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Entry from March 10, 2009
“Never convert a convertible stock/bond” (Wall Street adage)

"Never convert a convertible” (convertible bond or convertible preferred stock) is a Wall Street adage that is usually attirbuted to Benjamin Graham (1894-1976), author of Security Analysis (1934) and The Intelligent Investor (1950). It’s not clear that the exact wording can be found in either book, although both books explain convertibles—an investment vehicle that Graham did not particularly like.

The theory behind “never convert a convertible” is that the option to convert to common stock shares is usually worth more than actually doing so.

Wikipedia: Benjamin Graham
Benjamin Graham (born May 8, 1894 – September 21, 1976) was an American economist and professional investor. Graham is considered the first proponent of Value Investing, an investment approach he began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd through various editions of their famous book Security Analysis. Well known disciples of Graham include Jean-Marie Eveillard, Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss. Buffett, who credits Graham as grounding him with a sound intellectual investment framework, described him as the second most influential person in his life after his own father. In fact, Graham had such an overwhelming influence on his students that two of them, Buffett and Kahn, named their sons, Howard Graham Buffett and Thomas Graham Kahn, after him. 

Wikipedia: Convertible bond
In finance, a convertible bond (or convertible debenture) is a type of bond that can be converted into shares of stock in the issuing company, usually at some pre-announced ratio. It is a hybrid security with debt- and equity-like features. Although it typically has a low coupon rate, the holder is compensated with the ability to convert the bond to common stock, usually at a substantial discount to the stock’s market value.

From the issuer’s perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. However, in exchange for the benefit of reduced interest payments, the value of shareholder’s equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.

Wikipedia: Stock
Types of stock
Stock typically takes the form of shares of either common stock or preferred stock. As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders. Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date. Shares of such stock are called “convertible preferred shares” (or “convertible preference shares” in the UK)

About.com: Investing for Beginners
The Many Flavors of Preferred Stock
A Possible Investment for your Fixed Income Portfolio

By Joshua Kennon, About.com
If, however, the investor had owned convertible preferred shares in this scenario, the price of convertible “percs”, as they’re known, would have experienced a tremendous rise and fall based on the expected profit an investor could have realized by converting his shares into common stock. As long as the holder of the preferred did not convert his shares or acquire more preferred at the inflated price, he would experience no loss of principal. (Perhaps now is the time to repeat the old Wall Street maxim, “never convert a convertible stock”.)

Google Books
The Money Masters
By John Train
New York, NY: Harper & Row
Pg. 95:
Elsewhere he reaffirms the Wall Street maxim, “Never convert a convertible.”

Google Books
The Intelligent Investor
By Benjamin Graham
Contributor Jason Zweig
Edition: 4, revised, illustrated
New York, NY: HarperCollins
Pg. 409:
In so doing they ran counter to an old maxim of Wall Street, which runs: “Never convert a convertible bond.” Why this advice? because once you convert you have lost your strategic coombination of prior claimant to interest plus a chance for an attractive profit. You have probably turned from investor into speculator, and quite often at an unpropitious time (because the stock has laready had a large advance).

Fundoo Professor
Of course, Benjamin Graham, the father of value investing also knew about the idea of preserving optionality. In his book, Security Analysis, Mr. Graham discussed the wisdom of the principle:

“Never convert a convertible”.

Suppose that a bond issued by a sound company, having a face value of $100 is convertible into 2 shares of the company at a fixed price of $50 per share. The option to convert is available to the bondholder for the next 3 years, and the stock price of the underlying company is $60 per share.

Such a bond should sell for $100 plus some premium reflecting the value of the option to convert. The option to convert itself is worth $20 plus some additional value due to the long period of 3 years till conversion.

Suppose this bond is selling in the market for $150. Should the bondholder convert?

Mr. Graham suggested that he should not convert. Why so? Because by converting his bond which can be sold in the market for $150, the bond holder will get two shares having an aggregate market value of $120, a loss of $30.

So, the bond holder should not convert because doing so will result in the loss of the time value embedded in the option to convert. If the bondholder is bullish on the company, he should continue holding the convertible and if he is bearish on the company he should sell the convertible, but he must not convert it because doing so will destroy the time value of the option.
Posted by Sanjay Bakshi at Saturday, December 03, 2005

Forums of Loathing
Fri, Nov 2nd, 2007, 06:22 PM
Now, there is a Wall Street adage: “Never convert a convertible security.” The net economic effect of this change should be that there is a price floor for any IotM just a bit above a Mr. Accessory (because the convertible nature of the item would always be worth something.) And if everyone followed the adage above, nobody would ever convert the item, they’d sell it to someone else who wanted to assume the ownership of the item, and derive whatever value (use, investment, etc.) they wished from it.

The Enlightened American
More Reader Questions On Chesapeake Energy
Posted by Davy Bui on January 6th, 2009
And remember Ben Graham’s advice: Never convert a convertible.  Either hold it or sell it.

Google Finance
Date: Thu, 15 Jan 2009 18:27:09 -0800 (PST)
Local: Thurs, Jan 15 2009 8:27 pm
Subject: Re: So Did They Miss Some Divy Payment(s) or Does Google Just Suck?

Not a big deal. I also read somewhere an old Wall Street saying that goes “Never convert a convertible stock”, because it’s worth more on the market than the sum of its parts.

The Simple Dollar
The Intelligent Investor: Convertible Issues and Warrants
January 30, 2009 @ 8:00 am - Written by Trent
Categories: Book Club, Books, The Intelligent Investor
This is the seventeenth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.”
For convertible issues, Graham points out that convertible issues that are issued late in a bull market are almost always an awful investment. Why? The bonds themselves usually aren’t a very good investment - your hope is usually that you’ll be able to convert the bond (or sell the bond when the conversion is good). At the end of a bull market, prices are usually inflated and are about to sink. Thus, convertible issues bought late in a bull market are usually not able to be converted at a profit, making them a terrible investment.

Here’s the kicker: the latter stages of a bull market are when most convertible issues are created and sold. Companies are usually seeking to fund expansion and big spending projects when the economy seems to be roaring and that’s when they issue things like convertible bonds.

So, in a nutshell, Graham is very wary of all convertible issues - he all but encourages individual investors to simply leave them out of their investing plans.

Posted by Barry Popik
New York CityBanking/Finance/Insurance • (0) Comments • Tuesday, March 10, 2009 • Permalink