Finding Bargains Among 'Wrecked Convertibles'

I am fortunate to have a lot of friends and associates who are much more astute observers of the market than I will ever be. I am doubly fortunate that many of them share their observations with me.

On Friday morning I got an email form a good friend in New York City who, in spite of being between the rivers, is an accomplished practioner and observer of the stock market game. It was a simple attachment of a chart of year-to-date returns from various hedge fund strategies. I was surprised to see that the worst performer of all was the convertible arbitrage category. One could opine that this group got hurt by the temporary ban on short-selling, but the negative 50% return in 2008 seems excessive to me. Digging a little deeper, I found that this strategy lost more than 30% in October alone.

I have noticed over the years that there is a certain ecology to asset classes and strategies. Someone finds an edge and begins to outperform his or her peers. This attracts attention, and like a forest clogged by too many trees, the sheer number of investors using the method chokes off returns. An overgrown forest will have underbrush killed off by lack of sunlight and competition for nutrients from the excess of trees and plants. A hedge fund strategy will have way too many people chasing far too few good trades and too much leverage used to squeeze every dome out of thinning margins.

Eventually, the fire comes along, and when it does, the strategy explodes. All the money that flowed in during the previous good times runs for the exit. Just as the forest grows fastest in the aftermath of a fire, opportunities grow in the investment category.

Typically, convertible arbitrage involves buying a convertible preferred stock and selling short the underlying common stock on the basis of the conversion ratio and the stock's trading relationship to the underlying.

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At the time of publication, Melvin had no positions in stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.