Time to take a close look at Warrants

This post is a reprint of an article found in Business Times on 18th April and I find that it is a good article for sharing and also a possible way to invest to get a better returns on your capital!

Time to take a close look at warrants by Ven Sreenivasan which appear in Hock Lock Siew section of the Business Times - 18th April 2013

In 2008, shortly after Lehman Brothers collapsed, a scared Wall Street banking giant, Goldman Sachs, turned to the legendary Warren Buffett to shore up its capital and restore market confidence. Mr Buffett, the ever savvy investor, invested US$5 billion in Goldman's preferred stock and negotiated, as a sweetener, another 43.5 million Goldman warrants with five years to expiry

He redeemed the preferred shares in 2011. But Mr Buffett still holds the 43.5 million Goldman warrants. Marked to market, these warrants are now in the money to the tune of some US$1.22 billion. On conversion, he will become one of Goldman's largest shareholders - without having to incur a huge outlay.

That same year, Mr Buffett also bought into the troubled Bank of America (BOA). As a sweetener, he was issued 700 million warrants with a 10-year lifespan and a strike price of US$7.14 each. BOA last traded at US$11.97, giving him an imputed profit of some US$3.38 billion.

Warrants are commonplace in developed markets. They give the holder the right, but not the obligation, to buy the underlying stock at a certain price and quantity, within a time.

So companies often include warrants as part of a new offering to entice investors into buying the new security.

But warrants are also bull market instruments. They give holders the leverage to realise greater percentage gains than their underlying shares in a rising market. As the cost of a warrant is relatively low, the initial outlay to gain exposure to a large amount of equity can be relatively small.

On the New York Stock Exchange, whenever there are rumours, rumblings of corporate action, the first sign of activity is always on the warrant.

Alas, this is not always the case in Singapore. Though trading volumes in warrants have picked up somewhat, investors here generally regarded these instruments as a poor cousin of the underlying stock. One need look no further for proof of this than to the many in-the-money long-dated warrants trading at attractive discounts.

This problem arises because market players here tend to take a short term, trading orientated view of warrants. Also, many buy warrants to quickly convert into stock.

They should not. Rather, one has to take a longer-term, balanced view of warrants. While warrants provide an avenue for companies to raise funds in the future, investors should also see them as an opportunity to ride on the upside of the underlying stock on the cheap. Also, large amounts of early conversions cause earnings dilution to the underlying shares.

There are 42 listed warrants on the Singapore bourse. But three are worth illustrating. The first is mDr, which is the most actively traded warrant here. At the current share price, this warrant is in the money. Many buy it on expectations that the underlying stock will be propelled upwards as this company pursues its potentially lucrative Myanmar telecommunications ventures.

However, daily market filings also show a substantial amount of conversions. This is because of a quick arbitrage opportunity provided by a slight discount to the "mother" share on conversion.

Let's move from the most heavily traded warrant to the one traded at the biggest discount. Sinar Mas Land's warrant trades at 25 cents with the exercise price of 10 cents and expires at end-2015. The underlying shares is trading at around 43 cents. It doesn't take a rocket scientist to figure out the almost 20 per cent discount to be had. Sinar Mas is a property conglomerate with assets in four countries: Indonesia, Singapore, Malaysia and China. Its 49 per cent stake in Jakarta-listed Bumi Serpong Damai (BSD) alone is worth $1.8 billion or 59 cents per share. And this does not include its assets in Singapore (128,000 sq ft in Orchard Towers), Malaysia (Palm Resort at Iskandar) and China (developments in Shenyang City)

Warrants are akin to putting down an option on a house, If the price of the house (or underlying security) goes up, you should be able to either exercise your option or sell it at a gain to the highest bidder.

As one wit wrote, the world of warrants is a relatively undiscovered constellation in the universe of securities. It's about time Singapore investors use their investment telescopes to take a close look at them in this emerging bull market.