When Bank of America (NYSE:BAC) was in deep trouble following the financial crisis, Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) came to the rescue with an enormous investment in the struggling bank. Part of this investment was the right to purchase 700 million shares of BAC at a strike price of $7.14 via warrants that expire in 2021. The Treasury, having received different warrants as part of its bailout efforts, subsequently auctioned theirs off and as a result, they are now publicly traded instruments. In this article, we'll take a look at how individual investors can buy BAC warrants and own the right to BAC stock in a similar fashion as Buffett does.
To begin, we'll only be looking at the BAC "A" warrants in this article (BAC-WTA, may differ depending on your broker). These warrants expire in January of 2019 and give the holder the right to purchase one share of BAC common stock for each warrant held at a strike price of $13.30. In addition, the warrants have a provision where the strike price is reduced if BAC raises its common dividend over the current 1 penny per share per quarter. For instance, if BAC issues a dividend of 10 cents instead of the current 1 cent, the strike price on the warrant will drop 9 cents to $13.21.
So what makes these an advantageous way to buy BAC? The obvious advantage to these warrants, and the reason I suspect Buffett made a similar, but more lucrative deal, is that they provide cheap leverage on BAC. Basically, what you are buying is a very long-dated call option, much longer than you can currently buy in the options market. This means you've got to be long term bullish on BAC, and anyone who reads my articles knows I am. You've also got to believe that BAC shares will rise appreciably in the next five years or your warrants will finish with a loss.
The other reason besides leverage is that the warrants adjust for dividends. Call options don't afford this protection for holders but this is a terrific provision for warrant holders as it means that dividends paid on common shares won't make it that much more difficult to achieve the breakeven point on the warrants. If you own a call option on a stock that pays a large dividend, when the stock goes ex-dividend the share price is reduced by the amount of the dividend. However, the strike price in your call option stays the same, making it more difficult to achieve breakeven. With the provision in the warrants, that is not an issue.
With these warrants trading at $7.20 as of this writing and the $13.30 conversion price, the breakeven price needed for these warrants by January 2019 is $20.50. While that is a robust 26% gain from BAC's current pre-market price today, we also have nearly five years for that to take place. Thus, the small premium on this warrant given the time that is still outstanding makes it an exemplary value in my view.
The investment thesis for these warrants is pretty simple. For those that think BAC will not pay a substantial common dividend, and thus have no reason to hold the common stock for income purposes, this warrant offers the chance to more cheaply gain exposure to BAC common shares' upside potential. The additional upside comes from the conversion price reset if BAC begins to pay a larger dividend than today; warrant holders don't have their breakeven points disadvantageously affected by common stock dividends being paid. This is an enormous benefit of these warrants and is a significant advantage over traditional call options.
With the warrant price trading less than half of the common stock price, investors wanting to gain some cheap leverage in BAC would do well to look at the "A" warrants. They offer extremely cheap leverage considering the time premium is only around $4 and that the expiry is nearly five years away. This puts the odds in warrant holders' favor and if BAC shares don't appreciate for some reason, the risk of loss is minimal. Given that you are in a very similar position to Buffett in owning BAC warrants, there are worse places to invest your money. Given my price target of $25, these warrants would offer tremendous upside if I prove correct, with a $4.50 gain on a $7.20 investment.