TSX TrendWatch Weekly

Last week’s discussion of the Nasdaq Canada Index (CND) and its constituents drew quite a bit of interest.  Check the archives if you haven’t read it yet.

Essentially we reported that the little-known CND (^CND on Yahoo! Finance) has outperformed both the S&P/TSX Composite Index and the US-based Nasdaq Composite Index for many years now.   As if to confirm our observations, CND rose another 9.1% last week… a much bigger increase than most of the other 30 or so indexes that we track regularly.  The year-to-date figure there is now a staggering +70%!

We’ll no doubt revisit the CND in more detail later, but this week I’m going to discuss another investment vehicle that doesn’t normally get enough attention… the stock purchase warrant.  But first, the summary for last week…

WEEKLY REVIEW…  The S&P/TSX Composite Index rose a respectable +3.8% last week, bumping the year-to-date figure to +15.4%. This time the emphasis was more on the larger blue-chip stocks. The S&P/TSX Venture Index  rose a more moderate 2.5%. The Dow rose 2.5%, the Nasdaq, 4.9%, and the S&P 500, 3.6%.

Nine of the 10 sector indexes on the TSX now have positive trend values. As has been the case for quite a while, ENERGY, MATERIALS, and FINANCIAL SERVICES are leading the way… each climbing 2%+ per week on average. The 10 week moving averages of the other sectors are more modest… 1% or less per week.

As I’ve mentioned in previous posts, it’s extremely rare that our measure of the percentage of stocks with positive trend values breaks through 70%, let alone the 80%+ we’ve seen for seven consecutive weeks now.

As is often the case, people on the sidelines who missed out on the rally that began in early March are asking themselves whether they should jump in now or wait for a pull-back.  Our attitude continues to be “go with the flow”.  We’ll continue to buy until any such pull-back occurs. We’ll continue to stick with predominantly Canadian securities, since the US dollar may finally have started its long-overdue collapse against all currencies world-wide. (We play that separately in the Forex markets for an extra boost to the overall portfolio.)  The Canadian dollar in particular will continue to strengthen as oil prices rise again. So, the bottom line is that even if your US stocks do well, you could still lose money.

WARRANTS… When the equities markets shift into recovery mode, many investors with a reasonable tolerance for risk will look for ways to leverage their investments. If they see that a favoured stock is consistently rising 1-2% per week or more, they look to ways of bumping that 1-2% to something higher.

The simplest way to do that is to buy on margin, where you essentially buy more stock than you could normally buy outright by borrowing from your broker.  Another approach is call options which trade on derivatives exchanges. These are contracts to buy 100 shares of a particular stock at a particular prices during a pre-specified time window… typically up to nine months (although longer-terms up to several years are possible in some cases).  Since you’re buying a contract with fixed stipulations, you put down much less capital than buying the stock outright.  Again, if you’re right about the direction and the rate of price appreciation, you leverage your way to some very significant profits relative to simple stock trading.

And, then there are warrants.   For ages if you Googled “warrants”, you got mainly legal references as in “search warrant” or “warrant for the arrest of…”.  That was changed now. Even though stock purchase warrants have been an equity investment choice for many decades, it apparently took the search engines quite a few years to find many references to them.  This could also have been a factor of low investor interest.  So, what are they?

Warrants are similar to call options in that they allow the holder to purchase common shares of the underlying company at a fixed price until a fixed expiry date… but there are some significant differences:

