On the abc's of Warrants.

"On what you may often have wondered -but never dared to ask".

Today I wish to address a bit on the topic of Stock Warrants. Not in an exhaustive way, just a few comments so to help you with a basic understanding around what they are and how they work. And why they exist at all.

Thai stock warrants trade on the SET as do stocks and while some are not very liquid at all, others trade relatively well.  Warrants are like a financial tool, and like any tool, they can be rightly used or misused.

First of all a warrant is not a stock, nor shares and it should never be called anything else then what it is. Marketing officers here often refer to warrants as shares or stocks. Example: "confirmed, you bought 5000 XXX-W shares at ….Baht".  In the US if a broker calls a warrant a stock (or shares) one violates a specific securities law. Let’s be clear from the start: a warrant is never a stock.  Warrants have no voting rights and are not entitled to any dividends. In fact the single and only right a warrant has is the option at some future point(s), to convert into a specified number of common shares. Before expiration date.

Warrants have an expiration date and a conversion ratio; both are important to know. Warrants should not be called "an investment" as if not acted on, they will expire worthless one day.  If you buy warrants with a clear intend to convert them into shares, then the underlying shares are the only investment.  If one owns warrants with the idea of just selling them at a higher price, this should be viewed as a speculative endeavor. One key benefit of warrants to a long term investor is that he/she can first buy these with a smaller capital amount -and then later, at various future pre-determined dates, convert them into common shares.

The mighty important expiration date is the future specified date on which these particular warrants will expire worthless. After this date, there is no more possibility to convert the warrants into common shares, hence they so become worthless. Again, the only right/value at all a warrant has is the right (but not obligation) to convert into common shares, at a specified price and at specified dates. If never converted, they end up expiring worthless. (See later for a real example).

The conversion ratio simply specifies the amount of shares one can convert the warrants into the underlying common shares, and at a guaranteed purchase price. If the guaranteed conversion price is below the current market price of the stock, the warrants are called "in the money".  If the guaranteed future conversion price is higher then the current market price, they are called "out of the money". In Thailand most issued warrants are in fact, "in the money" with expiration dates ranging from 1-5 years.

Warrants allow an investor to control a specified number of shares with less capital invested. Hence exposing your investment Baht’s to warrants is a bit more risky -as it's a more leveraged investment, besides no dividend income along the way.  Stocks do fluctuate up and down and most often the warrant will be more volatile then the underlying stock.  Sometimes the warrants are mis-prices and one can find a better investor formula or objective in owning the warrants first  -and only then later converting them. The fee to convert warrants into common shares is minimal if any, it must be done with the Thai broker and some paper work.

Take a specific recent example for the purpose of clarity:

Rojana (8.35), one of the various stocks I currently like has existing outstanding issued warrants. One warrant is convertible into one common share at guaranteed 3 Baht per share. Currently these warrant trade around 5.25 Baht, per warrant. Rojana’s current market price currently is 8.40. Hence, these warrants are "in the money" by (8.45 -3 Baht) or 5.45 Baht. The expiration date is January 19, ’08, and as I recall one is allowed to convert every 3 months.

At first view the warrants look undervalued. After all one can control more shares by investing the same capital amount in the warrants, by only paying around 5.25 instead of 8.45 Baht. As often in finance, as in criminology and many other fields, "at first view" is not the full view.  For one, the warrant investor will not get any of the high expected annual dividends. I think over the next 4 years it is likely that Rojana will pay out a couple of Baht in cash dividends along the way. (Or more, (?) but dividends are never guaranteed).  Also if the stock has a sudden surge the conversion date might not be up (as most warrants are convertible only at every 3 month anniversary), of course the warrant price would surely also then rise in price -but perhaps unevenly so? The market pricing on warrants is not always rational.  Also possibly one misses a dividend or, one certainly is not able to vote at the annual shareholder meeting.

Warrants as well as stocks can be held in a foreign name or as "NVDR"s . NVDR noted shares also forfeit the right to vote and this is the only difference between NVDR and the local shares.  (An NVDR held stock is often noted with an (R) after its symbol).

Here are the specifics of Rojana and its warrants, from the past:

Issued common shares 623.3m

Par value Bt1

Warrants 276.7m

Conversion ratio 1:1

Conversion price Bt3

Conversion dates Quarterly until Jan/09

Surely if the stock surges up or drops, so would the warrants follow.  However warrants can be notoriously more hysterical behaving compared to the underlying shares. At times the warrants may not move as quick as the stock, other times the warrants are well ahead of the stocks movements, percentage wise.  This then is another, perhaps minor, uncertainty which equals risk.  Call it the sentiment risk associated with warrants. Of course they usually dance together up and down around the same time.

The number of warrants outstanding in is most often far less then the outstanding shares, so most warrants are traded with far less liquidity -and hence with more volatility.

The theoretically value of a warrant can be calculated in finance incorporating the various assumptions. Like the sum of the future dividend expectations, prevailing and future interest rates and the historical volatility of the common stock etc..

I will not review these formulas here as its well beyond the overview intended in this article. Books on warrants are notoriously expensive as the math on theoretical fair values is advanced and mostly written by finance PhD. professors of developed countries which nevertheless have a limited audience. In Thailand listed warrants are straight forward and easier to grasp, as compared to such derivatives in more sophisticated financial markets.

I would not place too much merit on such theoretical values & books anyway, as its far more important to get the choice of the stock correct, then to try to find market distortions.  I do agree that on the SET, warrants can regularly fluctuate around what their true value should be, as compared to the common shares. Hence it can be a good investor tool.

A few other remarks worth reiterating: Warrants, if not converted, always expire worthless at some pre-determined point in the future. Warrants cannot be purchased on margin loans. Warrants are often originally issued when a listed company has a new stock rights offering; these so as a "sweetener/enhancer" to the investors in the newly offered shares.  Also a way to increase shares outstanding and so equity, at a future date. 

Warrants are dilutive to common share holders as when converted this will result in more shares outstanding. Hence it always pays to see if a stock you like has any warrants outstanding, and if yes how many relative to the total common shares outstanding.  If the warrant conversion ratio is not overly generous,  i.e. no too much "in the money", then warrants are not too concerning to common shareholders. As then, at least, the company will get a nice capital/equity infusion upon any conversions.

Finally, warrants can and have been abused by senior management of listed companies. Both here in Thailand, as in other financial markets around the world. This can happen when management issues too many (or for mostly itself), with a low conversion price -and this to senior management for the sole purpose, on often excessive, compensation. Some companies are notoriously well know for this abuse.

Of course not all warrants issued to management are abusive, but the excess of these should raise questions.

Here then is my attempt to help you understand some of the basic ABC's around warrants. I always welcome questions.

Best Regards,

"I here simply share for free my own independent views which must not be interpreted as specific investment advice".