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Understanding Warrants: Opportunities and Risks

On last November 2014, I decided to buy shares in the construction sector, in this case Nusa Raya Cipta (NRCA) at an average price of Rp910 per share, because I see that the sector would probably benefited from the plan of long-term infrastructure development by President Jokowi, who was inaugurated just a month earlier. Then why NRCA? Well, that's because, after taking into consideration about 1. The fundamental/financial performance of the company, both historically and its latest, as well as 2. The valuation of the shares (in value investing of our style, we only look at these two things, and only after that we look at the ‘prospects’), then NRCA is indeed the most sensible option compared to seven other construction stocks that available in the market. More details related to NRCA, read again its analysis here.

Unexpectedly, NRCA did not take a long time to rise. Within the next two or three months it rose to briefly reached 1,600, or well above the target price of 1,200 that (although one thing: it was not just NRCA that rose, but all the shares of construction including Adhi Karya et al also rise significantly). However, after considering that the increase is too fast and did not fully supported by fundamentals but rather because of the euphoria and any other positive sentiments (the popularity and expectations for President Jokowi was then at its peak), I decided to sell it first.

Even though NRCA generated decent profits, but a friend send an e-mail: 'Dear Sir, did you not take the warrant of NRCA? I saw that the increase is much higher than the increase of NRCA itself. Other than that, could you please explain, what is warrant?' After I take a look, when NRCA increases substantially, its warrant (the ticker: NRCA-W) was increased even more, in this case from Rp200 per warrant to briefly topped 500, or in other words it had gained 150% (although later it dropped back to 185 as its current position). While NRCA, at the same time, the increase is 'only' about 70% (from Rp900’s per share to 1,600’s). This then begs a question: If we find a stock that is good enough to be purchased, while it has warrants (not all stock has warrants), then why not take the warrants instead? Because, who knows, the profits could be greater!

From the e-mail, I just remember that we have never discussed about warrants on this website, and about this question: Is it true that a warrant of a stock offering a greater profit potential than the stock itself? Okay, let’s get it on.

Warrants are sort of coupons, where the owner of 1 warrant could use it to purchase 1 new share to be issued later (the new shares will only be issued if the warrants are actually used), at predetermined prices or exercise price, not at market prices. It is just like if the Government held the market operations of rice by selling rice directly to the public, which the Government would distribute coupons to certain persons who have been selected before, and these people will be able to use the coupon to buy rice from Government at pre-determined prices, which usually lower than the price of rice in the market. This market operations are usually has purpose to lowering the price of rice in the market, if the market price has risen too high.

Warrants are usually issued by a company at the same time when the company issued new shares (by IPO or right issue), where the warrants will be granted for free to investors who purchase the new shares issued. The goal, of course, to make the investors to be more interested to participate in the IPO/right issue. In the NRCA example, when the company held its IPO in June 2013 at an initial price of Rp850 per share, the investors who participated the IPO also receive 1 free warrant for every 3 shares of NRCA that they bought. Let say, an investor buys 300,000 shares of NRCA, so he obtained 100,000 warrants of NRCA (NRCA-W). When NRCA began to be traded on the Stock Exchange, NRCA-W is also traded. If the price of NRCA-W is up from Rp0 (because the investors obtained NRCA-W for free, its initial value is zero) to become Rp100, for example, and the investor sold its warrants at that price, then he will obtain a profit of 100,000 x Rp100, equal to Rp10 million (about US$ 900), and it is arguably a free money because he did not spend a dime to obtain his warrants.

Meanwhile, when another investor buys NRCA-W in the market at the price of Rp100 per warrant, for example, then he has two options. The first, sell it back before the warrants are expired, or second, actually use the warrants to purchase the shares of NRCA at the exercise price, once again, before the warrants are expired.

