Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 16

 We concluded chapter 15 with some general advice for selecting stocks, but seemingly out of nowhere Graham jumps to a chapter titled ‘Convertible Issues and Warrants’. It is not my place to be Graham’s editor and discuss the merits of the placement of this chapter, but it is likely that after discussing stocks, Graham was turning his attention to these ‘hybrid’ instruments that carried stock exposure.

While my purpose is not to examine these instruments, I will provide a brief overview. Warrants are simply stock options, the right to buy common shares at a stipulated price.  Convertible issues are bonds or preferred shares that offer the investor the “bond like” protection in terms of paying a coupon/dividend, plus the opportunity to participate in the upside of any substantial rise in value of the common shares.

Graham discusses some of the challenges with owning these instruments, the details of which I will skip. With respect to convertibles he summarily concludes: “Our general attitude toward new convertible issues is thus a mistrustful one.”  His starting point for stock option warrants is that they are: “a near fraud, an existing menace, and a potential disaster.” He bemoans the dilution impact of options and their general misunderstanding by issuers and investors alike.

If I were to take one thing from Graham in this chapter, it’s really his skepticism for new financial innovations, especially those created and marketed during bull markets.

How did Zweig decide to tackle this somewhat technical and arcane discussion?

Commenting on Commentary on Chapter 16

Like Graham, Zweig tackles convertible bonds first, describing them as offering less income and more risk than other bonds or a “worst of both worlds” investment, caveating that it really depends on how you are using convertible bonds in your portfolio construction.  His points here really boil down to: 1) understanding that most convertible bonds are more “stock-like” than bond-like and might be “stocks for chickens” and 2) to understand the intricacies of the specific issues you own including things like any call protection and other specific redemption features.

Moving to stock options, Zweig highlights a strategy that is still prevalent today, writing covered calls to generate income.  What is a covered call strategy?  It is when an investor owns shares of an underlying stock and sells a call option which gives someone the right to buy those shares from you at a higher price in the future.  You, the call writer, pocket income in the form of the option premium which could be viewed as an enhancement to your portfolio providing some protection against stock prices falling.  However, if the price of the stock underlying the option increases you have set a maximum return you can earn from that stock as the holder of the call option will buy your stock from you at the now below market price set at the inception of the contract.

Nowadays there are a number of popular covered call ETFs available. Zweig cautions investors against “surrendering most of your upside”.

For me context is key here, if you’re going to use convertibles and options in your investment portfolio it’s really all about knowing what you own in terms of the exposure these products present and why you own them.

It is one, if not the shortest commentary Zweig provides, so we won’t bemoan it.  

Next we turn to a couple of case studies that Graham believed showed different extremes that all investors should be warned about.

“That which thou southwest is not quickened, except it die.”

-1. Corinthians, XV:36