WARRANT BASICS
A stock warrant, to put it simply, allows the holder of the warrant to buy a particular number of shares of a particular stock at a particular price (the "exercise" price) for a particular period of time.
To illustrate, let's say you own one stock warrant. The "terms" of this warrant dictate that one warrant allows the owner to buy one share of XYZ stock for $10.00 until December of 2009. Now, let's say XYZ stock is currently trading at $20.00 and the warrant costs $5.00 (a ridiculous situation, as you'll see). That would mean that a $5.00 investment would entitle you to own a $20.00 stock for just $10.00! If the market allowed such absurdities, you could buy the warrant ($5.00), "exercise" your just-bought warrant for $10.00, and own a $20.00 stock...a considerable profit in nary an instant! Like paying fifteen dollars for a twenty dollar bill.
Given the above example, it's obvious that an efficient market should price this warrant at a level at least as great as the difference between the current stock price and the exercise price of the warrant. In this case, the warrant ought to be trading at $10.00 or above (20 - 10 = 10). Actually, the warrant really ought to be valued at something greater than $10.00, since the warrant allows you to buy the stock at the exercise price until 12/2009. If the warrant were trading at $11.00, we'd say that there's one dollar of "time premium" figured into the price of the warrant. You'd actually lose money if you bought the warrant at that price and exercised it immediately, but because you have good reason to believe that XYZ stock will appreciate considerably before 12/2009, you might be more than happy to pay that time premium and wait awhile for the stock price to rise.
Let's say XYZ stock is currently trading at $7.00 instead of $20.00. How much would you pay for the warrant? More concretely, how much would you pay for the rights to own XYZ stock for $10.00? If the expiration date were tomorrow, you'd be foolish to pay anything for the warrant. But the expiration is not tomorrow, and you know there's a chance that XYZ stock will trade at greater than $10.00 before the expiration date. Would you pay a dollar for the warrant? Fifty cents? A nickel?
It goes without saying that a great deal of thought has been put into the determination of the fair value of warrants. Without too much thought, you can see that the volatility of the underlying stock ought to have something to do with the price of the warrant. If you're technically oriented you might like to find a way to figure historical price trends into your valuation model. On the other hand, a fundamentally oriented investor would like to incorporate earnings growth into the model. The whole purpose of our service, of course, is to seek out warrants that are unusually cheap using methods that we believe to be quite powerful.
Before continuing, let's get a couple of definitions straight. An "in-the-money" warrant refers to a situation where the stock trades at a level greater than the exercise price. Here, if the warrant were to expire tomorrow, you could exercise it today and at least get a little money back. An "out-of-the-money" warrant refers to a situation where the stock trades below the exercise price. People sometimes speak of "at-the-money" or "near-the-money" warrants; you can guess what these mean.
Stock warrants trade just like stocks. Intel, for example, had stock warrants that traded under the symbol intcw. You could call up your broker and tell him or her that you want to buy 100 shares of intcw and you could own the warrants a minute later. So you don't necessarily have to exercise the warrants to realize a profit...you can sell the warrant, just like a stock, until the warrant expires. Warrants can change hands many times before getting exercised. We've seen situations where an underlying stock loses 25% of its value while its warrant actually doubles in value...warrants are ultimately tied to the laws (and nuances) of supply and demand, and sometimes pay little heed to even the most fastidious of fair value calculations.
Most warrants are "redeemable" or "callable" by the issuing company at a particular price. This means that the issuing company may choose to force you to exercise your warrants (or sell them, leaving the exercise to someone else) once the stock has reached or exceeded its redemption value. If XYZ warrants are redeemable at a stock price of $25 dollars, then XYZ company can "call in" the warrants when the stock trades at that level. You, as a warrant holder, would receive a notice in the mail that would tell you that you have, say, 30 days to exercise the warrant. If you don't exercise or sell the warrant in those 30 days, you'd receive the "redemption value" of the warrants... usually about five cents per warrant! You don't want to find a five dollar check in the mailbox when you could have had a profit! Don't let that happen.
One common reason a company issues warrants is to raise capital. Essentially, when you exercise a warrant, you create new stock. The issuing company receives capital from this new stock just as it would if it had completed an initial or secondary public offering. So the redemption price sets the level at which the company can forcibly gather in that money. There's usually nothing particularly traumatic about receiving a redemption notice...if the warrant gets redeemed, you're probably already in a position to profit from your investment.
The issuing company doesn't necessarily have to redeem its warrants at the redemption price. Many companies still have outstanding warrants when the stock price is well above the redemption price. Generally speaking, the specific terms of the warrant usually dictate that the stock must trade at no less than, say, $25.00, for 20 days before a notice of redemption can be issued. In those 20 or more days, the stock may have risen considerably above $25, to the warrant holder's benefit.
