems a lot easier than continually calculating deltas and theta, so that's how I have used the strategy over the years. It also occurred to me that with forced selling in many convertibles as well as in the underlying common stocks, there were probably some bargains that could smply be owned outright.

I went looking through the universe of convertible preferred stocks to see if there were any that looked attractive at these levels. I found several issued by companies I already like at current market prices. In most of these I would be comfortable owning the convertible outright without the need for further hedging.

I wrote not too long ago about El Paso, a pipeline and energy company that looks attractive at current levels. The company has a convertible preferred stock that is badly busted. It converts into just 1.2022 shares of El Paso. At the current level, that is a conversion value of less than $10. The convert issue trades at $25 with a yield of 9.76%; the preferred has a face value of $50 and is callable at that price. The common stock would have to go back above $20 for the conversion factor to kick in. Given that the stock traded there earlier this year, a patient investor could see that happen and gain substantial appreciation in addition to the generous yield.

All the bank restructurings have created a supply of convertible preferred stock that trades with attractive yields as well. We can expect several of the banks to not only survive but do well in the coming years. KeyCorp, Fifth Third and Huntington Bancorp all raised capital in the last year by offering convertible preferred stock.

All three trade below the issue price and have yields of 8% or more. The stocks would not have to move up very much over the next several years for the conversion factor to kick in and provide capital gain opportunities.

Coal stocks are priced right now as if the stuff is going to be outlawed. It is not going to be. Westmoreland Coal has a busted convertible stock that trades on the American Stock Exchange for $16 and change. The convertible value is just $13, and the shares yield better than 12%. The common has been as high as $25 in the last year, so over time there could also be appreciation. I confess that it is not my favorite coal stock, so I would probably hedge this one by selling short 450 shares of common for every 1,000 preferred shares I purchase.

As usual, I am going to run out space to cover all the convertible ideas I see in the market right now. The combination of a falling stock market, the short-sale ban and deleveraging hedge funds has pushed the convertible stock of some good companies to prices that offer attractive yields. When the market recovers and these stocks begin to appreciate again, there will be a chance to cash in on gains as well. Convertible stocks allow you to get paid to wait.

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Know What You Own: ETFs that enable you to invest in preferred shares include the iShares S&P U.S. Preferred Stock Index Fund, the PowerShares Preferred Portfolio and the PowerShares Financial Preferred Portfolio.

Buzz up!