Learn Stocks (Part 3)

Introduction to Convertible Preferred Shares

Buying stocks always poses the risk of losing money, but avoiding stocks altogether means missing out on the opportunity to make good profits. There is one security, however, that may help solve this dilemma for some investors: convertible preferred shares give the assurance of a fixed rate of return plus the opportunity for capital appreciation. Here we review what these securities are, how they work and how to determine when a conversion is profitable.
What Convertible Preferred Shares Are
These shares are corporate fixed-income securities that the investor can choose to turn into a certain number of shares of the company's common stock after a predetermined time span or on a specific date. The fixed-income component offers a steady income stream and some protection of the investors' capital. But the option to convert these securities into stock gives the investor the opportunity to gain from a rise in share price.

Convertibles are particularly attractive to those investors who want to participate in the rise of hot growth companies while being insulated from a drop in price should the stocks not live up to expectations.

The Opportunity for the Investor
To demonstrate how convertible preferred shares work and how they benefit investors, let's consider an example.

Let's say Acme Semiconductor issues one million convertible preferred shares priced at $100 a share. These convertible preferred shares (as they are fixed-income securities) give their holders priority over common shareholders in two ways. First, convertible preferred shareholders receive a 4.5% dividend (provided Acme's earnings continue to be sufficient) before any dividend is paid to common shareholders. Second, convertible-preferred shareholders will rank ahead of common shareholders in the return of capital if Acme ever went bankrupt and its assets had to be sold off. That said, convertible-preferred shareholders, unlike common shareholders, rarely have voting rights.

By buying Acme convertible preferred shares, the worst investors would ever do is receive a $4.50 annual dividend for each share they own. But these securities offer their owners the possibility of even higher returns: if the convertible preferred shareholders see a rise in Acme's stock, they may have the opportunity to profit from that rise by turning their fixed-income investment into equity. On the reset date shareholders of Acme convertible preferred shares have the option of converting some or all of their preferred shares to common stock.

Determining the Profit of Converting
The conversion ratio represents the number of common shares shareholders may receive for every convertible preferred share. The conversion ratio is set by management prior to issue, typically with guidance from an investment bank. For Acme, let's say the conversion ratio is 6.5, which allows investors to trade in the preferred shares for 6.5 shares of Acme stock.

The conversion ratio shows what price the common stock needs to be trading at in order for the shareholder of the preferred shares to make money on the conversion. This price, known as the conversion price, is equal to the purchase price of the preferred share, divided by the conversion ratio. So for Acme, the market conversion price is $15.38 ($100/6.5).

In other words, Acme common shares need to be trading above $15.38 for investors to gain from a conversion. If they do convert and the common shares drop below $15.38, they will suffer a capital loss on their $100-per-share investment. If common shares finish at $10, for instance, then convertible preferred shareholders' receive only $65 ($10 x 6.5) worth of common share in exchange for their $100 preferred shares. (The $100 represents the parity value of the preferred shares.)

The Conversion Premium
Convertible preferred shares can be sold on the secondary market, and their market price and behavior is determined by the conversion premium, the difference between the parity value and the value of the preferred shares if they were converted. As we show above, the value of the converted preferred share is equal to the market price of common shares multiplied by the conversion ratio. Let's say Acme's stock currently trades at $12, which means the value of the preferred shares is $78 ($12 x 6.5). As you can see, this is well below the parity value. So, if Acme's stock is trading at $12, the conversion premium is 22% [($100 - $78)/100].

The lower the premium, the more likely the convertible's market price will follow the common stock value up and down. Higher-premium convertibles act more like bonds since it's less likely that they will offer the chance for a profitable conversion. That means that interest rates too can impact the value of convertible preferred shares: like the price of bonds, the price of convertible preferred shares will normally fall as interest rates go up: the fixed dividend looks less attractive than the rising interest rates. Conversely, as rates fall, convertible preferred shares become more attractive.