• Call options are an artificial construct/contract created and maintained by a derivatives exchange. To facilitate liquidity you can typically only find options on large-cap stocks.  As mentioned earlier expiry dates commonly run up to 9-12 months, although LEAPS offer a longer term alternative (2-3 years) for an even smaller subset of large caps. Long or short-term, the derivatives exchanges offer a variety of exercise prices and expiry dates.
• Warrants are issued by the same company that issues common shares, so to that extent, they are more “real” than options. Since warrants typically originate with smaller companies, you’re dealing with the other end of the company size continuum from the options markets… in fact the one that is outperforming right now! When they’re issued, warrants are like a perk to help companies sell more stock.  A new issue might consist of an offering of “units” that consist of a common share plus one-half of a share-purchase warrant. Each whole warrant plus a fixed exercise price will let you buy an additional share of common stock.  Generally, the exercise price is quite a bit higher than the current price of the stock, so you keep your warrants until using them (like coupons) gets you more stock at a discounted price (i.e. the common stock is above the exercise price). Many investors don’t have the patience for that, so they sell their warrants on a stock exchange just like ordinary shares.  Even though the warrants might be intrinsically worthless right now, they still have future potential value, especially if the expiry date is in the distant future.

Traditionally, warrants have generally been offered by MATERIALS and ENERGY companies, but there have been exceptions. Let’s look at one in more detail… Canadian Western Bank (CWB), whose common shares are included in the S&P/TSX Composite Index. The stock closed on Friday at $14.40.  The Canadian Western Bank warrant (CWB.WT) closed the day at $4.32.  Now here are the terms.  You can exercise the warrants that you own to buy CWB common shares for $14 until March 2, 2014.  If you bought the warrants on Friday, would you exercise them right away?  No, of course not.  The intrinsic value of the warrant is only 40 cents ($14.40-$14.00), yet you paid $4.32.

Now, let’s look at why the $4.32 you paid for each warrant isn’t totally outrageous.

If this is the beginning of the next bull market and FINANCIAL SERVICES are one of the leading sectors, we could conservatively expect CWB shares to gain 10% in value per year over the next (roughly) 5 years in the life of those $4.32 warrants.  That would take CWB common shares to about $23… approximately 60% in total.  But with the common shares at $23, your $4.32 warrants that you bought on Friday would then have an intrinsic value of $23-$14= $9.  On a percentage basis that’s a 108% profit… close to double what you would have made buying and selling the stock.  Now, that is leverage! And, you put up a much smaller amount of capital ($4.32 vs $14.40), which means that you could be buying more warrants than you would common shares.  That’s even extra profit potential.

Now, obviously a lot of unpredictable events could happen over the next five years, but you can keep in mind that there will always be a time premium on your warrants over and above the intrinsic value. If you were bullish on CWB right now, the warrants are definitely undervalued. If the underlying stock starts losing ground, you can still sell the warrants with a nice profit.

Now here’s a real life example.  By watching the DATA & CHARTS workbook of the S&P/TSX Composite Index stocks, I found that Thompson Creek Metals (TCM) shares were moving up with high trend and consistency values. On May 5 the TCM common shares were trading at about $9.25.  At the same time I purchased the warrants (TCM.WT) instead at $3, even though the intrinsic value of those warrants was only 25 cents. The TCM warrants have an exercise price of $9 until October 27, 2011… a little over two years.

As of Friday, the common shares closed at $10.29 for a gain of 11% since the day I purchased my warrants… not bad for three weeks. My warrants closed Friday at $3.65, for a gain of 22% for the same three weeks.  Now, that’s leverage, and I clearly bought more warrants than I would have common shares.

Premium Service subscribers will know that there are over 100 warrants traded on TSX and Venture exchanges, although many are nearly worthless even from a longer-term perspective (because the exercise price is so high).

You’ll never see warrants listed as index components on the S&P/TSX Composite Index, but there are roughly a dozen S&P/TSX Composite Index companies that have them… several with multiple classes of warrants, so the grand total is about 20. To follow up on those, check the investor relations pages of the web sites for these S&P/TSX Composite Index companies… AEM, CWB, FNV, G, K, MFL, NGD, OSX, PRE, QUA, SLW, TCM, YRI.  If you like any of those stocks, the warrants will give you more traction.

Warrants aren’t for everyone, and clearly not for the risk-averse. After all, they’ll fall as fast as they rise, if you’ve made a bad call.  All the same, they’re another tool for your investment toolbox!