Much ado about warrants!

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One of the things I’ve been thinking about recently, is how does one invest or speculate in warrants intelligently?

Is it even possible for the purchase of warrants to be considered to be an investment?

The main reason for this, this year is the first time, I’ve bought some warrants to be held, instead of a quick punt, and the position is more than nominal. And also because they are all down a minimum of 40%. Hahaha. The warrants I purchased this year, their size, current price and loss is shown as below.

Layhong-WA: RM0.320. It is 1.85% of portfolio on a cost basis, and is now down 50%.

Gadang-WB: RM0.275. It is 0.82% of portfolio on a cost basis, and is now down 40%. The best performer! Haha

Insas-WB: RM RM0.210It is 1.95% of portfolio on a cost basis, and is now down 65%. The biggest position and the worst performer. Clearly my best decision!

Well, let’s reflect. Or at least, bear with me as I put my thoughts down in words and crystalize my thoughts.

 

What are warrants?

Warrants are essentially pieces of paper that grant you the option to buy shares at a certain price in a certain point in time.

And historically, they are very popular in under developed markets, where people do not have an understanding in terms of earning per share, or intrinsic value per shares.

Where instead, market participants consider stock splits good things, and warrants to be free gifts from management, as if remuneration.

Needless to say, I’m generally not a fan of companies that do a lot of warrants. I’m sure that if one were to do a study, companies that issued a lot of warrants in the Bursa are likely to be rubbish.

However due to their nature, they can sometimes be severely under-priced, or severely over-valued.

As there is a fixed timeframe. It is also acutely speculative.

In addition, if you actually buy an investment bank issued warrant, FROM an investment bank. You might be retarded. Buy it from stupid people who bought from IB and have to sell cheap. Not IB who make a profit the moment they sell.

 

Interesting aspects of warrants.

Warrants are in more ways than one very similar to options. They are intrinsically levered instruments, because a much smaller sum is needed in order to get an option to buy a large amount of shares.

As prices are mostly correlated to the share on a nominal basis (they do fall off in an extreme manner once the mother share goes below the conversion price), but off a lower base, this results in significantly higher movements on a percentage basis.

This extreme swings, results in investor psychology going absolutely insane. As they rise higher, with 200% gains being normal on a stock that has risen 30%, the majority  of market participants start to feel the fear of missing out, while those who already have it feel like a genius, both then keep buying and result in severely overpricing.

Likewise, in a downturn, they fall a lot more. And as it falls, people start to become acutely aware of the limited timeframe, which induces a certain panic, as you now can’t help but wonder if the price will ever go up, or if sentiment will ever change (making the error of extrapolating the now into the future). This coupled with the extremely fast drops, result in panic selling at any price, or shocked holding at any price (me probably lol!), and thus it spirals down.

What I’m trying to say here is. The conditions that allows one to invest or speculate in warrants intelligently tend to be very limited.

Statistically, logically and mathematically sound homeruns in warrants mostly comes from bear markets. Its mostly in these markets, that one will be able to buy these warrants using sound decision making profitably. The rest of the time, any profit is likely to be extremely speculative, and well, adventurous. Ie, more gambling and feeling, than cold logic.

 

The biggest mistake people make in buying warrants.

If you notice how most market participants here think of warrants, the most common way is looking at premiums. We often start by looking at how close is the premium, relative to the time, or if better yet, if it’s at negative premium.

But I think, this is a completely wrong way of looking at warrants. When premiums are low, this is precisely the moment when most warrants are most expensive.

For example, there are so many times, when GAMUDA-WE and GENTING-WA was negative premium, ie selling at a discount to the mother. Currently, GAMUDA-WE is down 70% and GENTING-WA is down 99%.

However, at RM4.8-RM5, or RM9.5. Both companies were already valued richly and priced to perfection. Even the conversion price, despite being lower than the current price, is arguably overvalued. Both companies were also at record earnings.

As my 500% trader friend says, it is at these times, when the easy money can be made. But you must realise, it is trash you’re holding. If you’re not decisive and clear about who you are and what you’re holding. Easy money turns into grenade faster than you can react.

When premiums are low, this is often because the warrant have already risen greatly (often multiple times) up to the share price. Unless the share price is still significantly undervalued compared to its intrinsic value. The warrant is in more ways than one, priced very close to perfection with huge downside.

And usually the shares are not undervalued, as they are currently having record breaking earnings year, mostly due to external macro factors, instead of the inherent improvement in quality and economic power of the business. These earnings are castles in the sky.

This is doubly dangerous, when the current valuation, is not that far off from its exercise price. When it goes from “in-the-money” to “out-of-the-money”, the drop will scare your pants off if you have significant amounts in it.

