1. Spicing Up Your Portfolio
Call Warrants are always met with a frown. No respectable investors should dabble in such short life instruments. They are only for speculators.
Or are things really as simple as that ?
On 1 September 2016, I made a Buy call for Affin at RM2.15 in anticipation of better financial performance ahead. True enough, Affin came up with reasonably good results in subsequent quarters. As at todate, share price has gone up to RM2.86. Within a period of 6 months, it delivered return of RM0.71 or 33%. Not bad, but nothing to boast about also. Many other stocks had gone up during that period by the same amount, if not more.
But that is not the end of the story. Around end September 2016, CIMB issued 50 mil Affin CV. It expires on 31 July 2017. Excercise price is RM2.15. Conversion ratio is 1 for 1. For every one Affin share I hold, I bought one Affin CV to companion it. My average cost was RM0.17, if I remember correctly.
Today, Affin CV has gone up to around RM0.70. A gain of RM0.53.
As a result, my Affin gain was no longer RM0.71 per share. It has become RM1.24. Based on original cost of RM2.32 (being RM2.15 + RM0.17). The gain is a sexy 53%, within a period of 6 months.
Due to lack of statistics, I am not really in a position to claim that it beats the market (many penny stocks had gone wild in these few weeks). But for an investment in a bank stock, it is no small feat.
Now you can see where I am heading.
2. Be Careful Of Premium
Money is good, but what are the risks ?
First of all, I like the fact that the Call Warrants still have nine months to go, and the premium was low at 8%.
When you buy Call Warrants, pay particular attention to its conversion premium. Unlike conventional warrants, the Issuer has the right to issue additional Call Warrants during the tenure if they have already finished selling the first batch. It is a standard term, you can find it in most term sheets.
The IBs don't incoporate terms like that in the document to look good. They actually do that in real life. I encountered such incidence once before, and suffered huge capital loss of more than 20% in a single day. It was an Index Linked Warrant and was trading at premium of more than 30%. Suddenly one day, the IB announced that it has finished introducing its stocks of warrants into the market (through market making) and was ready to issue new Call Warrants shortly. Everybody freaked out. The first thing that came to mind was that the IB will be dumping the new Warrants on them all the way until premium becomes zero (at that level, the Warrants will cease falling as its valuation will then be backed by the formula).
The next day, before the IB can lift a finger to do anything, everybody rushed for the exit and the Call Warrants's premium collapsed to almost zero.
If you are wondering why the authority allows the IB to do such horrible things, then you have misunderstood the situation. The answer is that "NO, it is not meant to allow the IB to exploit investors". When the IB issues the additional Warrants, they will not simply dump dump dump until premium collapses to zero. They will provide buying and selling around the market price of the Warrants at that time.
For example, if the Call Warrants are trading at 26 sen with premium of 30%, the IB will not disturb the premium. It will queue to buy and sell at 25.5 sen and 26.5 sen respectively (this is the so called market making, a process that provides liquidity). That will allow them to introduce the new warrants to the market without causing price disruption.
But confused investors don't care. In a state of panic, everybody just jump. And they all go down together.
That is the risk of holding Call Warrants with high premium.
3. Exposure and Mitigating Factor
By adding Call Warrants to our mother share investment, what additional risk we have introduced into our portfolio ?
The answer is : Essentially, you have increase your cost of investment.
Let's take Affin as an example. Without the Call Warrants, my cost was RM2.15. With the Call Warrants, my cost became RM2.32. In the unlikely event that the Warrants expire with zero value, my effective cost in Affin would have gone up to RM2.32. It is Boh Song (not nice), but hardly a life threatening situation.
But the above scenario is only true if the Warrants become zero on expiry. In most cases, you won't lose all your money. Barring a dramatic collapse of mother share price (that is why you must choose a stock that has undemanding valuation for this strategy), the Warrants might slowly decline and stabilize at 7 sen (let's say) if mother price stagnates and expiry date draws nearer. You should have sufficient time to exit without losing entire value. In that sense, I would say that the actual downside risk is 10 sen (not 17 sen), or 4.7%. This is really not such a big deal, if you compare with the potential upside.
4. Concluding Remarks
First of all, I would like to point out that this strategy is not meant for trading purpose. It will only work well if the mother share you bought is attractively priced and there are signs that earnings going forward will be good and cause share price to rise. Preferably the re rating can happen during the tenure of the Call Warrants. In several cases, I have actually suffered small losses by cutting loss the Warrants closed to expiry because mother shares encountered temporary set back and need further time to unlock its potential. Sometimes, I doubled down by further buying into new Call Warrants issued by IB as the existing one expires, so as to artificially extend the life span of the Warrants (of course, unlikely to have perfect match of terms).
My experience so far is not so unpleasant. Provided I pick the stocks wisely and there is no market meltdown (as mentioned above, a meltdown is no big deal as it will cause my cost to go up from 2.15 to 2.32), my chance of success is 50%. And for the successful cases, the extra return they generate can offset whatever small losses that I incurred in the past (in some cases due to other stocks) in multiple orders of magnitude.
In my opinion, this strategy is interesting not only because it makes your portfolio more sexy. It also opens up a new universe for retail investors like us in terms of exposure to blue chips. Some of us might never buy Maybank in our lifetime even if it trades at attractive valuation of RM7.00. But if you add some Maybank Call Warrants to your mother share exposure, then Maybank suddenly looked red hot sexy (not a bad idea if you have spare cash and Maybank is trading at RM7.00 in early December. Window dressing is near !!!)
If you are not a risk taker (and yet a little bit greedy), you can reduce the ratio. Instead of 1 Call Warrant per mother share, you can probably have 0.5, or even 0.1. Choose a combo that you are comfortable with.
Last but not least, I would like to point out that Call Warrants are not the top choice. If the stocks that you buy have normal Warrants with expiry of more than one year, always choose them over Call Warrants. Of course, provided the terms are more or less the same.
