TARP Warrants Again Worth Watching

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Includes: COF, WFC
by: Terrier Investing

Summary

TARP warrants have been a value investor favorite for several years.

I sold my WFC and COF warrants for a nice profit after they ran up, but now that markets are tanking, they've come back on my radar.

These are too illiquid for big funds or institutions, but smaller funds or individual investors should keep an eye on them.

This is a relatively straightforward thesis which I've written (and profited from) before: the TARP warrants of several well-capitalized, well-managed, generally risk averse banks, most notably Capital One (NYSE:COF) and Wells Fargo (NYSE:WFC). Summarily, these warrants expire in the fall of 2018, are based on strike prices at or below book value, and offer investors leverage to price appreciation in the stocks of those banks while paying very low (or no) time premium. You could either do these as a pair trade against options or the stock, or you could just buy them straight up at a price you felt comfortable at, depending upon your views of the American economy over the next few years.

Here's an overview of the relevant facts regarding each.

Wells Fargo

I'm not going to spend much time discussing Wells Fargo because I assume most investors are familiar with the general thesis... it's Buffett's favorite bank. This is less an article about whether or not you should like Wells Fargo and more about the warrants. The prospectus is available here. Key terms:

  • Expiry is on October 28, 2018.
  • Strike price is $34.01 per share (a hair above Wells' current book value of $33.69).
  • Warrants are adjusted for the amount of any quarterly dividends above $0.34 (WFC currently pays $0.375).
  • I'm not sure if the buyback provision counts for non-tender-offer buybacks so I'm not making any adjustments here.

At the last quoted price of $15.95 (call it $16), the warrants bake in roughly 50 cents of time premium with WFC at $49.50.

In contrast, $35 strike calls expiring in January 2018 (nine months earlier) trade for $15.12 at the midpoint - a little bit higher time premium - and they obviously don't have the adjustment provisions.

Capital One

Capital One has been cheap for a while and I'm really not sure why. While I'm hardly arrogant enough to call myself an expert on the segment-by-segment credit quality of any mega bank, Capital One has actually been prudent in several areas that I can identify, such as staying away from subprime auto loans amidst the recent froth, and letting acquired loans from HSBC (NYSE:HSBC) that didn't fit its credit preferences run off. Exposure in "scary" areas like energy and taxi medallions does not appear to be substantial. Rich Fairbank is smart, the bank is well-positioned for the ongoing secular trend to digital, and it is shareholder friendly with capital returns.

Warrant prospectus is available here. Key terms:

  • Expiry is on November 14, 2018,
  • Strike price is $42.13/share (vs. tangible book value per share of $54.66).
  • Warrants are adjusted for the amount of any quarterly dividends above $0.375 (COF currently pays $0.40).
  • Similar provision for pro rata share repurchases.

At the last quoted price of $24.35, the warrants bake in roughly $2.20 of time premium, which is slightly above the midpoint of the options - but there's a narrower bid/ask on the warrants, and they will receive at least 27 cents worth of adjustments assuming a flat dividend.

What I'm Doing

Based on recent experiences, I've become substantially more averse to leverage than I was previously - and, additionally, I have several unlevered (actually, highly unlevered) investment opportunities with great IRRs. So I don't own these right now and am not yet in a hurry to buy. That said, if this selloff deepens to a point where the banks are trading at very cheap multiples, a basket of TARP warrants is a decent way to gain long equity exposure for a cheap price without tying up too much capital.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.