Get Paid to Wait

The bond market doesn't offer much satisfaction either. Short-term yields are a measly 2%. Payouts on longer-term obligations are modestly higher (4% for 10-year Treasurys). But if interest rates go up, the decline in bond prices could more than offset the income.

With so much uncertainty, I've been scouring the landscape for unusual opportunities. This month I'll tell you about two oddball alternatives that are especially intriguing. For people who like cashing dividend checks, there's an unusual preferred stock that lets you exchange some of tomorrow's potential profit for a higher yield today. And for conservative investors who enjoy owning real assets, several almost-forgotten oil and gas royalty trusts offer attractive current income as well as the potential for fat capital gains.

First, the lowdown on mandatory convertible preferreds — which aren't as off-putting as the name implies. Companies create these shares when they need cash but can't afford to borrow and are worried that a conventional equity offering will depress the price of their common stock. So they sell special preferred shares (usually with their own unique ticker symbol), which are typically issued in $25 or $50 amounts and automatically convert to common stock in a few years.

It's a popular product: Through August of this year, 25 companies sold $12 billion worth of these shares. What is the attraction? An above-market yield. A new Corning five-year mandatory convertible, for example, pays 7% annually, while Corning common stock has no dividend. At maturity the shares will convert to common stock based on an exchange ratio that was set on the date the preferred shares were issued.

Now the hitch. While convertible shares move up and down with the common stock, they don't participate in all of the upside. That's the price you pay for having gotten those juicy dividends. Each prospectus will lay out the specifics in greater detail, but here's basically how it works: When the common stock rises above the price it sold for on the day the convertible shares were issued, the exchange ratio declines slightly. The math is complicated, but the bottom line is that buying a mandatory convertible means you trade about 20% (the exact number varies) of the common stock's upside in return for higher current yield. (To learn more, check www.convertbond.com, an excellent Web site.)

What intrigues me are situations in which a company's shares have collapsed since a mandatory convertible was issued. When the common is below the price it sold for at the time the convertible was issued, the convertible matches its gains on a 1-for-1 basis. Meanwhile, because the convertible has slid along with the common, its yield is even higher.

Consider Motorola, which scores well on some of my favorite value screens. Last November it sold $1.2 billion worth of a three-year mandatory convertible with a yield of 7% ($50 issue price, common stock at $17.28, exchange ratio of 2.89). Since then, Motorola common has tumbled to $12. The convertible has fallen too — from $50 to $39.70. That's a slight premium over its current conversion value ($12 x 2.89, or $34.68). But the dividend is still the same, so the convertible now yields 8.8%.

Play with the numbers and you'll see that unless Motorola goes up more than 44% between now and November 2004 (a number I call the 'free' gain in my table), the convertible is a much better buy. If the common moves down, the convertible's extra yield is great protection. And if the common moves up, the convertible gets the yield plus full participation in the gain — until the common hits the issue price. Then the exchange ratio declines slightly, and further gains on the convertible won't match those of the common. But who's keeping score when everyone is a winner?

Similar relationships hold for the other convertibles in my table, a roster of backdoor bargains on attractive companies. Alltel and American Electric Power are strong, well-run outfits in troubled industries. Capital One has top-tier credit card customers with some of the lowest delinquency rates around. Under tough new management, EDS has cut costs and enjoys a bulging order book. Toys 'R' Us is steadily modernizing stores and selling more high-profit 'exclusive' merchandise. Solectron is risky, I know, but it's also a great play on a tech turnaround. The yield is of junk proportions — 14%. That's a nice chunk of change for waiting.

Now shift your thinking from Wall Street to the oil patch. Once upon a time, energy stocks were glamorous. In the early '80s many big companies spun off their energy operations to raise cash — a move akin to the urge to do Web spinoffs during the Internet bubble. When the operations were oil- or gas-producing wells, deals were occasionally structured as royalty trusts. Think of them as holding companies created to do nothing but pass along income.

About a dozen royalty trusts have NYSE listings, but no one pays much attention. There's no investment banking revenue to attract brokerage firms. There are no executives with stock options and a story to tell. There aren't even any employees — just a few bankers hired by the trustee to mail out monthly checks. And, of course, oil and gas are classic 'wasting' assets. Eventually, the wells run dry, and your trust shares will be worthless. Despite all this, royalty trusts aren't disappearing as fast as you'd think. The audited reserve life of the trusts in my table averages only 10 years, but that's a conservative number. Oil production keeps improving, and higher prices would make it profitable to pump reserves that are marginal today.

Kurt Wulff, a former Wall Street analyst who studies royalty trusts, figures that new technology will more than double estimated reserve life. Wulff doesn't follow Sabine (its diverse holdings are a plus, but difficult to track). But based on current prices of energy futures, he thinks Cross Timbers, Hugoton and San Juan are trading today at an average 25% discount from present value. For more of Wulff's ideas, see www.mcdep.com.

Two other strong points: One, royalty trusts are an inflation hedge and handy insurance if an oil crisis brings down the rest of the economy. Two, they attract smart people. The billionaire Robert Bass has a sizable stake in San Juan, as does respected money manager Jean-Marie Eveillard, whose First Eagle SoGen funds are actually making money this year. My table gives a sense of the relative position of each trust. But be cautious about the numbers. Even though yields have averaged close to 10%, payouts vary depending on oil prices and well upgrades. San Juan distributed nothing in December and January, but 40 cents in March 2001. There are also tax advantages. Unit holders can deduct depletion, which defers much trust income. Nice — but not the reason to invest.