New position – GM B Warrants

I bought some GM B warrants this week under $14. I like GM’s fundamentals for the next several years. GM is widely covered so I won’t go over the fundamentals much other than to say I think it is undervalued here and I don’t think we are near a cyclical peak in auto sales, based on pent up demand, average age of cars on the road, improving employment figures, etc. Even if growth isn’t much from here I think a leveling off is more likely than a cyclical downturn. I also think GM’s quality is vastly improved and their leadership in trucks and SUVs is a positive. Mary Barra seems like the right leader for GM, and I think worries about the ignition switch problem, slowing sales in China, and a cyclical downturn in North America have provided an attractive entry point here.

The reason I established a position in the B warrants this week is because I thought the risk/reward was particularly attractive. Technically GM looks like it has good support around the $30 level, both from a long term support line and the 200 week moving average. Fundamentally I think there is good support with the dividend yield around 4.5%. There are a couple value investors with positions in GM (Berkshire Hathaway, Doug Kass, Mohnish Pabrai) and there was some activist investor activity recently which helped return more cash to shareholders. So if GM were to fall far from the $30 level I think it would quickly find support from an even higher dividend yield, and it becoming even more attractive to value investors.

The B warrants appeared to offer an especially attractive risk reward with where they were trading this past week. The B warrants have a strike price of $18.33 and expire in July 2019. During the past week they were at times trading only $0.50-$0.60 above intrinsic value, with around 4 years until expiration. That is only around $0.12-$0.15 per year to benefit almost dollar for dollar from any appreciation in GM’s shares above current prices.

When I have found these sorts of situations in warrants in the past where they are trading mostly at intrinsic value with very little time premium, and there is a long time remaining until expiration, they have proven not just to be bargain priced, but also a contrarian indicator of sorts. Perhaps the market is so doubtful of the underlying company’s future potential that they believe the underlying shares are likely to trade down and thus the warrants should not carry a premium over intrinsic value. However this could prove to be a beneficial time to go long among the prevailing pessimism.

The last time I encountered such a situation was my trade on ROIC warrants. The warrants were trading only a couple of percent above intrinsic value with almost two years remaining until expiration. Soon after a roughly 17% move in the underlying caused the warrants to more than triple.

On other occasions I have noticed warrants which appeared to be trading significantly below almost equivalent call options. Such was the case with my trade on Ubisoft warrants, which also produced a triple. This also appears to be the case with the GM B warrants currently. There  are Jan 2017 $18 calls on GM which traded last around $13.50 ($13.20 bid, $14.10 offer). The B warrants also traded as low as around $13.5 last week.  Remember that they have a strike of $18.33 (pretty close) but don’t expire until July 2019, around 30 months later. Compared to the Jan 2017 $18 calls, the warrants cost the same for basically the same strike price, but offer an expiration around 2 1/2 years further out.

The GM B warrants don’t have as much leverage as my previous ROIC and Ubisoft warrant trades, but with nearly 4 years until expiration and my belief that GM is undervalued I think the upside is significant, especially in comparison to the downside. I could easily see GM trading at $50-$60 in the next couple years, which would result in a triple in the warrants. I don’t see GM heading much lower than $25 and if that were to occur it seems unlikely to stay there long as it would be approaching a 6% yield at that price. So I think the downside in the warrants could be limited to around 30% or so resulting in an attractive risk/reward ratio.

With my purchase of the B warrants I am down to around 20% cash. I would be willing to double down on my position in the warrants if they were to drop significantly. I didn’t anticipate using my cash so soon, especially with the market looking weak of late and many stocks I follow taking hits after earnings. However I felt strongly about the risk/reward of my recent moves.