Great value exists among specific TARP warrants offered on a small number of US based firms. These warrants are a byproduct of the financial crisis and allowed the US Treasury to purchase up to $700 billion of troubled assets during the 2009 bailout. Warrants were provided by recipients of bailout funds and allow the holder to purchase stock at a specified price, approximately 10 years in the future. The government has subsequently sold some of these positions into the public markets with several years remaining until expiration. Our own expiration dates range from January 2019 to July 2019, approximately 30 to 36 months from today.
Warrants of this nature, particularly those trading at-the-money, exhibit significantly more volatility than the underlying equity. Over the short-term, this can feel uncomfortable. However, because we are focused on only the most deeply undervalued firms, the prices over time will adjust upward to their intrinsic value and the warrants will perform dramatically better than the stock.
Bank of America Corporation (BAC) is a particularly undervalued security today. With tangible book value over $18 per share and a quarter end stock price of $13, shares of stock are selling below the liquidation value of the bank. While BAC can appreciate nearly 40% before reaching one times tangible book, industry peers like Wells Fargo & Company (WFC) trade today for 1.8 times.
The warrants we hold have a strike price of $13 giving us the right to purchase equity for $13 in January, 2019. Furthermore, each dividend paid by BAC reduces the strike price. Ultimately, at expiration in 2019, our strike price is likely to be closer to $12.
In June, prior to the Brexit vote at quarter end, the stock sold for $14 and the warrants for $4. In the final days of the quarter, the equity declined 14% to $12, while the warrants experienced a nearly 25% decline to $3.10. Price fluctuations like this are not alarming; they are common in both directions. A review of one long-term scenario demonstrates the insignificance of movements such as these.
At warrant expiration in 2019, a conservative BAC equity price of $20 will translate to warrants priced above $8 (at expiration: Stock Price – TARP Strike Price = Warrant Price). This suggests that conservative equity appreciation of 66% over 2.5 years will result in warrant appreciation of over 150% ($3 to $8) over the same period. In the event that markets are more euphoric, the upside can be even greater. It would be a mistake to speculate whether the warrants will decline to $2 before reaching $8. It is far more useful, despite the psychological discomfort, to simply buy more if prices decline. It is essential to ignore the short-term noise and focus on the longer term picture. We are willing to accept this short-term volatility for asymmetric gains.
Over the past twelve months, these warrants have fluctuated between $3 and $7. The second quarter concluded with the prices again below $3.5. This bodes well for the upside of these and other warrant positions.
[us_separator] The above post has been excerpted from a recent letter of Peterson Capital Management.
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