I believe this is how most retailers get burned. Gamuda-WE, Prlexus-WA, Genting-WA, Tguan-WA, Ekovest-WB etc

Warrants with high premiums on the other hand, if bought correctly, have a two factor undervaluation. The main reason why warrants have high premiums, is because they are out of the money.

And often, in bear markets, these warrants are out of the money, because the current valuation given to the shares are so low! This is the first undervaluation.

The second undervaluation comes when, people look at the large premiums, and therefore completely ignore it, despite the significant tenure left, and with the conversion price being an undervalued one!

 

Speculating/Investing and valuing warrants intelligently

How do we do the above then? Well, I think there are two ways to go about it. One is the investing way, the other is the speculative way.

The methods or process comes from very different kinds of financial instruments. The first being extremely long dated share options, the other being 3-6 month options.

The investing way

Most people do not know this but, back when Warren Buffet did not have as much capital (Still billions, but not 100 billion), one of the methods he used to buy shares, was to make extremely long dated options on stocks. This was because there were times, he wanted to make sure he had very comfortable levels of cash, while not wanting to miss out on some opportunities.

He would essentially sign a contract to buy a certain amount of shares, at a certain price, at say 2-5 years from now. His thinking was, if the price of the shares was below the price agreed, he would have been able to buy the shares are a discount to the price he was willing to pay, and therefore the option being burned was not a problem, since he was getting a discount anyway.

But, if the price of the shares was above the price he agreed to pay. This was fantastic, since now he would again be getting a discount!

The essence here is, “The conversion price plus the price of the warrant needs to be the price you would have been willing to pay regardless. And the price of the warrant, must be the price you would have been willing to pay for the value of time or lower”.

The speculative way

There is a fund called Cornwall Capital in the US. This fund was started in 2002 with USD110,000. Before 2007, it had turned that into USD30 million or so. In 2007, it bought a certain number of insurance on CDO’s which returned 80 times, and turned USD30 million into USD110 million.

One of the way they did it, was too look for highly asymmetric investments worldwide, regardless of markets.

For example. The stock of a Korean company is currently USD 50. There is a piece of news, coming out in 3-6 months that will either make it worth nothing, or USD 100. Odds are about 50/50

Call Options on the stock at USD60 (to buy at this price), was selling at USD 4 dollars a share.

The expected value of this trade is

Worst case: Loss of USD 4 – 50% odds. Value is: USD4 X 50% = -USD2

Best Case:  Gain of USD36 – 50% odds. Value is: USD4 X 50% = USD18

Expected value = USD16 or 400% gain over USD4 investment.

Or, for example, I thought that Donald trump was going to be elected, as most of the interactive news online seem to indicate that (Hillary’s post was filled with more angry face than “Likes”, and if they can’t even win online, there’s no way they are winning the rust belts etc. And the vast majority of votes is in coastal cities, but the US is similar to Malaysia, you can get the big votes, but if you don’t win in enough areas, you have nada).

However, the market seem to think that Hillary is definitely winning, and so I through a friend, I had him help me buy a little put options (sell at a certain price) for PESO (Mexican Currency) that is denominated in RMB.

Needless to say, I doubt I can ever beat that trade in my life.

The essence here is: “Find bets or investments where the market have a decidedly very different views from you, with highly asymmetric payoffs due to the levered nature of instruments. A certain fixed timeline or catalyst is preferred. If a catalyst or fixed timeline can’t be found, a long enough timeframe may be enough.”

 

Criteria’s and valuation warrants in KLSE markets.

So how do we make the above lessons work for us? The one’s i can think of is as such.

Let’s begin with the most basic requirements.

  1. The company from whom the warrant is issued, must retain a significant portion of its earnings. If all or most earnings are paid out instead of reinvested, the probability of the stock price increasing would be significantly lower.
  2. The longer the tenure, the better. More than one year is preferred. In bear markets, warrants with 4 year tenure, can be priced as if only a few months is left.

The other criteria’s are

  1. The conversion price plus the price of the warrant needs to be the price you would have been willing to pay regardless. And the price of the warrant, must be the price you would have been willing to pay for the value of time or lower.
  2. Find warrants of companies, whose prospects and future, the market have decidedly different views from you, and thus have severely mispriced them and thus have severely depressed valuations, with warrants being out of the money.

Needless to say, very few warrants meet these criteria. And I can even think of one or two in my current holding that is less than perfect.

 

Conclusion

Having said so much, I have to concede that this is a topic I’m likely to not be as experienced as many of the grizzled sifu’s here. And am therefore likely to be wrong in parts, or even completely

Kindly correct me if you think I’m wrong, or if you have a very different ways of looking at things.

In addition, tell me about warrants you find interesting after reading this article!

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