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Francis Chou - An Interesting Way to Invest in Banks (Warrants That were Issued to the U.S. Treasury)

August 29, 2010 | About:
CanadianValue

CanadianValue

212 followers
I detailed last week the recent letter to shareholders from Francis Chou who one of the best value investors in North America.


http://www.gurufocus.com/news.php?id=105691


In that letter Francis has provided us with a very interest investment idea. In 2006 he laid out for all see the merits of buying extremely cheap credit default swaps. Oh, if only we had paid closer attention and made 100x our investment like Prem Watsa of Fairfax (FFH) and others did. This time I am paying closer attention.


Here is what Francis wrote:


“One of the more interesting ways to invest in the better capitalized banks is through the stock warrants that were issued to the U.S. Treasury by the banks when they received funds under TARP. The stock warrants give the holder the right to buy the bank's stock at a specific price. When the banks repaid TARP funds to the U.S. Treasury, the U.S. Treasury either sold the stock warrants back to the banks or they auctioned them to the public. So, what is so unique about these stock warrants?

1) They are long dated, with most expiring in 2018 or 2019. This time frame of eight- plus years

allows banks to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price of the stock warrant.


2) The strike price is adjusted downward for any quarterly dividend that exceeds a set price.

Normally, you don't see that in a stock warrant. This is a truly stringent condition. In this case we should give the government credit for extracting a pound of flesh. An example: for Bank of America, class 'A' warrants, the strike price is adjusted downward for any quarterly dividend paid

exceeding one cent a share.


3) Many of the banks have excess capital on their balance sheet. When the economy settles down,

we expect the banks to use this excess capital either for buybacks or a one-time special dividend

that may reduce the strike price on the stock warrants if this provision applies.


4) The concerns over financial reform and its ultimate impact on the earning power of the banks

may be somewhat exaggerated. We believe the banks will most likely be able to pass the majority

of the costs to customers. For an economy to flourish we need sound financial institutions that

can generate reasonable profits.


5) Investing in financial institutions requires a leap of faith. Mind you, this leap of faith is no

greater than those we make on any company's future prospects, its position in the industry and

how well it will do in a future economy. Looking forward, as each year goes by, the quality of

earnings of the banks should be higher, the books should be cleaner, the risks will be lower and

management will be far more risk averse. Too bad we had to go through so much turmoil to get there.”

Below, August 13, 2010 prices of some banks stock warrants.

Warrant - JP Morgan

Warrant Price - $12.51

Warrant Strike Price - $42.42

Stock Price - $37.50

Expiration Date - 10/28/2018

Strike Price Adjustment - Quarterly Dividend over $0.38


Warrant - Capital One

Warrant Price - $14.50

Warrant Strike Price - $42.13

Stock Price - $38.82

Expiration Date - 11/14/2018

Strike Price Adjustment - Quarterly Dividend over $0.375


Warrant - Bank of America, class B

Warrant Price - $2.59

Warrant Strike Price - $30.79

Stock Price - $13.23

Expiration Date - 10/28/2018

Strike Price Adjustment - Quarterly Dividend over $0.32

Warrant - Bank of America, class A

Warrant Price - $7.12

Warrant Strike Price - $13.30

Stock Price - $13.23

Expiration Date - 1/16/2019

Strike Price Adjustment - Quarterly Dividend over $0.01


Warrant - PNC

Warrant Price - $11.50

Warrant Strike Price - $67.33

Stock Price - $55.09

Expiration Date - 12/31/2018

Strike Price Adjustment - Quarterly Dividend over $0.66

Warrant - Wells Fargo

Warrant Price - $7.77

Warrant Strike Price - $34.01

Stock Price - $25.84

Expiration Date - 10/28/2018

Strike Price Adjustment - Quarterly Dividend over $0.34

Warrant - Comerica

Warrant Price - $12.20

Warrant Strike Price - $29.40

Stock Price - $35.87

Expiration Date - 11/14/2018

Strike Price Adjustment - Quarterly Dividend over $0.66


Warrant - Valley National

Warrant Price - $2.24

Warrant Strike Price - $17.77

Stock Price - $13.48

Expiration Date - 11/14/2018

Strike Price Adjustment - Quarterly Dividend over $0.1814


6) Even so, everything is not hunky dory for the banks. Banks face many issues and challenges. I have listed a few here:

a) We still do not fully understand or trust the numbers

b) Financial regulatory reform may reduce earning power

c) New Basel rules may require more capital and reduce profits

d) There may be a double dip recession

e) The unemployment rate may go higher and create more defaults

f) Commercial real estate prices may fall dramatically

g) Banks are still not marking loans in their books properly

h) Residential real estate prices may fall further

i) States and municipalities are in bad shape

Our investing horizon is long-term - eight years or more for these bank warrants. Over that period, we believe the odds are it will work out to be decent investment - more so for the better capitalized banks. We view it as the glass being more than half full rather than being more than half empty."

While it is hard to ignore all of the pessimism in the financial news the past few weeks it is even harder to ignore investors like Chou and Berkowitz who are bullish on the sector.

About the author:

CanadianValue
http://valueinvestorcanada.blogspot.com/

Rating: 4.0/5 (22 votes)

Comments

WIBruin
WIBruin - 4 years ago
Great article. Thanks. Are these warrants available to retail investors?
Sivaram
Sivaram - 4 years ago


It's interesting that some prominent value investors, such as Chou here and Berkowitz, are betting on financials. If we get any sort of deflationary outcome, banks are probably one of the worst places to be. I don't think they will get govt support like they have in the recent past.
Jehnavi
Jehnavi - 4 years ago
The best way is to invest in yourself first. Learn how to analyze financial statements, understand the stock market, go about.com or google about it, read Warren Buffett, and do your research. I do not really recommend you to look for an advisor on investment after I've read The Tao of Warren Buffett. Make yourself become the master.

Thanks

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