Risky Business

A Primer of Stock Market Speculation, Part II

This is part two of a two-part article.
Read part one here.

If you think you know what you are doing, the stock market offers an enormous potential for proving yourself right. Anyone who feels that his outlook toward stock prices is the correct one can make or lose a lot of money simply by using such speculative techniques as leverage, puts and calls, margin and short selling. One of the reasons that the stock market is fascinating to so many people is that it offers the opportunity for capital gains regardless of the individual’s economic outlook. In addition, there is a wide spectrum of risk and reward, and it is up to the individual to decide how much of each he wants. The man who buys a hundred shares of RCA may have the same value judgment concerning the stock as does the speculator who buys ten calls on the same security. But the confidence of each man in his own judgment and his willingness to take risks are quite different.

The techniques that we outlined in the July Atlantic are interesting, and an understanding of them is indispensable to a true market operator. Nevertheless, they are basically technical in nature and make up only a small part of the opportunities available for risk in the market. Certain securities by their very nature are speculative and offer anyone who buys them the possibility of receiving an inordinately high return on his money. As we examine warrants and low-price stocks, keep in mind that these are types of securities which are inherently speculative because of the leverage involved.

Warrants

Warrants are similar to puts and calls in the sense that they too are options, and their holders have the right to do certain things. Unlike puts and calls, they are traded on stock exchanges and in the over-the-counter market and may have no time limit. Each warrant must be examined to determine what right it gives its holder. In addition, unlike puts and calls, warrants are part of the capitalization structure of companies (although they are not forms of ownership) , and therefore not all corporations have warrants outstanding.

To make this hodgepodge a little clearer let us say that our friends at Unmentionables incorporated decide to sell warrants. Each warrant gives its holder the right to buy one share of Unmentionables’ common stock at $10 per share. The common is selling at $20. Theoretically the warrant is worth $10. If Unmentionables Incorporated were selling at $22 per share, the warrant would be worth $12. Let us also say that these warrants will grant this right to their holders until 1974, at which time they expire and become worthless. If the price of Unmentionables’ common stock doubles—that is, if it goes from $20 to $40, the price of the warrants should triple. Since they still give us the right to buy the stock at $10, they are worth $30. In other words, the holder of the warrant would receive a far higher return on his money than the holder of the common. In addition, since the warrants were selling at $10 whereas the common stock was selling at $20, the price of the warrants could only drop to points while the common could fall 20. Thus, the buyer of: this particular warrant assumed less risk and a higher possible return than the owner of the common. The tact that he bought a security which gives him no say in the running of the company and pays no dividends seems a small price to pay for the potential leverage that he receives.

Lest the reader is now tempted to tear up all his economics books and start buying up warrants as if they were the key to wealth and happiness, it should be noted that things aren’t so simple. Several million people are as intelligent as you and I, and recognize the leverage involved in warrants. As a result, the price goes up.

A good example of what the public is willing to pay for warrants of volatile companies is the price of the warrants of Gulf & Western Industries. As most people know, Gulf & Western is a conglomerate company which is a favorite among stock-market traders. Some time ago, it acquired Consolidated Cigar Corporation and offered shareholders of Consolidated a package which included warrants. The warrants give their holders the right to buy Gulf & Western common stock at $55 per share through January 31, 1978, at which time they become worthless.

On April 11, 1968, the price of Gulf & Western was 43 5/8. Theoretically, therefore, the warrants are valueless and will continue to be valueless until the stock goes up another 113/8. However, in view of the leverage potential involved, the warrants closed on the American Stock Exchange on the same day at 1914. The only way for these warrants to work out much better than the common stock would be for Gulf & Western to experience a really dynamic rise. If the stock went up to $155 per share, the warrants would go to at least $100. That is, the price of the warrants would have appreciated 400 percent, whereas the common merely went up some 260 percent. If the stock trades in a narrow range, the warrants will fluctuate purely on a supply and demand basis that has little arithmetical similarity to their actual value. In addition, as they get closer to the time they expire, there will be a tendency to lag. Obviously the premium will lessen as time goes on, particularly it the common stock has not done extremely well.

Each warrant should be individually evaluated by the speculator to make sure that the premium being paid is commensurate with the prospects of the company. If the speculator feels that the company is one which will appreciate at an abnormally fast pace, he almost always is better off buying the warrant. However, he must make sure that he understands the terms of what he is buying and must realize that he may be purchasing a piece of paper which will become worthless.

