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.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the sixteenth chapter, which is on pages 403 to 417, and the Jason Zweig commentary, on pages 418 to 421.
The final five chapters of The Intelligent Investor (of which this is the first) really serve as a “wind-down” for the entire book. Graham spends the chapters looking at examples, special cases, and special topics that really almost serve as a supplement to the real meat of the book – the earlier chapters.
This chapter is a particularly interesting one, as it focuses on an area of investing that very few people in mainstream life are even aware of – convertible issues and warrants.
What are they? Convertible issues refer to financial instruments (usually bonds) issued by companies that can be converted into other financial instruments. The most common example of this is a convertible bond issued by a company in order to raise money. A convertible bond is just like any other bond – you buy it for a certain price, it pays a certain amount every so often, and when it’s finished, the bond has a face value. You might, for example, pay $9,800 for a bond that pays $400 a year for five years, then can be redeemed for $10,000. A convertible bond adds another option – you can, at any time, convert it into stock of the company that issued the bond at whatever rate was specified when the bond was issued. So, let’s say you have that $10,000 face value bond and it can be “converted” into 500 shares of stock in the company. If the stock’s value goes much above $20, it might be worthwhile to convert it.
A warrant is a long-term option to buy shares of stock at a certain price. For example, you might have a warrant for company A that lasts ten years that allows you to buy 1,000 shares of their stock at $10 a pop. If the company’s stock goes up to $20, that warrant itself has some significant value to it.
While I doubt I’ll ever find direct use for knowing how to find value when buying warrants or convertible issues, one can still garner useful principles from reading this information. So let’s dig in.
Chapter 16: Convertible Issues and Warrants
In short, Graham seems pretty wary of both of these types of investments. For the most part, throughout The Intelligent Investor, Graham seems to totally eschew the complex in favor of the simple.
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.
What about warrants? He’s pretty clear about them on page 413: “We consider the recent development of stock-option warrants as a near fraud, an existing menace, and a potential disaster.” That’s about as clear as one can be – stay away from these as well.
Commentary on Chapter 16
Zweig’s commentary here is very short, and he focuses exclusively on convertible bonds. His primary point about such investments is that, if you choose to invest in convertible bonds, don’t think of them as bonds. Instead, think of them as rather stable stocks, since the performance of convertible bonds mirrors the stock market, not the bond market.
Next Friday, we’ll take a look at Chapter 17: Four Extremely Instructive Case Histories.