Warrants - Cheap Long Term Exposure to Banks

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During the crisis, AIG (NYSE: AIG), Bank of America (NYSE: BAC), Citi (NYSE: C), The Hartford (NYSE: HIG), JPMorgan (NYSE: JPM), as well as many others received aid from the government.  As a result, the government was given long term warrants in the companies which they have been selling off.  These warrants are now publicly traded and accessible to all investors.  These warrants have an expiration date between late 2018 and 2021.  They now serve as a low cost way to gain long term exposure to these companies.

Many of these stocks have had a great run over the past few years but they are still far from their normal valuations.  Almost all of the large banks and insurance companies are trading at or below their book value.  Before the financial crisis, banks generally traded at 1.6x book value and insurance companies traded at roughly 1.4x book value.  Since the warrants in these institutions have between 6 and 8 years till expiration, these are good ways to bet on a return to more normal valuations.  I don’t expect valuations to return all the way to the previous levels but a move up to at least book value is reasonable and a move above book value isn’t out of the question.

In the table below, I list the relevant information about each warrant, the current stock price, the current stated book value, from the latest quarterly report, and two scenarios for warrant returns based on price relative to book value.  I assume book value grows conservatively at 3.5% per year.

In some cases, such as JP Morgan, valuations above book value are probably warranted because these are the best run banks.  In others, such as Bank of America and Citi, simply moving back to book value or slightly higher is reasonable.  To keep the analysis relatively simple, I’m going to apply the same historical multiple to all banks.

<table> <tbody> <tr> <td> </td> <td>AIG Warrant</td> <td>BAC Warrant A</td> <td>BAC Warrant B</td> <td>Citi Warrant A</td> <td>Citi Warrant B</td> <td>Hartford Warrant</td> <td>JPMorgan Warrant</td> </tr> <tr> <td>Warrant Strike Price</td> <td>$45.00</td> <td>$13.30</td> <td>$30.79</td> <td>$106.10</td> <td>$178.50</td> <td>$9.79</td> <td>$42.42</td> </tr> <tr> <td>Warrant Exp. Date</td> <td>1/13/2021</td> <td>1/16/2019</td> <td>10/28/2018</td> <td>1/4/2019</td> <td>10/28/2018</td> <td>6/29/2019</td> <td>10/28/2018</td> </tr> <tr> <td>Warrant Price</td> <td>$13.90</td> <td>$5.34</td> <td>$0.77</td> <td>$0.49</td> <td>$0.07</td> <td>$15.74</td> <td>$13.35</td> </tr> <tr> <td>Current Book Value per Share</td> <td>$68.87</td> <td>$20.24</td> <td>$20.24</td> <td>$61.57</td> <td>$61.57</td> <td>$48.13</td> <td>$51.27</td> </tr> <tr> <td>Time until expiration (years)</td> <td>7.96</td> <td>5.97</td> <td>5.75</td> <td>5.93</td> <td>5.75</td> <td>6.42</td> <td>5.75</td> </tr> <tr> <td>Warrant price if stock trades at 1x BV which grows at 3.5% per year till expiration</td> <td>$45.57</td> <td>$11.55</td> <td>$0.00</td> <td>$0.00</td> <td>$0.00</td> <td>$50.23</td> <td>$20.06</td> </tr> <tr> <td>Historical P/B Ratio</td> <td>1.4</td> <td>1.6</td> <td>1.6</td> <td>1.6</td> <td>1.6</td> <td>1.4</td> <td>1.6</td> </tr> <tr> <td>Warrant price if stock trades at historical P/B & growth in BV of 3.5% per year</td> <td>$81.80</td> <td>$26.46</td> <td>$8.67</td> <td>$14.72</td> <td>$0.00</td> <td>$74.23</td> <td>$57.55</td> </tr> <tr> <td>Warrant Return if stock at BV</td> <td>228%</td> <td>116%</td> <td>-100%</td> <td>-100%</td> <td>-100%</td> <td>219%</td> <td>50%</td> </tr> <tr> <td>Warrant Return if stock at historic P/B</td> <td>488%</td> <td>396%</td> <td>1027%</td> <td>2905%</td> <td>-100%</td> <td>372%</td> <td>331%</td> </tr> </tbody> </table>

One interesting aspect of these warrants is that they have dividend protection.  As the dividend rises above a certain threshold, the strike price of the warrants is adjusted down.  The threshold is different for each instrument.  To be conservative in my return estimates, I am ignoring any potential future adjustments in the strike price.

Two big factors are currently depressing finanical company valuations: litigation risks and interest rates.  Banks and insurance companies should return to more normal valuations, relative to book value, as their litigation risks die down.  Currently, most of these institutions are engaged in lawsuits stemming from their conduct before or during the financial crisis.  In the next several years, these suits should work their way through the system and be resolved.  Also, as interest rates rise on the long end of the curve (sometime in the future, probably within the next 3 years or so), banks will be able to earn more from lending activities.  In the short run, rising rates will likely push up their funding costs pressuring net interest margins, but over time these margins should expand as the spread between borrowing and lending eventually widens.

If you expect valuations to stay at or near current levels, i.e. below book value, these warrants should be avoided.  Some of the returns calculated above seem pretty outlandish.  I don't expect all of the companies to be trading at their historically normal valuation when the warrants expire.

Using the assumptions from the table, the warrant with the highest return is AIG, with a return of 200% over current levels at expiration if the valuation returns to book value.  Within the money center banks on a return to book value, the best option is the Bank of America Series A warrant.  If you are very optimistic on the banking sector over the next 6 years and expect valuations well above book value, the Citi warrants are the best bet because they have extremely high leverage above book value.  They have a high strike price though, so if valuations don’t improve significantly, the warrants could expire worthless.


ahokiealum is long AIG, AIG warrants, BAC Series A warrants, and JP Morgan. The Motley Fool recommends American International Group. The Motley Fool owns shares of American International Group, Bank of America, Citigroup Inc , and JPMorgan Chase & Co. and has the following options: Long Jan 2014 $25 Calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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