Low-Price Stocks.

Low-price stocks are fun. They are fun to own because very often they have exotic names and engage in romantic-sounding activities; more important, they often go up. In addition, the risk is limited in a low-price stock by the nature of the low price. Nobody goes to a cocktail party to talk about General Motors or the Dreyfus Fund, but if you know somebody who bought a thousand shares of a three-dollar stock which is now at nine you can bet that you will hear about it. Low-price stocks are legitimate speculative techniques because of the leverage inherent in the price. It is obvious that a stock can go from five to ten quicker than most stocks can go from fifty to a hundred. In addition, a five-dollar stock that goes up a point has already given the owner a 20 percent return on his money. This is leverage.

Although low-price stocks offer sound opportunities for speculators, most people lose money when they buy them. If you can avoid the pitfalls outlined below, it might save you a few extra dollars.

1. Don’t trade low-price stocks. It is a truism to say that someone who can’t afford to buy a high price stock cannot afford to buy a low-price one. Even truer is the saying that he who cannot afford to trade high-price stocks shouldn’t trade at all. In the first place, low-price stocks lack the volatility to make them good trading vehicles. Those that do move up and down rapidly are usually the products of special situations, or are simply trading on rumors. Do not go into low-price stocks unless you are willing to be patient.

2. Don’t buy on tips or rumors. This is especially true with low-price stocks because very often there is no information on the company being considered. Since there is no way to evaluate it, the odds are stacked against you to begin with. Even if the stock goes up, the question of when would be a good time to sell remains.

3. Only buy legitimate low-price stocks. This is most important and is probably the reason why most people lose money in low-price stocks. A good low-price stock is one which has a low price because the company is small, sales are small, earnings are in relation to the price of the stock, and most important, the amount of common stock is small.

An example of an artificially low-priced stock is Toyota Motors, a Japanese company, whose stock is traded in the over-the-counter market in the United States. Toyota is the largest automotive company in Japan, and most people in this country are familiar with its products. In 1966, for example, the company produced 18,046 trucks and buses, 247,583 small trucks, 300,275 passenger cars, and 101,228 exports. Sales for that year were $816,206,000. The unsophisticated investor might marvel that the stock of such a large company is only selling at around $1.

The reason Toyota’s market juice is so low is that there is such a tremendous amount of stock outstanding. The company has 3 billion shares authorized and a total of 765 million shares outstanding. This is approximately three times as many shares as General Motors has, and over 250 million more than AT&T. At the present time, Toyota is quoted at $1 bid and $1.10 asked. The commission on a hundred shares would be $6. or the maximum of 6 percent. This means that the buyer is paying $1.16 for a stock that he could sell a moment later for $.94 (the dollar bid price less the $6 commission) . This is like paying $92 per share for General Motors when the stock is selling for $80. In addition, considering the amount of shares being traded, it is going to take a tremendous buying demand to move the stock up sufficiently for the owner to make a significant profit.

Toyota is a low-juice stock. It is not, however, a cheap stock. If one examines the issue closely, he will find that Toyota is selling in line with most automotive issues. A stock can be selling at two cents a share and be way overpriced, whereas a hundred-dollar stock can be very low. The market price of an individual security is important only in comparison with all other factors. Too many novices buy stocks because of market juice without examining what’s behind it. Ordinarily, particularly in times of market optimism, there are excellent reasons why stocks sell tor a dollar or less. Usually the reason is that the company is not even worth that, and the small dollar price represents faith, hope, and charity. If you have all three, you can buy these issues blindly. If you do, let me suggest that you also have a good sense of humor and some extra money in the bank.

Convertible Bonds

Convertible bonds don’t necessarily belong in a discussion of speculative techniques, since they are just as good for investment as they are for speculation. The quality of the bond depends upon the quality of the company which has issued it.

A convertible bond is a bond that can be converted into common stock at a specified juice. The advantages of such an arrangement are obvious. In the first place, the buyer can get as great appreciation with the bond as he can with the common stock. If he owns a bond which is convertible into ten shares of common stock, and the stock goes from $100 to $200 a share, you don’t have to be the dean of the Harvard Business School to figure out that the bond has to go up too. In addition to the profit potential, the bond pays interest, and is ordinarily somewhat safer than the common stock, as I shall explain. As far as the company is concerned, the convertible bond is an excellent means of financing because the interest payments to the bondholders are a pretax charge whereas dividends to the holders of stock must come out of profits.

