Q: Chick, you have been in the investment business for decades. Please tell us about your background and how you became an investment manager.
A: I was born and raised in Springfield, Illinois. Strong family with lots of cousins. Life was simple, not a lot of choices and you did what your parents told you to do, almost always! Attended public schools, two years at Springfield High and two at Exeter. Majored in History at Yale with only one course on Economics (the worst course in my four years there). When I graduated, the idea of balance sheets and income statements was totally foreign. In the spring of 1955, after working as the guinea pig for a bank management-training program (three months in Loan Credit Review raised my awareness of balance sheets), I was moved into the “Bond department.” We managed the bank’s bond portfolio, the cash management function;,all trust investments and a small municipal bond dealership. Warren Andrews, the manager of the department and a seasoned pro, took me under his wing. Painstakingly, we worked through the 1934 edition of Graham and Dodd. It fascinated me and I was hooked, especially since we worked with real accounts every day. After a six-year apprenticeship, Mr. Andrews retired and I took over the department, which I then ran for ten years. I ended up on the other side of “The Street” in 1973, when I moved to institutional sales with W E Hutton in Atlanta. While thrashing about the securities industry for eleven years learning I was not a salesman, there came a broad education in all the ways to skin the investment cat. The most productive and stable clients were the insurance company private placement departments. They made loans with “Kickers”. As I had already been a buyer of many convertibles, this was validation of the basic philosophy. After a brief stint in investment management consulting, I joined Llama Asset Management Company in Northwest Arkansas, where the investment problems of wealthy families were unveiled. In 1993 Lanphier Capital Management was founded to apply the philosophy developed over the years.
Q: Why buy convertibles?
A: * Convertibles combine the income compounding of fixed income securities with the capital gain potential of common stocks.
* They occupy a balance sheet position senior to the common stock of a company, giving them a greater degree of safety, which is important when investing in companies perceived to have problems.
* The income stream attaches some mathematical certainty to the value of the bond – once a decision has been made as to the perception of what the instrument should yield, plain math takes over. In the case of common stocks the price is almost entirely based on perception of its worth.
* Timing – good analysis can give a rational idea of what is going to happen to a company, just not when. The convertible’s contractual cash income constitutes a decent return that rewards investors for a necessary degree of patience. It takes time for most of our purchases to work.
Q: What is a convertible and how does it work?
A: To fund their operations, corporations primarily sell three forms of securities: debt, preferred stock and common stock. There are various permutations to each of these. What distinguishes convertibles from straight debt or preferred stock, and what makes them convertible, is an embedded warrant that gives the bond or preferred holder the right to convert their security, at any time, into the corporation’s underlying common stock at a fixed conversion price. Our niche is busted convertibles, which I will explain in a moment. But it is easier to understand converts if I explain how a new issue works. For example, a corporation sells a $100 million convertible bond issue that includes the following features:
* Minimum denomination: $1,000 per bond
* Maturity: ten years
* Coupon annual interest rate: 5%
* Interest payable: semi-annually in arrears
* Conversion price: $20 per share
* Conversion ratio: 50 shares
* Not callable by the corporation for three years, then callable at the par or issue price of $1,000
* Putable by the bond holder back to the corporation in three years at par.
Since the minimum denomination of the bond is fixed at $1,000, you can derive the conversion ratio by dividing $1,000 by the conversion price, and vice versa. The convertibility feature, and the put and call features, impact the valuation of the bond because each is an option. Valuing these various imbedded options is a major part of investing in convertibles for many investors. The interest rate and the conversion price are established by supply and demand and the market climate at the time of original issue. Because of the warrant to convert the bond into common stock, the issuing corporation is usually able to issue the bond with a lower coupon rate than would be required for a comparable straight or non-convertible bond. The conversion price is usually 25 – 30% above the then existing common stock price. Thus, the convertible bond is valued and characterized by three interrelated features:
* A bond value component, represented by the contractual nature of the bond as an obligation to be repaid, and the fixed coupon interest payment, which constitutes current income.
* The equity value component represented by the conversion or parity value of the bond, which is defined as the conversion ratio multiplied by the current common stock price.
* An option value component, which reflects changes in interest rates, time and the volatility of the underlying common stock. Converts are often issued when the fundamental outlook for the corporation is very positive and the common stock price is close to an all time high. Thus, investors often optimistically view the convert as equity that pays interest, with the expectation of eventually converting into the common stock. The bond value is considered a floor or downside support. Continuing with the example above, if the corporation’s common stock price at maturity is $19, which is below the $20 conversion price, then face value ($1,000) will exceed conversion value ($950), and the corporation will repay the bondholder the $1,000 face value. But if the common stock price is $21, then the convert holder will forgo being repaid the face value, preferring instead to exchange the convert for the number of shares represented by the conversion ratio. Converting into 50 shares at $21 will get the holder $1,050.
Q: What is a “busted” convertible?