Conclusion
Convertibles appeal to investors who want to participate in the stock market without feeling as though they are taking wild risks. The securities trade like stocks when the price of common shares moves above the conversion price. If the stock price slips below the conversion price, the convertible trades just like a bond, effectively putting a price floor under the investment.

Putting Management under the Microscope
It's hard to know which companies to trust. Despite a succession of reform legislation, corporate misdeeds still go on. And while it is very difficult for investors to know if a company is cooking the books until it's too late, they don't have to be completely in the dark about questionable management activities and dealings. There is plenty of accessible valuable information that provides warning signs that executives may not be acting in the best interest of shareholders. This article will show some of the signs of dubious goings-on found in publicly available documents.
Compensation
These days, it's common for top executives to receive base annual salaries in excess of $1 million. But for some executives, that income isn't enough to prevent them from taking unwarranted compensation.

The annual proxy statement - an SEC-required document - filed once a year shortly after the 10-K annual report - shows how much money executives are taking from the company in the form of salaries, bonuses, pensions, stock options and other expenses. By checking the proxy statement, you can determine whether executives' pay is in line with performance. Also, comparing one company's compensation with that of its peers will indicate whether one management team's pay is excessive.

Consider the enormous compensation lavished on Hewlett-Packard's former CEO Carly Fiorina. During her tenure, HP's share price dropped more than two-thirds. But from the time she joined the company in 1999 until she was ousted in Feb 2005, Fiorina took home more than $16 million in non-stock pay. Furthermore, HP helped her with her mortgage and relocation expenses which totaled $1.6 million between 1999 and the end of 2003. The company also paid for her personal travel expenses on HP jets and funded her retirement up to an annual $100,000. And finally, her severance package was worth about $21 million.

If executive compensation swells while performance wanes, this is likely to signal that management is not working in the interest of shareholders. For more on evaluating the job of those running a company, see Evaluating A Company's Management and Lifting The Lid On CEO Compensation.

Employee Stock Options
Broadly speaking, management ownership is a good thing - with their own money on the line, executives are more likely to act in shareholders' interests. But ownership doesn't have this desired effect when it's in the form of employee stock options (ESO), or incentive stock options: when shares go up in value, executives can make a fortune from their ESOs - but when they fall, investors lose out while executives are no worse off than before. So, while employee stock options are a key element of compensation, watch out for companies that - compared to other companies - offer a lot of ESOs to executives.

At the same time, keep an eye on companies that reprice their options, originally issuing options at one price and then, because the companies' share price plunges, exchange the old options with new ones at a lower exercise price. Companies claim that such action as an investment in the long-term health of the enterprise, saying repricing is necessary to retain talented employees during lean times. Sure, repricing is great for executives with ESOs, but shareholders still bear the brunt of diminishing share value while executives' stakes in the company stay protected.

Technology companies are the most common abusers as they tend to compensate the most with employee stock options. Consider chip-maker Broadcom. In 2004, it issued 48 million options, representing about 15% of its total shares outstanding. Of that total, 18 million options were repriced at a lower exercise price.

You can find out about executives' stock options holdings in the annual proxy statement in the document listed "DEF-14A" on the SEC's EDGAR website.

Related-Party Transactions
A study by research firm RateFinancials shows nearly 40% of the 500 companies of the S&P have business arrangements with parties that have personal ties to the companies or their management.

Although the vast majority of related-party transactions are legitimate, the practice grabbed headlines during the demise of Enron. The company's related-party transactions with special-purpose entities helped the energy company cook its books. Related-party transactions have figured prominently also in other corporate scandals. These transactions raise questions about whether corporate insiders are fully focused on the interests of shareholders. The deals, no matter how small, can create the impression that an insider is using company assets for personal benefit, resulting in the the company getting the short end of the stick.