Convertibles offer another advantage, because they are bonds, they can be bought on 60 percent margin rather than the 80 percent required for stocks. Furthermore, the owner can run to the bank to hock them and do far better than it he had the common stock of the same company. As the result of the publicity given convertibles over the past couple of years, and the public readiness to embrace them, the supply of these securities has increased. Indeed, companies couldn’t wait to pawn off on the public convertible bonds which were indecently overpriced. Because of the sophisticated methods used in pricing a convertible, most people didn’t understand the concepts or the risks.

As I have pointed out already, a convertible bond is a bond that has large profit potential because it is convertible into the common stock of the company that issued it. Using the Unmentionables Incorporated illustrations, let us assume that the board of directors of that company decided to sell a convertible bond issue. Let us also assume that the price of the common stock is $20 and the common pays no dividend. There are two ways to price a convertible bond; one is with the interest the company is willing to pay to the bondholders, and the other is with the conversion price, or the price which the stock must reach before the bond at $1000 would be at parity with the stock.

To make this easier, assume that Unmentionables Incorporated decides that these bonds will he priced at par or $1000. have a 4 percent coupon, and be convertible at $25. This means the stock can he exchanged for 40 shares of the common at any time ($25 conversion price divided in the bond price of $1000). Since the common stock is selling for only $20 per share, the bond is immediately selling at a $200 premium (40 shares times the present price of $20 is only $800, and we’re selling this bond at $1000). Let’s take a look at what we’re getting for that 25 percent premium.

First, we’re getting an annual interest payment of $40, or 4 percent, compared with zero for the common stockholders. We are also getting a bond that we can cash in at a bank or can buy on less margin than the common stock. Last, and most important, if eve know what we are doing and can understand convertible bonds, we are buying a security which will not decline as much as the common stock if either the market or the stock takes a severe chop. If you understand the concept of investment worth of convertibles, you will be sophisticated enough to start thinking about buying them.

The investment worth of a convertible bond is the price at which that bond would sell if there were no convertible feature. For example, let us decide that the two largest rating services, Moody’s and Standard & Poor’s, believe that this issue being sold by Unmentionables Incorporated deserves an A rating. This is the third highest rating that these services give, and it represents a bond selling slightly below very high quality. This doesn’t mean that these people think the bond will go up or clown. The rating has to do with the company’s ability to continue to pay interest and eventually the whole principal. It is the quality of the finances rather than the growth prospects being evaluated. Let us also assume that A-rated bonds maturing in twenty years, as do these new convertibles, will give their holders a 6.5 percent yield to maturity. This would mean that if the conversion feature was valueless, this bond would sell at 72.20, or $722.00. (Bonds are traded in percentages of par—$1000.) This is the investment worth of the Unmentionables Incorporated convertible bond. Of course, if the ratings change or interest rates vary, this figure could be adjusted up or down. Nevertheless, all things being equal, the price of the Unmentionables bond should not fall below that figure.

A good example of how this concept works in real practice can he shown by examining International Minerals & Chemical convertible subordinate debentures 4s, January 1, 1991. These bonds were rated BB by Standard & Poor’s and had an investment value oF 561/2, or $565. On June 22, 1966, the common stock closed on the New York Stock Exchange at 65, whereas these bonds were trading at approximately 9 8½. In November of that year the stock was split on the basis of three shares for each two held. If you had bought one share at 65, you would now have 11/2 shares at a price of 43½. International Minerals & Chemical is the largest producer of fertilizer materials in the world. In 1967, business began to sink. Earnings dropped to $1.42 a share in 1967 versus $2.56 a share in 1966 and took another drop in 1968 to $1.01. The price of the stock dived along with the earnings, and eventually the dividend was halved. On October 4, 1968, the common stock closed at 22, while the price of the convertible bond ended up at 7514. or $732.50. In other words, whoever bought a share of International Minerals & Chemical at 65 would now have a share and a half worth 833, or a loss of 50 percent. The bondholder lost only approximately 25 percent on his original investment and was still getting his $40 a year interest payment. It should be pointed out that the investment, value of these bonds is 56½, and so there is still some risk in holding them. Nevertheless, the lesson here is fairly obvious — there are times when the convertible bond is a safer investment than the common stock.

