Warrants

Warrants

• There are 2 types of warrant traded in bursa, i.e. Company Warrants and Structure Warrants
• It is a derivatives whose value depends upon  an underlying share listed in Bursa.
• It serve as tools for hedging, speculating and arbitraging.

Company Warrants

• It is issued by the company to raise money. 
• Normally, it was issued “free” as a "sweetener" for a bond, preferred stock, or rights  offering. 
• It is a right, but not an obligation, to subscribe for new ordinary shares at a specified price during a specified period of time. 
• It have a maturity date (up to 10 years) after which they expire are worthless unless the holder subscribes for the new shares of the company before the maturity date. 
• It generally American style option which can be exercise any time by paying the exercise price and convert to the underlying shares before the expiry of the warrants
• It represent a potential source of equity capital in the future and can thus offer a capital-raising option to companies.

Structure Warrants

• It is a proprietary instruments issued by a third-party issuer (e.g. investment bank).
• It give holders the right, but not the obligation, to buy or sell the underlying instrument in the future for a fixed price.   
• There is no conversion to the underlying share. 
• They are essentially European style option with cash settlements only with the investment bank at expiry date.

The Lingo

•  Strike Price \ Exercise Price, X 
• The price at which an underlying stock can be purchased or sold.
• A stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit.
• It must occur before the expiration date.
•  Premium, P
• The total cost (the price) of a warrant
• It is determined by factors including the stock price, strike price, time value and volatility.
• P = (W + X ) / S – 1
• W = Warrant Price
• X = Exercise Price
• S = Underlying Share Price
• There are 2 components of the premium are the intrinsic value (IV) and the time value (TV), P = IV + TV
• Intrinsic Value is the difference between the underlying share price (S) and the exercise price (X), IV = S – X
• Hence P = (S-X) + TV
• The lower the premium the more valuable the warrant.  
• The more time to expiration, the greater the time value of the warrant. - time increases the likelihood that the position can become profitable. Time value decreases over time and decays to zero at expiration. 

Factor that influence warrant price

• Underlying Share Price
• if the price of the stock is below the strike price of the warrant, there is no reason to exercise the warrant
• Days to Maturity
• It is worth less as time goes on and expiration approaches.
• Time Decay - it will accelerate as expiration approaches if the strike price is above the current price.
• Dividend
• Warrant-holders are not entitled to receive dividends
• The corresponding reduction in the stock price reduces the value of the warrant.
• Interest Rate / Risk Free Rate
• Higher interest rates increase the value of warrants.   
• The influence of this factor is small.
• Volatility, σ
• It is measured by the annual standard deviation of return of the underlying share.
• The higher the volatility or the movement of the underlying share price, the higher the odds that the warrant will eventually be in the money and the higher the value of the warrant will be.
• Dilution
• The exercise of volume will increase company's outstanding shares.
• This adds a twist to valuation that is not present in normal option valuation.
• Restriction on Exercise
• Any restrictions on the exercise of warrants will impact the value of a warrant negatively.
• E.g. the different between American-style and European-style warrants; American-style warrants permit exercise at any time, while the later can only be exercised on the expiration date. 

Why buy warrants instead of underlying share?

• Speculation
• Betting on the movement of a security.
• It is the territory in which the big money is made - and lost. 
• You have to be correct in determining
• The direction of the stock's movement
• The magnitude and the timing of this movement. 
• Leverage
• When you are controlling 1000000 shares of warrants, it doesn't take much of a price movement to generate substantial profits.
• Gearing
• The ratio of the share price to the warrant price
• It reflects how much the price of the warrant changes for a given change in the stock. 
• The higher the gearing, the more valuable the warrant.

Valuing Warrants with the Black-Scholes Model

• This formula is for European-style options and, though American-style options are theoretically worth more, there is not much difference in price in practice.
• The valuation of a warrant is expressed as: W = S N(d₁) - X e^-rT N(d₂)
• W= price of the warrant
• S = price of the underlying stock
• X = option exercise price 
• r = risk-free rate 
• T = time until expiration 
• N() = area under the normal curve
• d1 = [ ln(S/X) + (r + σ2/2) T ] / σ T1/2
•  d2 = d1 - σ T1/2
• Because of the dilution that warrants represent, the value of that call needs to be divided by (1 + q) where q is the ratio of warrants to outstanding shares, assuming each warrant is worth one share. 

References:-

• Company warrants and structure warrants kcchongnz (private)

Value with Momentum

Momentum helps is that it provides an answer one of the biggest issues of value investing, namely the “when will it happen?” question.

