Saturday, October 31, 2015

Warrants (Cash Settled Call Structured Warrants) - A Confusing Affair

Warrants in KLSE can be a confusing affair. Perhaps it is done on purpose because it is at the interest of the issuer that buyers lost money in the trade.

What is a warrant? If one trades in US before, it is basically an option - a contract. There are some differences between a warrant and an option. Warrants can't be issued by retail investors unlike options. Option contracts are more standardized compared to warrants - probably the reason why retail investors could issue them.

Option is a form of derivatives and so as warrant. It would be advised for investors to exercise caution when trading warrants.

Few things that warrants traders should pay attention to are:
  • Strike Price
  • Maturity Date
  • Conversion Ratio 
And there are two types of warrants - Call and Put.

For Call warrant, if the underlying shares price is above its strike price, it is then In-The-Money (ITM). For Put warrant, it is ITM, the underlying shares price is below its strike price.

Warrant holders would received cash upon maturity if it is ITM. If it is OTM, their warrants will expire worthless. It is pretty much a bet between sellers (issuers) and buyers (holders).

Confused already?

Today, I'll focus on Cash Settled Call Structured Warrants which are usually issued by bankers.

Before that, lets look at a simpler warrant, AAX-WA (RM 0.055). This is a free warrant given by AirAsia-X to their shareholders and convertible into AirAsia-X shares. Its strike price is RM0.46 and mature on 8/6/2020 and a conversion ratio of 1:1. Current AAX share price as of 30/10/2015 is RM0.205 so it is OTM.

There is value for OTM warrants but I won't go into that (Yea, it is the Black-Scholes thingy).
But lets look at deep ITM warrants (Underlying price > Strike Price) as it is much simpler to value.

Scenario 1 (AAX: RM 0.66)

In this case, AAX-WA would worth around RM 0.20.

Scenario 2 (AAX: RM 0.86)

If AAX price increases to RM0.86 from RM0.66, AAX-WA would worth around RM 0.40. This would mean, a 30% increase in the mother share (AAX) would increase its (AAX-WA) by a whopping 100!!.

Cool ha? also work the other way round. A return to RM0.66 would half your investment. Maybe that is why warrants are attractive to those who believe in the myth of high risk high return.

If upon maturity AAX price is RM1.00, warrant holders would have the rights to purchase AAX shares at RM0.46.
Now, back to Cash Settled Call Structured Warrants - nama pun panjang.

Oh yea, Confused already?
The reason why I asked that is because for most structured warrants I saw, they come with a conversion ratio which adds to the confusion. Lets look at the most actively traded warrants on 30/10/2015. And I'll focus on ITM call warrants.

Out of the four ITM call warrants, FGV-C7 and UEMS-C17 are the ones that are deep ITM. Current FGV price is RM 1.780 while UEMS is RM 1.250. For warrants that is deep ITM, it should be worth very close to the cash received upon maturity.

From the table the fair price for FGV-C7 and UEMS-C17 should be around RM0.230 and RM0.200 respectively. This would show as if both of this warrants are underpriced. Here's where the confusion comes in.

The ratio. If FGV-C7 expires today, instead of receiving RM0.230, warrant holders would have to divide it by the conversion ratio which equals to RM0.059. That's a whopping 3.9 times less!

Less reverse this to compute the breakeven price if a buyer purchased it at RM0.175 today and were to hold it to maturity.

Breakeven Price  = Purchased Price x Conversion Ratio + Strike Price

The breakeven price for FGV-C7 holders (@RM0.175) would be RM2.233. That would also mean, FGV (the mother share) price would have to make at least a 25% increase. I am quite sure during that rally FGV-C7 would rally as well. That would make it a greater fools game, a game of musical chair and a zero sum game.

I won't bother to write about OTM warrants or those which are close to the strike price because the Greek characters would come into play. That's a lot more complicated and Black-Scholes has proven to be unuseful - would be a less harsher word.

Confused already?