A: The definition is fuzzy. It is an inelegant term for what can be a marvelous investment. Busted means convertibles trading in the market at significant discounts from the face or par amount. Although each situation is different, significant to us usually means 80% or less of par. Busted is likewise indicated by a market price 50% or more above the conversion or parity value. Busted is also characterized by higher current yields and yields to maturity or put. Converts trade to a distressed price level primarily because the fundamental outlook for the company has changed in a negative way. This deterioration of fundamentals will be reflected in a significant decrease in the common stock price, such that the conversion value of the convert decreases significantly. When this happens, the bond value component steps up to dominate the valuation, and the convertibility feature diminishes. By definition, companies with busted converts are perceived to have some form of trouble. The questions are whether the troubles are as bad as they seem, and whether the troubles are correctible. We pass on many situations where we are unable to determine that there is sufficient probability of adequate asset coverage to justify making the investment.
Q: Elaborate on different types of converts.
A: Most of the converts we buy are traditional coupon bonds or preferred stocks, with a conversion feature exercisable by the holder. There are numerous variations on the convert theme: zero coupons, put bonds, mandatories and most anything Wall Street thinks will sell. We want the income compounding from a coupon and the ability to exercise the conversion at our option.
Q: How do you identify convertibles with promising investment potential using fundamental and credit analysis?
A: We are constantly scratching around for converts that make sense. We regularly scan the Value Line Convertible Survey, Bloomberg and other sources. Every potential investment is different. We become interested when the convert is priced to offer a decent mid to upper single digit current yield and a low to mid teen yield to maturity. We rarely buy converts with maturity or a put (typically, the option to sell the bond back to the company at the holders option) longer than five years. We subject prospective purchases to traditional credit analysis, with default risk being our primary concern. When we get excited we dig into the company’s financial statements, which includes modeling historical and projected metrics (balance sheet leverage, margins, EBITDA, etc.). We look for hidden asset values. We search for the problems the market is pricing into the value of the company’s securities. We look for Wall Street research on the company. We rely on a network of friends and acquaintances with connection to that particular industry for a deeper understanding of the company. Often this information is much more revealing than any Street information. If the risks appear to be immaterial, exaggerated, already addressed or being addressed satisfactorily, and if the gut feel is good, we buy the convert. When buying, we make sure the yield is adequate for the quality and risk involved. Should the investment only pay interest and repay our principal or our purchase price, it will have been a reasonable return for the time period. If it performs as we expect, the conversion feature will provide an increase in price to enhance the income return.
Q: How can convertibles offer comparable returns to equities with less risk?
A: Fixed income investments are usually less volatile than common stocks. They have a contractual stream of income that gives them a value floor. Common stock, on the other hand, is mostly perception. Risk is generally defined as volatility of returns, most often standard deviation of returns. Our standard deviation of returns has been close to that of the S&P 500. However, the negative semi deviation, a complex name for the standard deviation of negative returns, is a better benchmark because it measures only the red returns. Using the negative semi, our deviation is only 71% of that of the S&P for both five and ten year periods. That means that our big surprises have been on the upside, not on the downside. I have never heard anyone complain about upside volatility. In 1998 our clients lost 4.74%. That is the only loss in the last ten years. We are committed to absolute returns, not relative returns.
Q: What are the effects of rising interest rates on a convertible’s performance.
A: Rising interest rates do two things. They erode bond values and they often cause stock market declines. Although rate increases hurt all bonds, our non-investment grade credit prospects are much more sensitive to credit events than rates. Most converts are relatively short maturity, which mutes some of the pain of increasing rates. When rates go up precipitously and stocks crash, busted convert buyers have the happiest hunting. When stocks soar to irrational heights like the late 90s, and to a degree like today, we can make a lot of money, but finding new candidates is very difficult. Established clients cash in but new clients have to wait for a more favorable environment. In 2000, having booked outsized profits in 1999, we took positions in a bunch of biotech converts that had balance sheets with cash and equivalents of three or four times total debt, no business except R & D expenses and low cash burns. The returns were priced in the mid teens. We watched them very closely and they performed as expected. Usually we can find decent candidates but sometimes, like today, we try to buy time at a decent return.
Q: Current levels of convertible debt?
A: The broad convertible security market is about $250 billion. It grows in line with overall corporate debt. We seldom buy new issues. That is when the company is trying to get the best deal for itself. We want to get the best deal for our client. So, while we pay attention to the new issue market, it is not an important part of our search. The busted market is a small part of the overall convert market. It grows when rates are high and stocks are low, and it contracts when they reverse.
The issue for us at LCM is not “is the market big enough”, but “can we find enough converts that meet our risk/reward characteristics.” Although 2005 was better, we are again having a hard time finding attractive converts. If we do not find good investments, we do not invest. We are comfortable with cash as an asset paying 4+%. We believe we can manage $100 million in client funds without disturbing our niche. We have $50 million under management today.
Q: What is your average holding period and how many securities do you generally hold?