• Imagine you’ve found a neglected jewel which you expect that will ultimately capture an upside of, say, 75%...  
• But, when will it happen? In 3 yrs, 5 yrs, 7 yrs..?
• Those periods equate to IRRs of 20.5%, 11.8% and 8.3% pa respectively. 
• Assume a catalyst exists that’s successful in prompting a realization of that full 75% upside within 1 year. That is, of course, a 75% IRR!

 
How to find under-valued, out-of-favour companies at the point when the market is starting to recognize them?

• Discover a group of value stock by examine the price-to-book, price to-cash flow, price-earnings and price-to-sales ratios.
• Ascertain which of them are likely to rebound versus being cheap for a reason, such as being near bankruptcy. 
• Look for sign of momentum
• in terms of price momentum (relative strength) 
•  in terms of improving analyst sentiment and earnings surprises.

 
Some examples of possible catalysts include:

1. Fresh management with new direction 
2. A change in strategy of existing management (e.g. new product strategy, business reorganization  or  cost  reductions)
3. A  disposal  or  purchase  of  a meaningful asset 
4. A recapitalization of the business
5. A  takeover bid, or 
6. Activist shareholders who may put pressure on management to act.

Screen Criteria

1.  At least one of P/B, P/CF, P/E or P/Sale more favourable than the industry
2. 6 month relative strength (% gain vs S&P) > 0
3. 3 month relative strength >= 6 month relative strength
4. Earning suprise by examines three inter-related measures
1. Standard earning surprise - most recent interims vs forecasts
2. Abnormal returns around recent earnings announcement
3. Revision in the analyst consesnsus - now or trending over the last 6 months

Diversification & Portfolio

• No one stock makes > 1.6% of the portfolio
• No single industry make up more than 3% relative to the weight in the corresponding benchmark
• Ruled out stocks than have been public < 2 years

References:-

• Investment Strategy: Buying bargains on the move, Stockopedia

P/E ratio as Invesment Strategy

What is P/E ratio?

• P/E = Stock Price / EPS
• It is the most widely used metric as a measure of how expensive or cheap a stock is. It have been used in valuation reports by stock analysts and investment bankers.
• It vary across sectors - some sectors have high P/E while some have low. 
• Generally, stock trade at low P/E than other stock in same sector must be misprice

Which "EPS"?

• ·         Is it the EPS of the most recent financial year? 
• ·         Is it an undated measure of EPS by adding up the latest four quarters results? 
• ·         Is it the expected EPS for the next financial year? 
• ·         Is it before or after the extra-ordinary items? 
• ·      Is it based on the outstanding number of shares or all shares that will be outstanding when all warrants or ESOS are converted (fully diluted)?

Why different P/E?

•  Every company (even those in the same industries) contain unique variables, e.g.
• growth
• risk 
• cash flow patterns
• Company A and Company B should have same P/E?
• Company A has poor operating efficiencies, no potential growth, a poor balance sheet 
• Company B has superior earnings and cash flow growth, and a healthy balance sheet.
• Company with strong market position in general generates more stable earnings should be accorded with higher P/E ratio.

P/E vs Mr. Market

• P/E ratio serve as proxt to reflect market moods and perceptions 
• This can be viewed as a weakness, especially when markets make systematic errors in valuing entire sectors. 
• Below figuee shows the PE ratio distribution of S&P500 stocks on 31^st December 2013. Most stocks are now trading above a PE of 16. Hence a PE ratio of less than 16 may be good, below 8 will be fantastic, but above 20 may be too expensive. 

• 

 

P/E ratio: Theoretical background

• The financial theory postulated by John Burr Williams in his “The theory of investment value” says the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. The simplest model for this purpose would be the Gordon constant dividend growth model for a stable firm.
• Eq 1: P₀ = DPS₁ / (r-g)  
• P₀ = Value of equity 
• DPS₁ = Expected dividends per share next year 
• r = Required rate of return on equity 
• g = Expected growth rate in dividends (forever)
• Divide Eq 1 by Expected EPS next year, Eq 2: P₀ / EPS₁ = Forward PE = (DPS₁ / EPS₁) / (r – g ) = Expected payout ratio / ( r – g )   Equation 2
• From Eq 2,
•  A higher growth firm should  have higher P/E.
• A higher risk firm having a higher cost of equity ,r , will have a lower P/E ratio
• P/E should increase when the payout ratio increases.
• Firms that are more efficient about generating growth by earning a higher return on equity will trade at higher multiple. 
• Eq 2 only applicable for firm with stable growth, for a high growth company, you would have to estimate the payout ratio, cost of equity and the expected growth rate in the separate phase of high growth and the stable growth period, and summing up the value in these two phases taking the time value of money into consideration. This approach is general enough to be applied to any firm, even one that is not paying dividend right now.

