How About a Convertible Preferred? : Hybrid Can Offer a Stock’s Growth but With Less Risk

As stocks drive toward unexplored territory along the road toward Dow 7,000, it might be time to take the top down and try a preferred convertible.

That’s not a car for hotshot securities analysts but a kind of stock that can provide your portfolio with a lot of the zoom of a raging bull market but protect it from crashing in a correction.

Convertible preferred stocks are hybrid securities invented to give companies and investors a middle ground between bonds and stocks. To fast-growing companies, they offer a chance to raise cash without giving away equity too cheaply or paying the high interest rates of bonds. To investors, they offer a security that appreciates like a stock in rising markets but that compensates for flat or sinking markets by throwing off fat dividends.

But they are more than a muddle: Mutual funds and private money managers specializing in convertibles say they’ve been increasingly successful over the last couple of years at growing their accounts at near-stock market rates with substantially below-market risk. And they think their advantages will become more evident if stocks slip substantially over the course of 1997.

“The reason one should be excited about convertibles now is that things have gone fantastically well over the past seven years,” says Barry Nelson, who co-manages a convertibles fund at Advent Capital Management in New York. “While the fundamentals may still be good, the use of convertibles is a way to keep participating in the good market while hedging your bets if things go wrong.”

Convertible preferred stocks are a bit complicated and come in many different varieties, but essentially they work like this: A company that already has common shares outstanding will issue a new preferred class of shares at a price that might be 25% over the price of the common. To entice investors, the preferred shares will typically offer a dividend substantially greater than the common. To further entice investors, companies declare that investors can convert the preferred shares into common shares at a fixed ratio, such as 1.5 to 1.

After issuance, the preferred and common trade in tandem according to a rhythm that requires a sophisticated computer software model to precisely identify. But the beauty part is this: A convertible preferred is prevented from falling as dramatically as a common share because its higher dividend payout provides a floor of essential value similar to that of a bond. And yet in good times it can rise in value almost as dramatically as the underlying stock.

Nelson, who claims that his convertible preferreds account rose 21% in 1996, says that a fundamental advantage of the instruments are the dividend difference: The average convertible preferred today yields about 6.5% because they are largely considered to be just below investment-grade debt, while the average common stock yields 2%.

“We have to have a strong stock market to overcome a handicap of 4.5 percentage points,” he said. “So if we have anything other than a continuation of an extremely strong stock market, it’s likely that convertibles will outperform stocks.”

Ravi Malik, senior analyst at Westwood-based investment management firm Froley, Revy Investment Co., said investors typically consider companies that choose to issue convertible preferred stock to have good growth prospects. “They issue a convertible because they consider their current shares undervalued and don’t want to sell new ones too cheaply,” he said.

What’s the catch? Companies reserve the right to call the convertible preferred stock away from you after a sharp rise in price in three to seven years, which might be a drag if it’s paying a great dividend. And unlike a bond, its dividends can be halted without pushing the company into bankruptcy.

Most major mutual fund families offer convertible stock and bond funds, but it’s not too hard to buy one on your own through a retail or discount broker. One of the best sources of information to start with is the Value Line Convertibles Survey, which is available by subscription ([800] 634-3583; $625 a year for 48 issues) or at most libraries.

Nelson recommends new convertible investors look at three issues:

* Beleaguered discount department store Kmart floated a preferred convertible last year at $50 with a 7.75% dividend that is callable in June 1999 at $52.71. The preferred is now trading at $50.75; the underlying common stock closed at $10.88 on Friday. The most important number to know, however, is that the preferred is convertible into 3.33 shares of Kmart.

The company is in the midst of a turnaround, so any purchase would be somewhat speculative. But the complex mechanics of preferreds reduces the risk. If the stock drops 25% to $8.125, the preferred would drop only 11%. Why? Because the resulting yield of 8.57% would support the price.

If, on the other hand, the stock rises 25%, Nelson’s computer model projects that the preferred would rise 15%. Considering that common stock pays no dividend and that the preferred will pay at least 7.75%, the potential gain of the preferred is quite close to the potential gain of the common.

“You’ll participate in 80% of the return with only 50% of the risk--a superb example of what equity investors are looking for but rarely find,” he said.

* International Paper recently issued a $50 par preferred stock that yields 5.25% (the common yields just 2.42%) and is convertible into 0.93 shares of IP stock. It is also call-protected until June 1999.

Nelson’s model projects that if the common should decline 25%, the convertible preferred would fall only 7%. However, if the underlying stock were to rise 25%, the preferred would rise 15% on top of its 5% yield. Therefore, an investor could participate in 74% of a potential rise in IP’s shares while risking less than a third on the downside--a situation Nelson calls “another example of superb upside/downside leverage.”

* Banco Comercial Portugues (BPCpA) was a convertible preferred issued last year on the New York Stock Exchange by the largest bank in Portugal at $50 with an 8% yield. It is now trading at $57.25 for a current yield of 6.9%.

Nelson says the stock has an unusually low conversion premium of 14.8% and is not callable until June 2003. As a result, his model projects that preferred stock investors will participate in 89% of the upside potential in the common shares while probably not participating in any of their possible future decline. “The best part is that if anything good happens to the stock, it can’t be taken away from you for seven years--a tremendous deal,” he says.

Malik, meanwhile, says his firm currently likes the convertible preferred recently issued at $50 with a 5.5% yield by Finova Finance, a company that makes loans to medium-sized companies. The preferred is now at $56, has a conversion ratio of 0.64 to 1 and isn’t callable until June 1999. It’s therefore throwing off a lot of dividends for an investment-grade security, and the stock itself has excellent prospects for appreciation.

Malik recommends that investors buy preferred stocks that are trading 10% below to 15% above their par, or issuance, value. Ones that are “too far in the money,” or above their original value, carry more of the risk of straight equities.

He also recommends that investors not buy convertible preferreds within a year of their call dates--adding that it’s often wise for individuals to sell three to 12 months before the call protection expires to keep their risk/reward ratio in balance.

Street Strategies explores investment tactics. Jon D. Markman is a Times staff writer. He may use strategies described in the column. He can be reached at jon.markman@latimes.com

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Convertibles on a Roll

It’s difficult for individuals to buy convertible bonds on their own, but buying convertible preferred stock at a brokerage is as simple as buying any equity. Even simpler: There are at least three dozen mutual funds that specialize in convertibles, and most have had excellent returns in the past year. Said one fund manager: “Buying convertible preferreds gives you a way to be defensive but not leave a lot on the table.” These funds had some of the best returns in the last 12 months:

*--*

Total return: Fund 1996 5 years Davis Convertible Securities A 29.5% NA Harris Ins.: Convertible A 20.8 79.8% Value Line Convertible Sec. 20.2 82.7 Northern Funds: Income Equity 20.0 NA Pacific Horizon Cap Income A 19.5 107.8 Keyfunds SBSF Convertible Sec. 19.2 85.2 Fidelity Convertible Securities 15.1 93.9 Average convertible fund 14.8 77.5 Average general stock fund 19.5 91.8

*--*

NA: not available. Fund did not exist for entire time period.

Source: Lipper Analytical Securities