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Note that, after special charges, the effect of the company’s calculation is to increase the earnings per share and reduce the P/E ratio. This is manifestly absurd. By our suggested method the effect of the dilution is to increase the P/E ratio substantially, as it should be.

FAUST: Imagination in its highest flight Exerts itself but cannot grasp it quite.

MEPHISTOPHELES (the inventor): If one needs coin the brokers ready stand.

THE FOOL (finally): The magic paper…!

Practical Postscript

The crime of the warrants is in “having been born.”* Once born they function as other security forms, and offer chances of profit as well as of loss. Nearly all the newer warrants run for a limited time—generally between five and ten years. The older warrants were often perpetual, and they were likely to have fascinating price histories over the years.

EXAMPLE: The record books will show that Tri-Continental Corp. warrants, which date from 1929, sold at a negligible 1/32 of a dollar each in the depth of the depression. From that lowly estate their price rose to a magnificent 75 3/4 in 1969, an astronomical advance of some 242,000%. (The warrants then sold considerably higher than the shares themselves; this is the kind of thing that occurs on Wall Street through technical developments, such as stock splits.) A recent example is supplied by Ling-Temco-Vought warrants, which in the first half of 1971 advanced from 2½ to 12½—and then fell back to 4.

No doubt shrewd operations can be carried on in warrants from time to time, but this is too technical a matter for discussion here. We might say that warrants tend to sell relatively higher than the corresponding market components related to the conversion privilege of bonds or preferred stocks. To that extent there is a valid argument for selling bonds with warrants attached rather than creating an equivalent dilution factor by a convertible issue. If the warrant total is relatively small there is no point in taking its theoretical aspect too seriously; if the warrant issue is large relative to the outstanding stock, that would probably indicate that the company has a top-heavy senior capitalization. It should be selling additional common stock instead. Thus the main objective of our attack on warrants as a financial mechanism is not to condemn their use in connection with moderate-size bond issues, but to argue against the wanton creation of huge “paper-money” monstrosities of this genre.

* Graham detested warrants, as he makes clear on pp. 413–416.

* Graham is pointing out that, despite the promotional rhetoric that investors usually hear, convertible bonds do not automatically offer “the best of both worlds.” Higher yield and lower risk do not always go hand in hand. What Wall Street gives with one hand, it usually takes away with the other. An investment may offer the best of one world, or the worst of another; but the best of both worlds seldom becomes available in a single package.

† According to Goldman Sachs and Ibbotson Associates, from 1998 through 2002, convertibles generated an average annual return of 4.8%. That was considerably better than the 0.6% annual loss on U.S. stocks, but substantially worse than the returns of medium-term corporate bonds (a 7.5% annual gain) and long-term corporate bonds (an 8.3% annual gain). In the mid-1990s, according to Merrill Lynch, roughly $15 billion in convertibles were issued annually; by 1999, issuance had more than doubled to $39 billion. In 2000, $58 billion in convertibles were issued, and in 2001, another $105 billion emerged. As Graham warns, convertible securities always come out of the woodwork near the end of a bull market—largely because even poor-quality companies then have stock returns high enough to make the conversion feature seem attractive.

* Recent structural changes in the convertible market have negated some of these criticisms. Convertible preferred stock, which made up roughly half the total convertible market in Graham’s day, now accounts for only an eighth of the market. Maturities