In a previous post I wrote about Wells Fargo TARP warrants, we saw that back then we needed 75.4% return from the stock over the warrant life to break even, or about 8% return per year. Back then the stock traded at $29.14 per share and $9.78 per warrant, or a price ratio of 2.98 warrants per stock.
Today, if we inspect the situation using the same tools, we can see something very odd: The stock trades for $33.44 per share, and the warrant, well, it is trading for $8.81 per warrant. The ratio is now 3.8 warrants per stock. This means that whoever bought the warrant back then, almost a year ago, lost 10% of his capital against a rise of 14.75% in the asset base – the stock. This means that now investors should expect only 5.25% return per year to be indifferent between the stock and the warrant, or only 38% over 6.3 years! (see all of this here)
How can this be? How can a stock rise 15% and the warrant, a derivative linked directly to the stock, decline 10%?
Simple – the warrant price is derived from the stocks’ implied standard deviation, and in turn the stocks’ implied standard deviation is derived from fear. As the American economy slowly recovers and the horizon looks more visible, fear declines. When fear declines, so does prices of assets linked to it by implied STDEV.
But still, is it logical? Assuming wells will earn a steady $3 per share in the coming 6 years, or 18$ per share in the course of 6 years – it will basically earn 55% of its market cap till then, without considering any improvement in the economy whatsoever. I think wells will most likely return much over 5% per year, but it’s just me.
In fact, in such a case it is favorable for an investor to convert the stock holding (or part of it) to the Warrant holding; He can now buy 3.8 warrants per each stock he holds. Currently, the break-even point is at $46 per share, much lower than before, and the yield curve is much steeper.
Lets look at it from the options point of view. If we look on a call option price for January 2014 with strike of $35, it costs about $3.7. The warrant’s strike price is $34.01, about a dollar less, so we can assume that if there was a call option with a strike price of $34.01 it would have traded for over $4. But January 2014 will occur in 1.5 years, while the warrant expires in 6.3 years, or 4.2 times the call option period. Would you pay roughly twice the price of “Jan 2014 Call $34” to win another 5 years? I bet you will. Add to that – I bet you that when Call options for January 2015 will be issued in September, you will see that C$35 price will be awfully close to the warrant price (if it will not correct till then).
It looks like there is a clear mispricing here, whether or not Wells will get to the target price or not in 6.3 years.
DISCLOSURE: Writer holds both the stock and the warrant