Weekend Edition – The Dividend Diet: Understanding Warrants

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Three weeks ago I mentioned the idea of calling what we dividend investors do day in and day out–eating consistent portion of fundamentally sound companies with a propensity to grow their dividends, whose management is strong and who hold their shareholders in high esteem–the Dividend Diet. A week later I followed up with a piece about one type of derivative, L.E.A.P.S, that dividend investors can use to fulfill part of the speculative hankering they have to “cheat” on their diet. Recall that a little speculation is akin to the concept of dessert as I continue to stretch the analogy.

Today I want to talk about another lesser known financial instrument that can be an interesting way for investors to silence the rumble in their stomach for a little speculation.

It’s fitting that last week I shared with you a number of quotes from Ben Graham’s seminal “Intelligent Investor.” Mr. Graham was a huge proponent of separating the concept of investing and speculating. He argues that speculating is more akin to gambling than true investing, which is more akin to placing sound “bets” when you understand the odds are in your favour. I tend to believe that some out-and-out speculation using a very small percentage of a total portfolio’s assets and being intellectually honest with yourself in differentiating investing from speculating, serves a great purpose. The purpose it serves is that by being blindingly clear in your own mind when you are investing vs. when you are speculating, and setting aside a small amount of capital to knowingly speculate, means you’ll be able to stay the course in your core, dividend investing activities for a longer period of time.

The inverse of this is absolutely no speculation, and it could lead to a slippery slope where one starts to blur the lines between investing and speculating, which at the extreme could result in building a portfolio that skews heavily to speculative bets, but is done so under an intellectually dishonest guise of investing. I’m not a proponent of any more than 1% – 2% of one’s total investable assets being allocated to knowingly speculative bets.

What Is a Warrant?

A warrant is another derivative security–like L.E.A.P.S–most often issued by a company as part of a debt or financing offering that acts as an incentive for the financing to sell. Warrants specify a time frame and a price at which the holder has the right, but not the obligation, to purchase an underlying security (most often the company’s common stock). Put another way, warrants are company-issued long term options.

By way of a quick refresher, derivatives are named as such because they derive their value based on the price of some other asset’s value; their value is based on something else’s value.

Warrants often crop up into the picture as an enticement to investors to buy a company’s debt. It’s an equity-kicker for owning the debt, a cherry on top if you will. You might ask, “but why do I need a cherry on top?” Companies are issuing debt in droves right now, taking advantage of super low interest rates, no cherry required, and the market laps up the offerings. Ah, but we live in an interesting time in stock market history because of the financial crisis that is so close in our rearview mirror. We don’t need to look back very far to find a time when companies needed debt and needed to add cherries on top to get investors interested in their offerings. Think back to 2009, for example.

The Brick Warrants

2009 was undoubtedly a fascinating, scary and amazing time to be managing money of any sort. The market was convulsing on a daily basis – the entire month of February had but only a few green days. It was brutal. But, as they say, blood on the streets creates opportunity. One such opportunity was a recapitalization that I studied of a company called The Brick (BRK.to), which was a furniture retailer up in Canada. Re-capitalizations are just as they sound, a re-working of a company’s capital structure. You can think of the components of a capital structure, at their most simple, as equity and debt. [For purposes of illustration we'll set aside complexities like preferred shares, which sit between equity and debt in the capital structure hierarchy]. Through the massive economic contraction, as to be expected, people stopped buying high priced consumer goods like the TVs, couches, washers, dryers and electronics that The Brick had so successfully sold for many years. Without getting into the depths of the details–I think my investment thesis was 20-ish pages long—the Brick needed to go through a recapitalization and it needed to issue new debt as part of the recap because it had way too much inventory that wasn’t selling and the company was quickly burning through its cash and credit facility reserves. It was a dire and unsustainable situation. The Brick needed to recapitalize its balance sheet.

Given the immense blood on the streets (remember, we’re talking May to June 2009, the S&P was somewhere in the 900 range while today it is nearly 2,000!) The Brick needed to include a warrant as part of its debt offering, which was one component of the recap. The warrants acted as the requisite enticement to potential bond purchasers to buy the company’s debt. The plan worked. The company fully subscribed its $120M debt offering, which included 120M 5 year warrants at a strike price of $1.00. For every $1 in debt you bought, you also got an option to purchase shares in the recapitalized Brick at any time over the course of the following five years at a price of $1.00 per share. Therefore the value of the warrants would be:

[IF > $1.00] Brick Stock Price – $1.00 = value of warrant

Through the time of the offering the stock traded near or higher than $1.00, implying inherent value at the time of issuance, forget about the potential value of owning that option for five years.

While I wasn’t fortunate enough to get any of the debt offering–large, opportunistic institutions lapped it up–after it was fully subscribed, a market was created for the warrants only; they were separated from the debt, as most often happens. Once this happened, anyone could buy the warrants on their own without owning the debt. They traded with the ticker symbol BRK.wt on the Toronto Stock Exchange.

The following years of owning these warrants was marked by fits and starts; huge drawdowns followed by huge spikes. Ultimately, the Brick was bought in November 2012 by a rival Canadian retail outfit, Leon’s, after much economic and stock market repair had occurred. Leon’s paid $5.40 / share to Brick stockholders. If you owned the debt and kept your warrants, you were paid 12% on your debt coupon, PLUS the warrant value, which you received for free as a cherry on top and was now worth $4.40 ($5.40 – $1.00 strike price) PLUS the principal appreciation on the debt.

Not a bad return if you can find it.

The Bottom Line

Warrants are options, options are derivatives, there is massive leverage baked into derivatives, and leverage can be very risky. That logic is sound and will always be. Look no further than the massive leverage that was piled into the financial system in the early 2000s and the outcome in 2008 / 2009 to see the damning effects of leverage for a great example of the risks implicit within leverage.

As long-term dividend investors, as we look for ways to sustain our fortitude in consistently applying our strategy for decades, warrants can be an interesting dessert, if used with extreme caution and only in a very small fashion.

As well as The Brick warrants worked out for their owners, there are a lot more stories of warrants becoming worthless as they’re often associated with companies in hard times. In the rare cases, like The Brick, they can produce spectacular returns, but like all speculation, the speculator must know A) they’re speculating and B) that the probability of their speculation going to zero is very, very real.

Have a great weekend as we head into next week with another jam-packed week of earnings releases coming down the pipe.