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In connection with the ownership of convertibles there is a special problem which most investors fail to realize. Even when a profit appears it brings a dilemma with it. Should the holder sell on a small rise; should he hold for a much bigger advance; if the issue is called—as often happens when the common has gone up considerably—should he sell out then or convert into and retain the common stock?*

Let us talk in concrete terms. You buy a 6% bond at 100, convertible into stock at 25—that is, at the rate of 40 shares for each $1,000 bond. The stock goes to 30, which makes the bond worth at least 120, and so it sells at 125. You either sell or hold. If you hold, hoping for a higher price, you are pretty much in the position of a common shareholder, since if the stock goes down your bond will go down too. A conservative person is likely to say that beyond 125 his position has become too speculative, and therefore he sells and makes a gratifying 25% profit.

So far, so good. But pursue the matter a bit. In many cases where the holder sells at 125 the common stock continues to advance, carrying the convertible with it, and the investor experiences that peculiar pain that comes to the man who has sold out much too soon. The next time, he decides to hold for 150 or 200. The issue goes up to 140 and he does not sell. Then the market breaks and his bond slides down to 80. Again he has done the wrong thing.

Aside from the mental anguish involved in making these bad guesses—and they seem to be almost inevitable—there is a real arithmetical drawback to operations in convertible issues. It may be assumed that a stern and uniform policy of selling at 25% or 30% profit will work out best as applied to many holdings. This would then mark the upper limit of profit and would be realized only on the issues that worked out well. But, if—as appears to be true—these issues often lack adequate underlying security and tend to be floated and purchased in the latter stages of a bull market, then a goodly proportion of them will fail to rise to 125 but will not fail to collapse when the market turns downward. Thus the spectacular opportunities in convertibles prove to be illusory in practice, and the overall experience is marked by fully as many substantial losses—at least of a temporary kind—as there are gains of similar magnitude.

Because of the extraordinary length of the 1950–1968 bull market, convertible issues as a whole gave a good account of themselves for some 18 years. But this meant only that the great majority of common stocks enjoyed large advances, in which most convertible issues were able to share. The soundness of investment in convertible issues can only be tested by their performance in a declining stock market—and this has always proved disappointing as a whole.*

In our first edition (1949) we gave an illustration of this special problem of “what to do” with a convertible when it goes up. We believe it still merits inclusion here. Like several of our references it is based on our own investment operations. We were members of a “select group,” mainly of investment funds, who participated in a private offering of convertible 4½% debentures of Eversharp Co. at par, convertible into common stock at $40 per share. The stock advanced rapidly to 65½, and then (after a three-for-two split) to the equivalent of 88. The latter price made the convertible debentures worth no less than 220. During this period the two issues were called at a small premium; hence they were practically all converted into common stock, which was retained by a number of the original investment-fund buyers of the debentures. The price promptly began a severe decline, and in March 1948 the stock sold as low as 7 3/8. This represented a value of only 27 for the debenture issues, or a loss of 75% of the original price instead of a profit of over 100%.

The real point of this story is that some of the original purchasers converted their bonds into the stock and held the stock through its great decline. In so doing they ran