Investing using the low P/E ratio strategy

• Basing on P/E ratio alone is not a desirable way as P/E ratio theoretically depends on a number of factors. 
• Low PE stocks are riskier than average and that the extra return is just a fair compensation for the additional risk, low future growth rates and poor quality earnings. 
• Additional screening criteria for low P/E stock
• Low P/E ratio with respect to the prevailing market, say not more than 12
• Low idiosyncratic risk as measured by 
• debt/capital ratio < 0.6
• current ratio of more than unity
• interest coverage ratio > 3.
• Reasonable expected growth in earnings > 5%
• Historic growth rate in past 5 years > 5%
• Good quality of earnings with reasonable cash flows

Estimating fair PE ratios from fundamentals

• Katsenelson’s absolute P/E method to find a fair value of P/E ratio for a specific firm. 

 

References:-

• Price-to-earnings ratio and its use as an investment strategy kcchongnz (private)

Beneish M-Score

Beneish M-Score is a mathematical model that uses financial ratios and eight variables to identify whether a company has manipulated its earnings.

It was created by Professor Messod Beneish. In many ways it is similar to the Altman Z score, but optimized to detect earnings manipulation rather than bankruptcy.

It is based on a combination of the following eight different indices:

1. DSRI = Days’ Sales in Receivables Index
• DSR = Receivable /Sale
• DSR t / DSR t-1
• A  large increase in DSR could be indicative of revenue inflation. 
2. GMI = Gross Margin Index
• Gross Margin = (Sales - COGS)/Sales
• Gross Margin t-1/ Gross Margin t
• Gross margin has deteriorated when this index is above 1.
• A firm with poorer prospects is more likely to manipulate earnings. 
3. AQI = Asset Quality Index
• Asset Quality = Non Current Asset other than PPE / Total Asset
• AQI = AQI t / AQI t-1
• Note: Biological assets is part of PPE for a plantation company. Likewise for land held for development, property development costs, investment property for property companies.
4.  SGI = Sales Growth Index
•  Sales t / Sales t-1
• Sales growth itself is not a measure of manipulation.
• A growth companies are likely to find themsleves under pressure to manipulate in order to keep up appearances
5. DEPI = Depreciation Index
• Rate of Deprecition = Depreciation / (PPE + Depreciation)
• Rate of Deprecition  t-1/ rate of Depreciation t
• > 1 indicates that assets are being depreciated at a slower rate - the firm might be 
• revising useful asset life assumptions upwards
• adopting a new method that is income friendly.
6. SGAI = Sales, General and Administrative expenses Index 
• SGA =  SGA Expenses / Sales
• SGA t / SGA t-1
7. LVGI = Leverage Index 
• Legerage = Total Debt / Total Asset
• Leverage t / Leverage t-1
• > 1 = increase in leverage
8. TATA - Total Accruals to Total Assets 
• Total Accruals = Change in Working Capital Account

 

The Beneish M Score Formula

M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*SGAI + 4.679*TATA – 0.327*LVGI

The interpretation...

• M Score > -1.78 - a strong likelihood of a firm being a manipulator. 

Beneish found that he could correctly identify 76% of manipulators, whilst only incorrectly identifying 17.5% of non-manipulators.

The 5 Variable Version of the Beneish Model

• It  excludes SGAI, DEPI and LEVI which were not significant in the original Beneish model.
• M  = -6.065 + 0.823*DSRI + 0.906*GMI + 0.593*AQI + 0.717*SGI + 0.107*DEPI 

References:-

• Pitroski F-Score, the Altman Z-Score and the Beneish M-Score kcchongnz (private)
• Beneish M Score to Detect Earnings Manipulation, Jae Jun
• M score for earnings manipulation paper 
• Benish M Score, YCharts Financial Glossary
• Buying bargains on the mend kcchongnz (private)

Pitroski F-Score

Embedded in that mix of companies, you have some that are just stellar. Their performance turns around. People become optimistic about the stock, and it really takes off [but] half of the firms languish; they continue to perform poorly and eventually de-list or enter bankruptcy.”
-- Joseph Piotroski, University of Chicago Accounting Professor

Pitroski want weed out the poor performers and identify the winners in advance.

He devised a simple nine-criteria stock-scoring system called the Pitroski F-Score, for evaluating a stock’s financial strength that could be determined using data solely from financial statements as below.

