Part 16:  Navigating Convertible Securities and Warrants

Words: 1,265 Time: 6 Minutes

💥 Why This Matters

• Practice, practice, practice: Before investing real money, aspiring stock pickers should practice their (derivative) techniques with hypothetical portfolios, tracking their decisions and evaluating their performance.

• Derivatives are complex: Whilst these instruments offer investors potential opportunities – they tend to be complex and very risky (far more than common stocks) 

• Discipline and patience: Developing a disciplined and consistent approach; and avoiding impulsive decisions

📝  Introduction

Chapter 16 looks at the complex world of derivatives.

For most readers – this can be a section to skip. For those who don’t mind going deeper – there are some important lessons.

Convertible securities and derivatives such as warrants, while offering potential opportunities, can be complex and potentially very risky investments.

This chapter delves into the characteristics of these instruments, highlighting their advantages, disadvantages, and potential pitfalls for investors.

🔄 Understanding Convertible Securities

Convertible securities are bonds or preferred stocks that can be converted into a predetermined number of common shares.

They offer investors a combination of fixed income and potential equity participation.

For example, if you want to read a great case study on how Warren Buffett made $3.1B on a convertible deal with Goldman Sachs in 2008 (during the financial crisis) – read this story.

But let’s expand on the list of advantages (and potential risks) Buffett took on making this trade with Goldman: 

✅ Advantages:

• Downside Protection: Convertible securities offer greater downside protection than common stock due to their fixed income characteristics and priority in a company’s capital structure.
• Upside Potential: Investors can participate in the potential appreciation of the underlying common stock through the conversion privilege.

❌ Disadvantages:

• Lower Yield: Convertible securities typically offer lower yields than comparable non-convertible securities due to the embedded conversion option.
• Quality Concerns: The presence of a conversion feature may indicate lower underlying quality compared to straight bonds or preferred stocks.
• Timing Risk: Convertible securities issued during bull markets tend to perform poorly when the market declines, as the conversion option becomes less attractive.

To demonstrate the complexity – below is how Buffett structured his convertible deal with Goldman Sachs.

At the time, he invested $5 billion in Goldman. More than anything, it was seen as a strong vote of confidence in the broader financial system (however Goldman also desperately needed the cash)

In exchange, Goldman gave Buffett the following:

• $5 billion worth of “perpetual” preferred shares. While technically a share of stock, preferred shares are a bit more like a bond. They’re slightly safer than “common” shares, because—should anything like a bankruptcy happen—preferred shareholders stand in front of common shareholders in the line to get their share of the proceeds from the garage sale of the liquidated company. They also typically pay a dividend (i.e, fixed income). Goldman agreed to pay a 10% dividend on those preferred shares to Buffett, which cost Goldman about $500 million a year.

• Warrants for 43.5 million additional shares. Warrants are similar to options. In this case they were the legal right to buy a stock at a particular price, which for Buffett was $115 per share. The deadline for exercising these warrants was Oct. 1, 2013.

🤷‍♂️ The Dilemma of Convertible Ownership

• Decision to Sell or Hold: Determining the optimal time to sell a convertible security that has appreciated in value can be difficult. Selling too early may mean missing out on further gains, while holding on for too long exposes the investor to potential losses if the market declines

• Conversion Considerations: If a convertible security is called by the issuer, investors must decide whether to sell or convert into common stock. Converting can lead to losing the downside protection of the fixed income component

So what did Buffett do with his convertible shares in positive territory?

• On the preferred shares Goldman had the right to buy them back, and did so in March 2011, paying Buffett $5.64 billion. That included the original $5 billion in principal, as well as a $500 million bonus for early repayment, and $140 million in dividends Buffett was due. So Buffett made $640 million on his $5 billion investment, or about 13% over two-and-a-half years. But Buffett was also collecting dividends while he held the shares, amounting to roughly $1.1 billion. So all in, Buffett made about $1.75 billion, a 35% return.

• The warrants are a different story. They derive their value from the difference between the price at which Buffett was entitled to buy—$115—and the actual price at which Goldman shares are trading when he buys. At the time he got the warrants, Goldman was trading at around $125. Since then, Goldman shares moved above and below that price, spending quite a bit of that time below the $115 level – making the warrants a losing proposition for Buffett.

• However, at one point, Goldman’s share price hit ~$190 (in 2009). Had Buffett exercised the warrants at that point, and sold his shares at that price, he could have cleaned up. Instead, he waited, and the stock sank back below $115 (2011 to 2012). In the end, Buffett profited on the warrants. He made $1.75 billion in cash and about $1.35 billion in stock, or roughly $3.1 billion on the Goldman investment; i.e., ~62% return on a 5-year investment.

🏷️ The Illusion of “Cheap” Financing

• Dilution: Conversion of convertible securities into common stock dilutes the ownership of existing shareholders, potentially reducing earnings per share.

• Surrender of Upside: Companies issuing convertible securities essentially surrender some of the potential upside in their common stock to reduce their financing costs.

🕳️ The Pitfalls of Stock-Option Warrants

• Artificial Value Creation: Warrants can create the illusion of value, as they separate and monetize the inherent right of common shareholders to subscribe to new shares

• Misleading Earnings: Companies may report earnings per share without adequately accounting for the dilutive effect of outstanding warrants, potentially misleading investors

• Limited Benefits for Companies: Warrants do not guarantee that companies will receive additional capital when needed, as warrant holders are not obligated to exercise their options

⚠️ Invest with Caution

Convertible securities and warrants require careful consideration and analysis:

• Scrutinize New Issues: Approach new convertible offerings with caution, as they often lack genuine investment quality and may be timed to take advantage of market optimism.

• Seek Value in Older Issues: Favor older convertible securities that have developed into favorable positions, offering a better balance of risk and reward

• Avoid Warrant Excesses: Be wary of companies with excessive amounts of outstanding warrants, as this can signal potential dilution and financial instability

• Focus on Fundamentals: When evaluating convertible securities or warrants, prioritize companies with strong fundamentals, reasonable valuations, and a history of shareholder-friendly practices

 3 Key Takeaways

• Wall Street often promotes complex convertible securities with features that limit potential losses but also cap potential gains. These instruments may seem attractive but are generally more trouble than they are worth.

• Similarly, strategies like covered call writing, which involve selling options on owned stocks, sacrifice potential upside for limited downside protection. For individual investors, this trade-off is rarely justified

• Instead of seeking complex solutions to limit losses, the vast majority of individual investors should focus on building a well-diversified portfolio across various asset classes, including stocks, bonds, and cash. This provides a more effective and reliable way to manage risk and achieve long-term investment goals.