Companies are required to disclose dealings they have with corporate executives and directors, and their associates and relatives. You can find the details of these dealings in the annual 10-K report under the heading "Certain Relationships and Related Transactions".
For example, on the 2004 proxy statements of two highly regarded stocks - The Gap and Best Buy – related-party agreements appear to directly benefit companies' top-level executives. Best Buy leases two stores from its chairman, and the combined rent on these two stores was about $950,000 for the fiscal year that ended Feb 28, 2004. As for the The Gap, its general contractor for store construction, Fisher Development, is owned by the brother of The Gap's chairman. Until 2002, this construction firm was the primary non-exclusive contractor for The Gap. When you see very large related-party deals, make sure to ask yourself whether they work in the favor of the company or to those running it.


Stacked Boards
Not surprisingly, excessive compensation, employee or incentive stock option repricing and suspicious related-party transactions all tend to be practiced by companies whose boards of directors are dominated by insider executives as opposed to outside directors. So be sure to check the 10-K and proxy statements to see if the board is stacked high with executives' associates, family, friends or anyone else who's likely to acquiesce to the decisions of management.
Also watch out for staggered boards, or classified boards, whose directors are not put up for re-election at the same time. The voting structure of staggered boards can delay the elimination of board members who are ineffective or who support dubious management activities. The undesirable effect is an entrenched management that is less responsive to shareholders. Also, staggered boards make takeovers and proxy fights more difficult to complete since a potential acquirer cannot force executives' dismissal at a single shareholder meeting, but must undergo a longer process.

Let's say a company that makes bricks had a board of 11 directors comprised of only four who were elected at any single general shareholder meeting. The company managers decided to take all the profits and invested it in a chain of luxury lingerie boutiques. Thanks to the staggered board, it could take years for shareholders to vote out the directors who decided to support the foolish investment decision.

Conclusion
Excessive management compensation, stock option repricing, related-party transactions and staggered boards are just a few practices investors should research before investing in a company. A close reading of the 10-K and proxy statement is a great way to ascertain whether a company is focused on building shareholder value or simply acting as a vehicle for managers' own interests.

It's not impossible for investors to detect a management's or board's double dealings. Find out where to look.
Keeping an Eye on the Activities of Insiders and Institutions
It pays to know what a company's owners are up to. By watching the trading activity of corporate insiders and large institutional investors, it is easier to get a sense of a stock's prospects. While insider or institutional ownership on its own is not necessarily a buy or sell signal, it certainly offers a handy first screen in the search for a good investment. Here we offer a quick review on how you can find and use insider and institutional-ownership information to make well-informed investment decisions.
Insider Ownership
Insiders are a company's officers, directors, relatives or anyone else with access to key company information before it's made available to the public. Savvy investors, making the reasonable assumption that insiders know a lot more about their company's prospects than the rest of us, pay close attention to what insiders do with company shares. And, because insider ownership and trading can impact share prices, the Securities and Exchange Commission (SEC) requires companies to file reports on these matters, giving investors the opportunity to have some insight into insider activity.

The Forms
You can retrieve reporting forms from the SEC's EDGAR database or the SEC Info Insider Trading Reports. Form 14A is the proxy statement in which you will find a list of directors and officers and the number of shares they each own. There is also a list of beneficial owners, or people or entities owning more than 5% of a company's stock.

The other relevant forms are 13D and 13G for disclosure of outside beneficial ownership, and Forms 3, 4 and 5 for disclosure of insider beneficial ownership. Insiders with more than 10% of the voting power file Forms 3, 4 or 5, and outsiders owning more than 5% file schedule 13D or its amendment form 13F.

Individuals file Form 3 when first acquiring shares, Form 4 to report changes, and Form 5 as an annual snapshot of holdings. Insider trading must be filed electronically through the Edgar system within two days of the transaction, giving outside investors reasonably up-to-date ownership information.

Interpreting Insider Reports
High inside ownership typically signals confidence in the company's prospects, and the ownership in its shares in turn gives management an incentive to make the company profitable and maximize shareholder value. Indeed, academic research has shown that firms with significant insider purchasing tend to outperform the market indexes.