1.  Net Income: Bottom line. Score 1 if last year net income is positive.

1. Operating Cash Flow: A better earnings gauge. Score 1 if last year cash flow is positive.   

1. Return On Assets: Measures Profitability. Score 1 if last year ROA exceeds prior-year ROA.  

1. Quality of Earnings: Warns of Accounting Tricks. Score 1 if last year operating cash flow exceeds net income.

1. Long-Term Debt vs. Assets: Is Debt decreasing? Score 1 if the ratio of long-term debt to assets is down from the year-ago value. (If LTD is zero but assets are increasing, score 1 anyway.)

1. Current Ratio:  Measures increasing working capital. Score 1 if CR has increased from the prior year.    

1. Shares Outstanding: A Measure of potential dilution. Score 1 if the number of shares outstanding is no greater than the year-ago figure.

1. Gross Margin: A measure of improving competitive position. Score 1 if full-year GM exceeds the prior-year GM.

1. Asset Turnover: Measures productivity. Score 1 if the percentage increase in sales exceeds the percentage increase in total assets.

 The interpretation...

• 8 - 9: Strongest Stock

• <= 2 : Weakest Stocks

Pitroski  made clear that the paper "does not purport to find the optimal set of financial ratios for evaluating the performance prospects of individual “value” firms" - rather, it is just one way that investors can use relevant historical information to eliminate firms with poor future prospects from a generic value portfolio.

It is not useful to check stock selected by

• Magic Formula -  buying good companies at good price

• Graham NCAV or NNWC

It will be a useful weapon if you want to 

• listen to some rumours from your remisiers, friends, internet forums of insiders going to pump up the share price (purportedly for your benefits) of some crappy stocks 

• ride on the band wagon on the turnaround stories

 Even that, one must exercise good judgment.

References:-

• Pitroski F-Score, the Altman Z-Score and the Beneish M-Score kcchongnz (private)
• Buying bargains on the mend kcchongnz (private)
• Value Investing: The use of historical financial statement information to separate winners from losers

Finding a Bargain - The "Cigar Butt" Approach

• Finding a bargain is a seductive prospect. And, Warrent Buffett calls this "cigar butt" approach to investing.
• “A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit”
• It having a very conservative measure of intrinsic value, essentially liquidation value, and a large margin of safety
• In bull markets it can be arduous
• But, in depressed and volatile conditions like 2009, the basket of potential stock candidates tends to swell. 
• How do you go about finding these kinds of deep value or bargain stocks?
• Pay less than book value 
• Price-to-book on a tangible assets only
• This is only applicable for manufacturing companie
• Service businesses - depends on intagible assets which isn’t even on the balance sheet
•  It may not give enough MOS if fixed assets may have been overvalued. Thus, a number of other (more extreme) metrics can be used by the deep Value Investors…
• Pay less than liquidation value (NCAV)
• Benjamin Graham advocated buying stocks that, if they were to collapse tomorrow, should still produce a positive return because of the underlying asset backing. 
• He ignoring fixed assets like property and equipment and solely valuing current assets (such as cash, stock and debtors) on the basis that only these assets could easily liquidated in the event of total failure, and then subtracting the total liabilities to arrive at the so called net current asset value.
• To defend against the risk on individual failure, Graham require MOS of about 33% & diversify to at least 30 stocks. 
• In a study by Henry Oppenhemier in the Financial Analysts Journal, the mean return from discounted net current asset stocks over a 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index – an astonishing outperformance.
• Pay even less than liquidation value (‘Net Nets’)
• Graham make allowance on cash due from debtors (as it might not able to collect it) and inventories (as it may have to be discounted).
• Net Net Working Capital = cash and short-term investments + (75% * debtors) + (50% * inventory) – total liabilities.
• Buy companies selling for less than their cash (Negative Enterprise Value)
• Investors can look for companies whose cash is worth more than the total value of their shares plus their long-term debt
• This investment approach is known as buying stocks with a Negative Enterprise Value and waiting for them to be revalued.
• It offer a potential arbitrage opportunity, whereby a buyer of the company could snap up the entire stock and use the cash to pay off the debt and still pocket a profit.
• New opportunities with new lows
• It  was taken by Walter Schloss, another investor that studied under Graham and went on to refine his tutor’s theories into his own strategy.
• It blends the all-important book value with stocks that have fallen to new lows in terms of market price. 
• Schloss saw new lows (e.g. 52W low) as an indicator of a possible bargain stock.
• He stressed the importance of distinguishing between temporary and permanent problems. 
• He would look for companies trading at a price that was less than the book value per share, no long-term debt, stocks where management owned above-average stakes for the sector and, finally, a long financial history.
• Schloss preferred to invest in sectors he understood, particularly old industries like manufacturing
• Schloss believed in significant diversification although his willingness to run up to 100 stocks would have many investors reeling. 
• Over the 45 years from 1956 to 2000, his fund earned an astounding compound return of 15.7%, compared to the market’s return of 11.2% annually over the same period. In the words of Buffett, Schloss “doesn’t worry about whether it’s January…whether it’s Monday…whether it’s an election year. He simply says if a business is worth a dollar and I can buy it for 40 cents, something good may happen”.
• Deep value investing is not an approach for the faint-hearted.
• Bargain Investors would invest in  the most unloved stocks in the market and  that leaves a bargain strategy open to significant risk.
• Investors should always back up their screening with detailed scrutiny as well.
• The original ‘bargain’ price probably will not turn out to be such a steal after all because, 
• “in a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. 
• Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.”
• How do deep Value Investors mitigate the risk of cockroaches? 
• Diversification - the successes should outweigh the catastrophes. 
• For Graham, the target was upwards of 30 stocks 
• For Schloss, the number could be as heady as 100.