It must be fairly clear that the higher the bond goes, the less important is the safety inherent in the bond form. If Unmentionables Incorporated does extremely well, and the price of the stock rises, the bonds will rise too. Let us say the stock doubles to $40. Since the bonds are convertible into 40 shares of common, the convertibles will sell for at least 160, or $1600. However, the fact that these bonds have an investment worth of 72.20 is far less important now than when the bonds were selling at par, since now the bonds can fall by over 50 percent and still be over that figure. As a result, the premium accorded the convertible bonds because of their investment worth will begin to decline and eventually disappear. Therefore, if the bonds are selling right at conversion parity, or 160, we can readily see that the bondholder has experienced a 60 percent increase in his investment, whereas the stockholder has doubled his money.

Furthermore, let us assume that Unmentionables Incorporated decides to put a call feature into this bond, giving it the right to redeem the bonds at 110 at its discretion. If the bond goes above this price and the management decides to call it, the bondholder is forced to convert into common stock or lose his profit. Obviously, if the bond is selling for 160, you have no desire to give it to the company at 110. If the bond is selling for a premium over the common stock at the time it is called, that premium will be lost.

The sophisticated speculator can use convertible bonds to increase his return through margin and bank borrowing. In addition, when used in conjunction with a short sale, convertible bonds can provide a good return with small risk.

The most riskless speculation for an individual speculator is probably hedging in convertible bonds. To set up a hedge, the speculator sells a stock short while buying the convertible bonds of the same company. Because of the investment worth of the bonds they should not hill as far as the common. If the speculator is wrong and the stock goes up, he can cover his loss with the gain he made on the convertibles, losing only commissions and interest on the margin account.

For example, let us assume that in 1966 we had set up a hedge in International Minerals & Chemical. To make matters simple, let us assume that the stock has split and instead of selling at 65, it is at 43½. To compensate for the change in price of the stock because of the split, the conversion price of the bonds is changed so that each bond is convertible into 17.16 shares of common. To set up a hedge, we buy ten bonds in the open market and sell 172 shares short. We cover the transaction two years later buying the stock at 22 and selling the bonds at 73¼. The whole transaction should look like this:

June 22, sold short 172 shares at 43½ = $7482

1966 purchased 10 bonds at 98½ = $9850

October 4, purchased 172 shares at 22 = S3784

1968 sold 10 bonds at 73¼ — $7325

Profit on short sale = $3698

Loss on bonds = $2525

Net Profit $1173

This situation worked out quite well because of the steep drop in the price of the stock. However, because of the premium paid for the bonds (it should be noted that in order to short $7482 of stock it was necessary to buy $9850 worth of bonds) , had the stock risen substantially and the premium lessened, a loss could have been sustained.

The problem with hedging is in finding the right situation. If one can be found, the speculation can either lose very little or make a fair return. If the following conditions do not exist, do not attempt to set up a hedge:

1. The bond must be selling near conversion parity. If the bond is selling at too high a premium, the bond loses a certain amount of protection, for as outlined above, if the stock rises and the premium evaporates, a loss will be sustained.

2. The bond should be selling near its investment value. This is extremely important, for if the bond is selling way above the investment value, there is no downside protection. Obviously, a bond that is selling at 200 with an investment value of 70 is no good, because its price can be cut almost to a third.

3. The stock should be volatile enough so that it it goes down, it will go clown quite far. We re not talking about one or two points with hedging because the bond will go down with the stock. The stock has to go down quite a bit before most bonds stop acting in conjunction with them. The mote volatile the issue Lite better.

Hedging is not for people who want to make a million dollars. Since the risk is small, the reward is not exorbitant. Nevertheless, if the right situation pops up, hedging can put a couple of extra dollars in your pockets without adding any sleepless nights.

This article has tried to emphasize one basic caution. All techniques of speculating in different types of securities are fine, if you know what you are doing. If you are looking for the technique that will make you a millionaire without worry and with very little capital, there is only one recourse: write a stock market book with a sexy title.

The stock market is more than a place to exchange securities. It is an arena of risk and reward. The intelligent speculator is the one who understands both concepts and knows the different ways of finding what he is looking for. The most important financial question an individual must ask himself is how much risk, and how much reward, he wants. If he finds that he is able to answer that question successfully, he will save himself the anxiety that many speculators feel when they begin getting in over their heads.