Disclosure: I have no positions in the above warrants mentioned and have no intention to purchase them within the next 72 hours.

Saturday, October 24, 2015 Berhad - Priced Like A Rubbish

Ok, before I start, I would like to admit that I am still "shiok" by kcchongnz's comment on his blog on i3. Yes, I have stop writing due to family and work commitments. I will try to write more frequently as I do miss writing to be honest. As for KC, I hope he'll continue blogging as he really wrote many good articles.

Alright, lets get started. Berhad (ICAP), despite its dotcom sounding name (in fact it is .biz) is not a tech company nor it is a company but it kinda run like one. ICAP is a close ended fund which is listed on KLSE. In other words it is an Exchange Traded Fund (ETF), BUT ... one that is actively managed. ETFs have always been associated with passively managed index funds. Maybe that's the reason why ICAP is being called a closed ended fund instead. For more information about ICAP I suggest you read the earlier posting from a friend of mine:

[Aboi] All About iCap Part 1
[Aboi] All About iCap Part 2

My posting today is about an interesting opportunity provided by the market - in current highly expensive market especially.

"Price is what you pay, value is what you get" - Warren Buffett

In ICAP case, price is what you pay, NAV is what you get. At the first glance, you would see a 20% discount to NAV or a Price to Book (P/B) ratio of 0.8

Price on 23/10/2015 : RM2.28
NAV on 22/10/2015 : RM2.84

What this means is that, if ICAP were to tutup kedai (close shop) today, its shareowners (as the managements like to call), would make 25% immediately.
(Correction: It should be 25% not 20% as previously stated)

Lets take a closer look. Latest quarterly filing shows that ICAP holds RM257.4 millions in cash or RM1.84 of cash per share. Here's the interesting part, if you take the cash portion out as illustrated below:

Price: RM2.28 - RM1.84 = RM0.44
NAV: RM2.84 - RM 1.84 = RM1.00

Do remember ICAP is a fund. What that means is that anyone who buys ICAP at RM2.28 is essentially paying 44sen for RM1 worth of assets. Why? Because that RM1.84 of cash you'll get it back anyway if ICAP were to tutup kedai - Now. That's a hefty 56% discount for all ICAP's holdings. It is like if you buy Padini straight from the market, you'll pay RM1.47. But if you buy from through ICAP, you only have to pay RM0.65 for a share. Sure it has management fees and many other fees, but it definitely doesn't warrant such a steep discount.

The table above is the P/E and P/B ratio I got from Bloomberg. I won't go too deep into each of those. I'm not a fan of P/E ratio but it is good to provide a quick glance on companies valuation. Apart from Wellcall and F&N, ICAP is not holding an expensive group of stocks. For Boustead, P/E might look expensive but P/B seems cheap. MSC losses might be a little concern. Teng Boo applies the principal of value investing for this fund, so yea....he won't hold expensive stocks. Anyway, when investing in a fund, you'll have to trust the fund manager.

Let's take a look how the ratio would look like if the 56% discount is applied to those holdings.

Now, that is CHEAP.  The weighted average P/B ratio for all that is 0.7. That means, on top that 56% discount, you'll get another 30% discount on the weighted average book value. P/B ratio is usually used for non going concern companies in other words, for companies that are going to "lingkup". And I don't think any of these holdings are going to go bust anytime soon.

Please to bear in mind, those discounts are by no means your potential upside. It is a margin of safety. The upside if ICAP were to close the discount the upside is 25% plus any price appreciation from the holdings. All these depends largely Teng Boo and co's skill which I definitely trust.

On the management side, I would only comment briefly. The fund is holding about 65% cash. One might ask, if the fund is holding cash why not return to the shareowners or even liquidate the fund? And management fee is paid why ICAP is holding cash.

My short answer is, I would feel a lot more comfortable if a fund is holding more cash at current market valuation. In fact, many local mutual funds are holding circa 20% in cash. And holding cash is part of asset allocation. Anyway, that's just me.

Disclosure: I have positions in the stock mentioned.