References:-

• Cigar Butts Investing and Diversification kcchongnz (private)

Altman Z-Score

• It is a statistical tool used to measure the likelihood that a company will go bankrupt dvised by Edward Altman, the New York University professor in the 1960s.
• It is a multivariate analysis to the mix of traditional ratio-analysis techniques (e.g. current and quick ratio), and able 
• to consider  the effects of several ratios on the "predictiveness" of his bankruptcy model, 
• to consider how those ratios affected each other's usefulness in the model.
• Altman evaluated 66 companies (half of which had filed for bankruptcy between 1946 and 1965) and started out with 22 ratios classified into five categories (liquidity, profitability, leverage, solvency and activity) but eventually narrowed it down to five ratios.
• X1 = Working Capital / Total Assets
• X2 = Retained Earnings / Total Assets
• X3 = EBIT / Total Assets
• X4 = Market Value of Equity / Book value of Total Liabilities
• X5 = Sales / Total Assets
• Altman re-evaluated his methods by examning 
• 86 distressed companies from 1969 to 1975
• 110 bankrupt companies from 1976 to 1995
• 120 brankrupt companies from 1196 to 1999
• Altman Z-Score, Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5
• X1: Working Capital / Total Assets
• Working capital = current asset - current liabilities 
• Valuable liquidity measure of the net liquid assets of the firm realtive to the total capitalization 
• Liquidity and size characteristics are explicitly considered.
• A firm experiencing consistent operating losses will have shrinking current assets in relation to totla asset
• X2: Retained Earnings / Total Assets
• RE = Total Amount of reinvested earnings / losses of a firm over its entire life.
• The age of firm is implicitly considered in this ratio - a relatively young firm will probably show a low X2 ratio (as it has not enought time to accumulate profit)
• Young firm is discriminated in this analysis? Its chance of going bankrupt is relatively hire than older firm. (this is precisely the situation on the real world)
• It also measure the leverage of the a firm - firm with highe RE relative to TA financed their assets through retention of profits and have not utilized as much debt.
• X3: EBIT / Total Assets
• A firm ultimate existence is based on the earning power of its assets. X3 measure the true productivity of the firm's assets - independent of any tax or leverage factors
• Insolvency in a bankrupt sense occurs when the total liabilities exceed a fair valuation of the firm's assets with value determined by the earning power of the assets. 
• X4: Market Value of Equity / Book value of Total Liabilities
• Equity = all shares of stock (preferred and commont)
• This measure show how much the firm's assets can decline in value before the liabilities exceed the assets and the firm becomes insolvent.
• It appear to be more effective predictorof bankruptcy than Net Worth / Total Debt [Book value]
• X5: Sales / Total Assets
• It illustrating the sales generating ability of the firm's assets.
• It measure management's capacity in dealing with competitive conditions.
• It is useful predictor when used with the other four.
• The interpretation of Altman Z-Score
•  > 3.0 = The company is "Safe" based on the financial figures only.
• 2.7 - 2.99 = "On Alert" 
• 1.8 - 2.7 = Good chance of the company going bankrupt within 2 yers of operations from the date of financial figure given.
• < 1.8 = Probability of Financial Catastrophe is Very High
• If Z close to or below 3, some serious Due Diligence on the company in question before even considering investing.
• Z Score was between 82% and 94% accurate 
• 'Garbage in, Garbage out' motto applies - if the company financials are misleading or incorrect, Z Score will be, too.

References:-

• Altman Z-Score  kcchongnz (private)
• Pitroski F-Score, the Altman Z-Score and the Beneish M-Score kcchongnz (private)
• Buying bargains on the mend kcchongnz (private)