On stock warrants, simply explained.

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Introduction

“On what you may often have wondered -but then never dared to ask”.

Today I wish again 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, as revised from an earlier version. Thai stock warrants trade on the SET as do stocks and while many 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. Speculators often chase warrants without having a clue on what they are or how they work.First of all a warrant is not/never a stock and it should never be called anything else then what it is. Marketing officers often here refer to warrants as shares or stocks. Example: “confirmed, you bought 5000 XXX-W shares at ….Baht”.  In the US if a broker names 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 and as so warrants have no voting rights and are never entitled to any dividends. In fact,  the single only right a warrant has is the option at some future point(s), to convert the warrants owned into a specified number of common shares. Warrants have an expiration date and a conversion ratio; both are mighty important to know before purchasing any.

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 into shares, then the underlying shares are the only investment.  If one owns warrants with the idea of just selling/trading them at 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 warrants with a smaller capital amount so to control the same amount of shares-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, yes worthless.

After this date, there is no more possibility to convert the warrants into common shares. Again, the only right/value at all the warrant owner has is the right (but never the obligation) to convert into common shares, this at a specified price and at specified dates. Again, 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 shares, and at which guaranteed purchase price. If the guaranteed conversion price is below the current market price of the underlying stock, the warrants are called “in the money”.  If the guaranteed conversion price is higher then the current market price they are called “out of the money”. In Thailand many issued warrants are in fact, “in or near in the money” with expiration dates ranging from 1-5 years.

Warrants do allow an investor to control a specified number of shares with less capital invested. Hence exposing your investments to warrants is more risky as it is a more leveraged investment, besides no dividend income along the way.

Stocks do fluctuate up and down –and often the warrant will be more volatile then the underlying stock.  Sometimes the warrants are mis-priced 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 but the process is burocratic. (Sign forms, copy of passport etc.., the broker must help with this.) 

Let’s take a specific example for the purpose of clarity: Rojana (8.35), one of the stocks I liked a few years ago had existing outstanding issued warrants. One warrant is convertible into one common share at guaranteed 3 Baht per share. Some time ago these warrant traded around 5.25 Baht, per warrant unit.  Rojana’s current market price then was around 8.40. Hence, these warrants were “in the money” by (8.45 -3 Baht) or 5.45 Baht. At first view the warrants back then looked undervalued. 

The expiration date is now near, or January 19, ’09, and as I recall one is allowed to convert every 3 months.  Currently (September 16 '07) these warrants are trading around 13.50 and the Rojana stock 16.80.  You can see how the warrants ended-up performing much better then the stock, as Rojana shares did exceptionally well. To my chagrin as I recently did not write much nor advocate again Rojana.

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 often the full or correct view.  For one, the warrant investor will not get any of the high expected annual dividends. As

I wrote back then "I think over the next 4 years it is likely that this company will pay out a couple of Baht in cash dividends along the way. (Or more, (?) but this are never guaranteed)". 

Further, 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? 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 remember this is the only difference between NVDR shares and the local Thai shares.

Here are the specifics of Rojana and its warrants:

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/will the warrants. 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. This then is another, perhaps minor, uncertainty which equals risk. 

Of course they usually dance together up and down around the same time with the market forces. 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 more volatility.

The theoretically market 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 here.

Books on warrants are notoriously expensive as the math on theoretical fair values is advanced and mostly written by 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.   Lately the warrants of  LVT did much better then the shares, rightly so as the LVT stock price surged some 25% since I posted my "buy now" view for members, a few months ago.

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 years ago new warrants were listed by SE-ED,  and broker Seamico claimed they had a certain value, but I was able to show differently.

A few other remarks worth reiterating: Warrants, if not converted, always eventually expire worthless at some point in the future.  Warrants cannot be purchased with margin loans. Warrants are often originally issued for free, to existing shareholders when a listed company has a new stock rights offering; these so as a sweetener/enhancer to the investors in the newly offered shares.  Or a company may just issue new warrants without new shares.

Also a way to increase shares outstanding and so equity, at a future date.  GEN currently has some warrants outstanding, but they are so far out of the money that these are very risky. (see my just recently posted member article on GEN).

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, and at what conversion price and expiry date.

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 conversion. 

If the warrant conversion price is far out of the money, like GEN's , they are not very concerning, that is earnings per share dillution wise, as its not likely to happen anytime soon. Finally, warrants can and have been abused in the past by senior management of listed companies.  Sometime free warrants get issued to employees as a benefit.  (ESOP).  This is ok if its not abused.

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.

Of course not all warrants issued to management are abusive, but the excess of these should raise questions.  I think this has not been an issue in recent times here on the SET/MAI.  Here then is my attempt to help you understand some of the basic abc’s around warrants, as updated today.

Best Regards,

Paul Renaud.

www.thaistocks.com