Because just like coupons in general, warrants also has a validity period. If the warrants had not yet used to purchase shares after the expiration date, it will be considered forfeited. If we take the example of NRCA-W, then its expiry date is June 27, 2016. If you buy NRCA-W and until the expiry date you have not used it to buy NRCA at its exercise price, ie Rp1,050, then your warrant will be forfeited by itself. If you buy the warrants as much as US$ 1,000, for example, then the money will be completely lost at all, or in other words your losses reach 100%, if you fail to sell it back or use it to buy NRCA (at the price of Rp1,050 per share) before the expiry date.

Well, from here you will be able to see what is the cause of the rise and fall of the price of a warrant, in this case NRCA-W: When the price of NRCA in the market continued to rise to more than Rp1,600 per share, then of course the investors who hold NRCA-W will make a substantial gain if using their warrant to buy NRCA on its exercise price of 1,050, then sell it back at the market price of 1,600 (the profits are Rp550 per share). Because of the potential profits, the investors will be busy buying NRCA-W in the market, and consequently the price will go up significantly. When NRCA-W rose from 200 to penetrate the 500’s some time ago, then it's because the investors who are buying NRCA-W at the price of 500 had thought that they could use the warrants to purchase NRCA at an exercise price of 1,050, and sell it at the market price of 1,600. Because the cost of warrants is 500, while the cost to buy new shares is 1,050, then the total cost is Rp1,550 per share. Since the market price of NRCA was 1,600, then the profit is Rp50 per share.

So it can be concluded that, when a stock goes up or down by, say, 500 points, then its warrants will likely to rise or fall by approximately 500 points as well. In the case NRCA, when its shares rose from 900 to 1,600, then its warrants also rose from 200 to 500 (or if calculated from its initial price of Rp0, the nominal increase of NRCA-W was Rp500 per warrant). Let say, if you buy NRCA at the price of 900 and sell it right at the price of 1,600, then your profits are more than 70%. But if you buy NRCA-W at 200 and sell it at 500, then your profits are 150%, or more than doubled!

So back to the question, rather than buy a share, then why not take its warrants instead?

However, also note the risk: If NRCA is not rising but dropped instead (we can never really tell if a stock would going up or down, can we?), say from 900 to 800 ie fell down Rp100 per share, then NRCA-W can also dropped by Rp100, from 200 to about Rp100 per warrant only. This means that your losses if you bought NRCA is only about 10%. But if you bought NRCA-W, then well, the losses could be 50%. Moreover, as we said above, if you did not sell your warrants or use it to buy NRCA-W at its exercise price until its expiry date (and it is very likely to occur. If the market price of NRCA is still below its exercise price at the expiry date of its warrants, then the holders of NRCA-W certainly has no reason to use their warrants to buy new shares), then the warrants will be forfeited, and your losses are 100%.

Therefore, or at least until today, I never purchase warrants. Because in investing, we are not only focus at the potential of profits, but also the risk of losses. And the potential gain of a few tens of percent of a stock is already quite good, especially if the risk is limited, compared to warrants which, although it may offer a profit of more than 100%, but on the other hand the risk is too large. During my investment career, I had (and quite often) suffered significant losses (more than 10%) from certain stocks, and the risk of losses has been anticipated in advance. But to take the risk of losses of up to 100%, I don’t think so.

Additionally, when you hold shares of a wonderful company, then you might be able to hold it as long as possible without the pressure of an ‘obligation’ to sell it quickly. While the warrants? Sooner or later you have to sell it because it is not a real financial assets such as stocks, but only a piece of coupon that will not have any value when the validity period is up.

Warrant is one of the many derivative instruments that are traded on stock exchange, other than the stock itself. Warrant is one form of options, ie derivative instruments that give its owners an option (option, not the obligation) to buy or sell shares or other financial assets at a predetermined price, before the expiry date. In addition to options, there are also futures and swaps. And just like warrants, these derivative instruments are usually also offer great profit potential, but on the other hand the risk is great too. After these warrant things, we will probably never discuss about these derivatives in the future, because frankly I’m not interested at all (I don’t like to live dangerously. This is stock market, not a jungle). So if you need any references, please ask Google or Wikipedia, it’s actually really easy.

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