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, Financial) 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.
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, Financial) 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.
