The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.
Convertible issues are those which allow the investor to convert the share/bond into something else. For example, a convertible bond that allows you to convert to common shares gives you the benefit of consistent bond coupon payments, with the upside potential derived from common stocks if the share price takes off. The downside is that you pay for the option to convert, through a lower yield or subordinate position to non-convertible issues.
Graham looks at the historical performance of convertible preferred shares to show that they tend to perform worse than the general market except during upsurges. Graham warns that the addition of a conversion privilege often shows an absence of genuine investment quality. Thus, conversion privileges may be added as sweeteners.
An additional problem with conversion rights is the decision of when to convert. It is difficult for an investor to convert and then watch as the price continues upward, and may lead to less prudent behaviour in the future.
The key point here is that convertible securities should be considered with greater scrutiny than regular securities. In doing so, you are looking for something with strong security, exchangeable for common stock which is attractive in its own right and convertible for a price only slightly higher than it currently trades at.
Convertible securities are also important to the intelligent investor in the analysis stage - it is important to consider the effect of these securities when calculating earnings per share, by “diluting” the figure as if all the convertible securities would indeed by converted. This dilutes the earnings available for the common shareholder, and so it affects the value the intelligent investor places on that common share.