On the other hand, you can have too much insider ownership. When insiders gain corporate control, management may not feel responsible to shareholders. This occurs frequently at companies with multiple classes of stock, which means one class carries more voting power than another. For example, Google's much publicized IPO in the fall of 2004 was criticized for issuing a special class of "super voting shares" to certain company executives. Critics of the dual-class share structure contend that, should managers yield less than satisfactory results, they are less likely to be replaced because they possess 10 times the voting power of normal shareholders.
While insider buying is usually a good sign, don't be alarmed by insider selling, unless there is a lot of it - insiders tend to buy because they have positive expectations, but they may sell for reasons independent of their expectations for the company.

Look for clusters of activity by several insiders. If a company has more than one insider trading similarly over a short period, there's a sign of a consensus of insider opinion. Also, large transactions mean more than small trades.

It's important to know which insiders to watch. Insiders with proven track records with their Form 4 activity should be watched more closely than those with little or poor past records. The most telling trading activity comes from top executives with the best insights into the company, so look for transactions by CEOs and CFOs.


Finally, be careful about placing too much stake in insider trading since the documents reporting them can be hard to interpret. A lot of Form 4 trades do not represent buying and selling that relate to future stock performance. The exercise of stock options, for instance, shows up as both a buy and a sell on Form 4 documents, so it is a dubious signal to follow. Automatic trading is another activity that is hard to interpret - to protect themselves from lawsuits, insiders set up guidelines for buying and selling, and leave the execution to someone else. SEC Form 4 documents disclose these hands-off insider transactions, but they don't always state that the sales were scheduled far ahead of time.

Institutional Ownership
Organizations controlling a lot of money - mutual funds, pension funds or insurance companies - buying securities are referred to as institutional investors.

The Debate over the Implications
Whether institutional ownership in a stock is a good thing remains a matter of debate. Peter Lynch, in his best-seller “One Up on Wall Street” lists the 13 characteristics of the perfect stock. One of them is this: “Institutions don't own it and the analysts don't follow it”. Lynch favors stocks that the big investment groups overlook because these stocks have more of a chance of being undervalued. Lynch argues that companies whose stock is owned by institutional investors are fairly valued, if not overvalued.
William O'Neil, founder of Investor's Business Daily, on the other hand, argues that it takes a significant amount of demand to move a share price up, and the largest source of demand for stocks are institutional investors. O'Neil reckons that if a stock has no institutional owners, it's because they have already seen it and rejected it. In his book “How to Make Money in Stocks”, O'Neil has institutional sponsorship as the sixth characteristic to look for in stocks worth buying.

O'Neil and Lynch, however, both agree that institutional ownership can be dangerous. These big institutions move in and out of positions in very large blocks, so they cannot buy or sell holdings gracefully. If something goes wrong with a company and all its big owners sell en masse, the stock's value will plunge.

Although there are mutual funds that operate with longer-term horizons, and pension funds tend to be long-term stockholders, institutional investors tend to react to short-term events. The high correlation between high institutional ownership and stock price volatility is a fact of life in investing. So, it pays to know what the institutions are up to and whether a stock you are interested in already has a large institutional interest.

Where to Find the Information
Institutional investment managers who exercise investment discretion of more than $100 million in securities must report their holdings on Form 13F with the SEC. Again, you can search for and retrieve Form 13F filings using the SEC's EDGAR database. To find the filings of a particular money manager, use the search entitled "Companies & Other Filers", go to"General Purpose Searches" and enter the money manager's name.

MSN Money also provides a very useful site that details stock ownership. Go to the Institutional Ownership link and type in the stock code of a particular company to receive details on the company's institutional holders.

Conclusion
Sure, insiders and institutions tend to be smart, diligent and sophisticated investors, so their ownership is a good criterion for a first screen in your research or a reliable confirmation of your analysis of a stock. But never base an investment decision solely on insider or institutional ownership information.