Generally speaking, the issuing company wants its warrants to be exercised. If the stock never reaches the exercise price, the company cannot realize any capital from the warrants. To this end, a company can, and often does, take special steps to help the warrants to get exercised. The company can extend the expiration date of the warrants indefinitely, or lower the exercise price. When a company announces that it has changed the warrant terms in such a fashion, the warrant price may suddenly appreciate considerably. You can sometimes make an educated guess as to whether a company might take these steps by reading "between the lines" of a company's annual report or 10K. Sometimes a company's investor relations person will slip a bit, and offer a hint as to the likelihood of a change in warrant terms.
If the company has no special interest in seeing its warrants exercised, the company, of course, is not likely to change its warrant terms to the benefit of the holders. For example, warrants are sometimes issued along with stock with the sole intent of making a public offering appear more appealing; in such a case, the company may not care to see the warrants get exercised. If the warrants were issued as a result of litigation (as is sometimes the case), the company may have no vested interest in warrant exercise. Also, the capital structure of a company may have changed since the issuance of the warrants to the extent that the negative effects of stock dilution (upon warrant exercise) outweigh the benefits of new capital, in which case the company may lose interest in appeasing the warrant holders.
Another important warrant parameter is the "conversion ratio". Usually, one warrant will convert into one share of stock upon exercise but this is not set in stone. Sometimes it takes 4 or even 10 warrants to convert into one share of stock. Sometimes one warrant will convert into 4 shares of stock. The conversion ratio is usually specified in the company's 10K report, and is obviously very important in any determination of fair value. If 4 warrants convert into one share of stock, we say that the conversion ratio is .25. Somebody else may say that the conversion ratio is 4.0; it's simply a matter of contrasting definitions.
Warrant terms can be quite creative. Some warrants have exercise prices that are tied to the company's earnings by a mathematical formula. Some warrants have exercise prices that rise by a certain amount after a certain period of time ("stepped warrants"). Some warrants even have an exercise price that falls after a certain date. Sometimes a warrant entitles the holder to own not only the underlying stock, but another warrant (with different terms)
It should go without saying that warrant investing is not a very conservative approach to personal finance. If you'll have a nervous breakdown or worse if your investment becomes worthless, warrant investing is not for you.
Being a "leveraged" sort of investment, warrants, as a whole, tend to be considerably more sensitive to the ups-and-downs of the broad market than ordinary stocks. Generally speaking, the risk associated with a warrant is correlated with how deeply in or out of the money the stock is trading. If the stock is well into-the-money, the risk is minimized (as is the potential reward). In fact, if the stock is deep enough in-the-money, the risk associated with the warrant will equal that of just owning the stock itself. If the stock is deeply out-of-the-money, the risk is maximized. If the underlying stock never reaches the exercise price before expiration, the warrant will expire worthless...a 100% loss.
Particularly with out-of-the-money warrants, the bid-ask difference becomes an important consideration. You might check the newspaper and see that a particular warrant costs fifty cents per share (the bid price), yet you may need to pay seventy-five cents per share to acquire the warrant (the ask price). Let's say you bought that warrant for seventy-five cents; if you decide to sell the warrant the next morning, you might only receive fifty cents per share. You're saddled with a very real 33% loss, instantly. Are you willing to take that loss in the hope for long term gains? Bid-ask spreads are correlated with the liquidity of the warrant. Heavily traded warrants tend to have smaller spreads than thinly traded warrants. So if large bid-ask spreads bother you, seek out heavily traded warrants. Unfortunately, common sense dictates that heavily traded warrants would tend to be more efficiently priced. Furthermore, some academic studies indicate that stocks (and presumably, warrants) with large bid-ask spreads tend to outperform stocks with small bid-ask spreads in the long term.
Another danger associated with out-of-the-money warrants involves takeovers. If a company is taken over below the exercise price, the company is not necessarily obligated to return anything to the warrant holders. In fact, we've noticed that a warrant that seems especially cheap is frequently one whose company is about to be taken over, suggesting that prescient insiders are unloading their warrant positions. If this possibility scares you, there are a number of measures you can take to avoid being stuck in this position. One, avoid deeply out-of-the-money warrants. Two, avoid companies that are likely to be taken over. Companies with stock buy-back programs and heavy insider ownership of stock and warrants are generally poor takeover candidates. A five minute chat with a company's CFO or investor relations person can be very productive in assuaging (or enhancing) your takeover worries.
It is possible to buy a warrant for which a notice of redemption has already been issued. In this case, you'll never see the notice of redemption, and you may receive a panicked call from your broker on or near the date of redemption telling you that you can either exercise the warrant, sell the warrant (at a somewhat depressed price), or receive the redemption value of the warrant. Worse yet, your broker might not call at all. In any case, you'll probably lose money. Sometimes, a company will lower the exercise price in order to hasten the exercise of the warrants. So it is possible to buy a warrant for which a redemption notice has already been issued when, given the old terms, you'd have thought that immediate redemption was impossible. Always call the issuing company about their warrant terms before buying the warrant! Always!
