Invest in GM Without All the Risk — and Get a Nice Dividend

In late March, I wrote an article in which I explained why General Motors (NYSE: GM) can rally more than 50% from current levels. I still think that to be the case, but since then, turmoil in the Middle East and specifically a NATO-led military campaign in Libya that started on March 27, have sent oil prices up to their highest levels in the past two and a half years.

Higher oil prices could slow the economy and auto sales in particular in the near term. I’m still bullish on GM in the long run, but I think downside protection has become even more important in the current climate.

To quickly reiterate why I am bullish on GM, its bankruptcy filing in the middle of 2009 allowed the company to clean house and come out with lower debt levels, close underperforming plants, rework agreements with the United Auto Workers union and become much more competitive as a result. GM is also getting high marks for the quality of its trucks and cars, and is benefitting from the missteps of rivals such as Toyota (NYSE: TM), which has had to issue numerous recalls of its namesake Toyota and its higher-end Lexus brand cars.

Given this enhanced competitive position and recovery in the business cycle, I believe the stock is a bargain at less than eight times forward earnings. A price-to-earnings ratio (P/E) of 12 and estimated earnings growth of 10% or more in the next couple of years means the stock can rally 50% or more from current levels.
Given the near-term economic uncertainty around the globe, there is a way to participate in most of the upside potential in the stock but also protect on the downside. This is through GM’s 4.75% Series B Mandatory Convertible Junior Preferred Stock (NYSE: GM-PB). Convertible shares (or convertibles) combine some of the best features of bonds and stocks. The bond component offers income potential through a coupon payment as well as downside protection, as the securities trade more like a bond in a declining market and principal is returned if there is a standard maturity date.

Here are some of the more important specifics on the security…

The convertible preferred stock was offered at $50 per share and can currently be had for a couple of dollars below $50. The shares automatically convert to GM common stock on Dec. 1, 2013, but can be converted at the discretion of the investor any time before that. There is a corresponding conversion schedule that shows the security’s downside protection while allowing investors to participate in most of the upside of the common stock.

If the common stock is above $39.60 on the maturity date, then the preferred owners will receive 1.2626 common shares for every Series B preferred share. If the common stock is equal to or less than $39.60 but equal to or greater than $33, then the conversion range will be between 1.2626 and 1.5152, calculated as $50 divided by the common stock price on this date. Finally, if the common stock is below $33, then the conversion ratio is 1.5152. 
Below is a better detail of hypothetical conversion values that GM provided in its prospectus. The hypothetical example is for the point the preferred shares mature on Dec. 1, 2013.

Also important, the convertible preferred shares offer a coupon yield of 4.75%, which is paid quarterly and can either be in cash or common stock. It is my understanding GM currently intends to make the payment in cash. This is a significant benefit of the security, as common shares of GM do not currently pay a dividend.

As it is supposed to work with a convertible security, if GM does well and its common stock rises, then holders of the preferred shares won’t do as well as the common stock holders by the time of the mandatory conversion, but they will still participate in most of the upside.

For instance, if the common stock price hits $50 by Dec. 1, 2013, then the common stock will see gains of 61.2% ($50 stock price divided by current share price of $31) while the preferred holders will see gains of 31% (conversion value of $63.13 divided by the current preferred share price of $48.20) on the conversion and will receive dividend gains of about 12.5% (dividends for 2.5 years), for a total return of 43.5%. If the stock rises 20% to $37, then the preferred holders will get the dividend gain of 12.5%.

The protection for the preferred holders is on the downside. If the stock falls about 20% to $25, then the preferred holders will only see a loss of about 8.9% (conversion value of $37.88 divided by the current preferred share price of $48.20, plus dividends of 12.5%. And if the stock falls off a cliff and hits $15 by Dec. 1, 2014, then common stock holders will see losses of nearly 52%, but the preferred holders will see a less severe decline of about 42% (conversion value of $22.73 divided by the current preferred share price of $48.20, plus dividends of 12.5%.  

Action to Take -> Investing in the Series B convertible preferred shares offers downside protection as well as the ability to participate in most of the upside potential in GM’s share price. This is due primarily to the annual dividend yield of 4.75%, which also means that investors will be able to earn quarterly dividend income as they wait to see what lies in store for the common stock performance up until Dec. 1, 2013.

[My colleague Carla Pasternak is constantly finding similar innovative ways to generate safe, reliable income — not just from high-yielding common stock, but also from convertible and preferred securities. For more information, check out this special presentation, brought to you by High-Yield Investing.]