Last Friday we exited our best performing investment.
|Apr 19, 2012||May 3, 2013|
|Price: $1/warrant||Price: $3/warrant|
|Net Gain: 199.11% net of commissions|
The warrants have tripled one time before as Andrew Tobias points out. With this triple, the warrants have returned 9 times the original investment in the last 3.5 years. We got in a little later than Andrew (He is the author of The Only Investment Guide You Will Ever Need, one of the first investment books I read, oh, about 20 years ago), but it has been a great investment.
ROICW is a warrant with a strike price of $12/share on the underlying stock (ROIC). The warrants expire in Oct 2014.
Warrant Premium is no Longer There
When we made the purchase, the underlying stock was trading at $12/share and the warrants were trading at around $1/warrant. With zero intrinsic value, the price of the warrants was purely the premium due to the time left to expiry.
Last Friday when we sold the investment, the underlying stock was priced at $15/share and the warrants were priced at $3/warrant. There is zero premium in the warrants today, despite the fact that there is still close to 1.5 years left for expiry.
What is even more interesting is that about 58% of the outstanding warrants have been exercised this year. If you have used warrants in the past, you know that warrants are SELDOM exercised as long as they are trading at a premium, however slight. Investors are always better off just selling the warrants in the market. So why are the investors making this sub-optimal decision to exercise the warrants?
The Company is Actively Working to Retire the Warrants
The company has bought back some of the warrants in the open market and I believe they have worked behind the scenes to get large blocks of warrants exercised. This is beneficial to the company as it flows $12 for every warrant exercised to the company. The exercises are dilutive to the common holders when they are done, but with the cash received, the company can take on new projects, retire debt, and/or increase the dividend paid to the shareholders.
They have been doing all 3.
The risk for the warrant holders going forward is an increase in the dividend on the common stock as it keeps a lid on the common stock price and the warrant holders do not benefit from the dividend.
Callback Feature – Too Much Appreciation Too Fast is Bad
Any time the common stock exceeds $18.75/share and stays above that for 30 days (on average), the company is allowed to callback all the outstanding warrants for a consideration of $0.01/warrant. Normally companies choose not to do this, but since it can be done, it is a risk.
Ideally the common stock does not exceed this price until the warrants expire to give the warrant holders the most benefit, however, now that the stock has run up, the media has started its hype machine and too much gain in the common stock too quickly can potentially leave the warrant holders with zilch.
This and the dividend risk (and not to forget another 42% of the warrants waiting to be exercised – which will dilute and pressure the stock) in my estimation will cap the appreciation in the warrants going forward. It also explains why the time premium has disappeared already (normally the time premium decays until the expiry, but in this case there is still 1.5 yrs left on the life of the warrants and the time premium is already gone).
Valuation of the Common Stock
When we purchased the warrants, I believed the common stock to be undervalued. If I am confident in the stock, and there is an instrument like a warrant that just levers up the returns (during this period, common stock has returned 25% while the warrants have returned 200%), it makes sense to choose to buy the warrants.
Today I am not so confident that at these prices the common stock presents a compelling value.
It has been a great investment and it is very likely that I am leaving money on the table by exiting. However, looking at the risks and the reduced conviction, it makes sense to exit. Discipline has served me well over the years and it is important to stick to it.
What do you think? Would you have stayed with the investment or would you have gotten out? Let me know in the comments.