I don’t profess to have a deep understanding of the large American banks, whether we are talking about Citigroup, Wells Fargo or Bank of America. In the case of Citigroup and Bank of America, they are all trading under book value. Wells Fargo undoubtedly has a premium because of the Warren Buffett influence and probably because its balance sheet is cleaner. There are multiple analysts in high-paid jobs that spend their careers understanding these entities and I have no chance on obtaining a competitive edge on them.
I do not have any positions in these stocks nor will I – they are too large for me and too difficult to understand.
That said, I will examine Bank of America (NYSE: BAC) and specifically their “A” warrants, which trade as BAC-WTA.
BAC has been a prominent entity among various value investors (i.e. I’ve read many recommendations to buy them) and year-to-date their stock has tanked about 25%. I do not know why other than there is a general concern about the large-scale US banking system and the stress that is going on in the financial system (i.e. China’s pending devaluation, macroeconomic games being played, and the impact of a negative rate environment to name a few).
The warrants have an interesting feature – while initially issued with an exercise price of $13.30/share, the exercise price gets adjusted downwards if BAC declares dividends in excess of a certain amount. You can read the details on BAC’s site here. The warrants expire January 16, 2019, or about 2.94 years from today. The current strike price is $13.106/share.
BAC shares closed at $12.95 last Friday, while their warrants closed at $3.75. There is a ton of liquidity on the warrants so there is no premium associated with liquidity concerns.
Without knowing anything about the company at all, we will ask ourselves: Would we rather want to buy the warrants or the common shares?
The calculations are much easier without having to factor in the 20 cents/share annual dividend of BAC, so I will leave the extra (required) analysis as an exercise for the reader. However, any dividends would still work mildly against the warrant holders despite the strike price revisions – the strike revision is not a 1:1 relationship and the warrant holders do not get the benefit of receiving any cash on hand between today and expiry.
If you buy a notional $100 of common shares or warrants, the results after 2.94 years given certain price changes in the common shares is as follows:
BAC Common vs. Warrants Decision
A quick and dirty results table, not including the impact of dividends, of a notional $100 investment in BAC Common or BAC A Warrants at the end of February 6, 2016.| Change | Common | Common Result | Options | Option Result | Diff | |
|---|---|---|---|---|---|---|
| -50% | $6.48 | $50.00 | $- | $- | $(50.00) | |
| -45% | $7.12 | $55.00 | $- | $- | $(55.00) | |
| -40% | $7.77 | $60.00 | $- | $- | $(60.00) | |
| -35% | $8.42 | $65.00 | $- | $- | $(65.00) | |
| -30% | $9.07 | $70.00 | $- | $- | $(70.00) | |
| -25% | $9.71 | $75.00 | $- | $- | $(75.00) | |
| -20% | $10.36 | $80.00 | $- | $- | $(80.00) | |
| -15% | $11.01 | $85.00 | $- | $- | $(85.00) | |
| -10% | $11.66 | $90.00 | $- | $- | $(90.00) | |
| -5% | $12.30 | $95.00 | $- | $- | $(95.00) | |
| 0% | $12.95 | $100.00 | $- | $- | $(100.00) | |
| 5% | $13.60 | $105.00 | $0.49 | $13.08 | $(91.92) | |
| 10% | $14.25 | $110.00 | $1.14 | $30.35 | $(79.65) | |
| 15% | $14.89 | $115.00 | $1.79 | $47.61 | $(67.39) | |
| 20% | $15.54 | $120.00 | $2.43 | $64.88 | $(55.12) | |
| 25% | $16.19 | $125.00 | $3.08 | $82.15 | $(42.85) | |
| 30% | $16.84 | $130.00 | $3.73 | $99.41 | $(30.59) | |
| 35% | $17.48 | $135.00 | $4.38 | $116.68 | $(18.32) | |
| 40% | $18.13 | $140.00 | $5.02 | $133.95 | $(6.05) | |
| 45% | $18.78 | $145.00 | $5.67 | $151.21 | $6.21 | |
| 50% | $19.43 | $150.00 | $6.32 | $168.48 | $18.48 |
Basic options 101 states that if BAC does not rise above the strike price, your warrants would expire worthless. However, we are concerned about the “break-even” point of calculation. Most amateur option traders fail to take into consideration the impact of an equivalent investment in common shares. If they were quickly asked what the break-even point of a call option trading at $1 with a strike price of $10 is, they will quickly say the common shares would have to be at $11, but in actuality the answer would be something higher than that because you could have invested in the common and received a higher gain.
So in BAC’s case, you can see that the indifference point is between 40 to 45% on the table. I will save the calculation and state it is 42.5%.
42.5% over 2.94 years implies a CAGR of 12.8% for break-even. This is a reasonably high hurdle for any stock.
What do we measure 12.8% against?
Analyst consensus is earnings of $1.69/share and contrasted to the $12.95/share price, this is a ratio of 13.1%. Return on equity is reported as 6.36%, but even if you take out some assumed junk on their book and normalize their equity to market capitalization, you still have a ratio of 10.8% there.
The quick conclusion is that I’d purchase the common shares rather than the warrants – the risk/reward on the common seems to be much better. If you’re interested in leverage, just buy the shares on margin.