A: Our average holding period is a little over two years. Normally, it takes that long for the world to see our wisdom. We hold 10 to 15 investments in each portfolio. We adhere to the thought that diversification devalues knowledge. Since we deal with companies that are usually under-researched and certainly unloved, the prices of their securities are often wrong. Inefficient markets offer great opportunity.
Q: How do you diversify your holdings?
A: As with common stocks, issuance of converts seems to concentrate in rotating sectors. Today, there are plenty of biotech and airline issues available but little in bank or oil converts.
Q: How do you avoid convertibles that become distressed debt?
A: Sometimes we don’t. I wish our collective judgments were infallible but they aren’t. In most cases we stick with the investment because analysis says that, with our senior position, the investment will give a decent return. Occasionally, we bail out. Sometimes the first loss is the least and best. Frequently we buy bonds of distressed situations. Most of the time we have been in contact with bondholder committees so we know pretty well how the negotiations will unfold. When we do participate, the bonds are very cheap relative to the recovery. When we receive common stock from a refinancing or bankruptcy we often hold it for some time. Patience, a trait rare in Wall Street, is very valuable in these cases and with most converts.
Q: How often do you find yourself selling your position because the convertible’s fundamentals deteriorate?
A: Not often. Yet, recently after analyzing and becoming comfortable with a company, we learned very unsettling information from a trusted industry source. This led us to liquidate our position with some loss. It would be nice to say our analysis is unerring. Not so!
Q: I have noticed your performance as a manager has done particularly well from 1999 to the present. What major economic or market influences helped your performance?
A: We received our first client money in late 1994. From 1995 to 1999 the stock market soared “irration-ally”. Early in that period, while our newly bought positions were cooking, the stock market was booming, up 37% in’95, 23% in’96, 33% in ’97 and 28% in ’98. While our clients earned teen returns in ’95 to ’97, they were not close to keeping up with that rise. In 1999 the positions that had been cooking took off. After capturing our profits we assumed the prenatal position, running for cover in relatively short secure bonds and continued building our positions in metals. The metal holdings have carried us the last couple of years and the first quarter of 2006. Over the years, our returns have been split between current interest plus dividend income and capital gains about 40%-60%. Our returns are reasonably tax efficient.
Q: You also work with a partner, Leonard Sojka. What is Leonard’s role with Lanphier Capital?
A: Leonard is a marvelous analyst and a good guy. We met some years back through a mutual friend of many years. We hit it off from the beginning. Leonard is a CPA originally from Duluth. Unhappy with public practice he went to the University of Chicago where he earned his MBA in Finance. His career has spanned the investment spectrum from sell-side convertible analysis at Merrill Lynch, through analytical work for Gabelli and several hedge funds. He is a retained consultant to Lanphier Capital Management. He has made major contributions to our performance of recent years. I know he will make many more. If I have contributed anything to him it is the patience to let your conclusions work. Leonard is an integral part of LCM. LCM has a contract with Leonard that if I am “hit by a truck” he can step in and guide clients to continue or liquidate in an orderly fashion.
Q: Is there any way that busted convertibles can protect me from rising personal and national debt, large trade deficits, and political uncertainty?
A: As mentioned earlier, our clients have significant positions in metals and mining companies, particularly precious metals. We are scouring ALL markets for ways to mute the problems that we see for the dollar. There are no guarantees. It is to the advantage of governments everywhere to debase their currencies. It is the only way to handle their debt service and debt structure as time goes by. Nice returns don’t matter if the buying power of the medium of exchange depreciates more than the return. There are no apparent easy answers.
Q: What kind of client is appropriate for your services and what percentage of their total investment funds would you recommend that they have in busted convertibles?
A: Clients expecting quick results should look elsewhere. Those who are looking for downside protection, absolute returns and who have a degree of patience will like our management. Our investments are not for cocktail conversation. Most of the names they will see in their portfolio will garner ughs rather than oooohs at social events. We prize interested clients and work hard to inform and keep our clients current as to what we are doing. We have thirteen client relationships, from corporate pensions to individuals and trusts to partnerships. We prefer not to take more than a third of the client’s investable assets, although some of our accounts have grown to be a much larger part of the client’s investment portfolio.
Q: Chick, how can you run a money management business from Hawaii?
A: Easy! This job entails a lot of reading, poring through reports and talking to company people and our industry contacts. Modern electronics make the contacts and availability of information quick and easy. By noon, being five or six hours behind New York, the phone and email cease to create “noise.” It allows a lot of time to ruminate over all facets of managing the accounts. Beach time is amazing in how it can clear the mind! So does tennis and Hawaiian canoe paddling.
Q: As a client, is it possible to visit you on your lovely island and write off the visit for tax purposes?
A: I can unequivocally recommend a trip to Kauai’s North Shore to anyone. If for investment purposes, I am told some part of the expense may be a “legitimate investment expense.” See your CPA! Kauai is an “indescribably delicious” place!