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By Root 2848 0

there are two offsetting factors, one of which is practically ignored and the other entirely so in optimistic markets. The first is the actual dilution of the current and future earnings on the common stock that flows arithmetically from the new conversion rights. This dilution can be quantified by taking the recent earnings, or assuming some other figures, and calculating the adjusted earnings per share if all the convertible shares or bonds were actually converted. In the majority of companies the resulting reduction in per-share figures is not significant. But there are numerous exceptions to this statement, and there is danger that they will grow at an uncomfortable rate. The fast-expanding “conglomerates” have been the chief practitioners of convertible legerdemain. In Table 16-3 we list seven companies with large amounts of stock issuable on conversions or against warrants.†

Indicated Switches from Common into Preferred Stocks

For decades before, say, 1956, common stocks yielded more than the preferred stocks of the same companies; this was particularly true if the preferred stock had a conversion privilege close to the market. The reverse is generally true at present. As a result there are a considerable number of convertible preferred stocks which are clearly more attractive than the related common shares. Owners of the common have nothing to lose and important advantages to gain by switching from their junior shares into the senior issue.

TABLE 16-3 Companies with Large Amounts of Convertible Issues and Warrants at the End of 1969 (Shares in Thousands)

EXAMPLE: A typical example was presented by Studebaker-Worthington Corp. at the close of 1970. The common sold at 57, while the $5 convertible preferred finished at 87½. Each preferred share is exchangeable for 1½ shares of common, then worth 85½. This would indicate a small money difference against the buyer of the preferred. But dividends are being paid on the common at the annual rate of $1.20 (or $1.80 for the 1½ shares), against the $5 obtainable on one share of preferred. Thus the original adverse difference in price would probably be made up in less than a year, after which the preferred would probably return an appreciably higher dividend yield than the common for some time to come. But most important, of course, would be the senior position that the common shareholder would gain from the switch. At the low prices of 1968 and again in 1970 the preferred sold 15 points higher than 1½ shares of common. Its conversion privilege guarantees that it could never sell lower than the common package.2

Stock-Option Warrants

Let us mince no words at the outset. We consider the recent development of stock-option warrants as a near fraud, an existing menace, and a potential disaster. They have created huge aggregate dollar “values” out of thin air. They have no excuse for existence except to the extent that they mislead speculators and investors. They should be prohibited by law, or at least strictly limited to a minor part of the total capitalization of a company.*

For an analogy in general history and in literature we refer the reader to the section of Faust (part 2), in which Goethe describes the invention of paper money. As an ominous precedent on Wall Street history, we may mention the warrants of American & Foreign Power Co., which in 1929 had a quoted market value of over a billion dollars, although they appeared only in a footnote to the company’s balance sheet. By 1932 this billion dollars had shrunk to $8 million, and in 1952 the warrants were wiped out in the company’s recapitalization—even though it had remained solvent.

Originally, stock-option warrants were attached now and then to bond issues, and were usually equivalent to a partial conversion privilege. They were unimportant in amount, and hence did no harm. Their use expanded in the late 1920s, along with many other financial abuses, but they dropped from sight for long years thereafter. They were bound to turn up again, like the bad pennies they are, and since 1967 they have become familiar