Traditional corporate equity warrants

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6. Disadvantages of warrants

Gearing

The principle attraction of warrants is their gearing. But it is also their greatest danger, as gearing works both ways. Warrants can rise spectacularly fast; they can also plummet just as quickly. However, as with most investment, the task is to use analysis and apply the right strategy to control as far as possible the risk/reward profile. Investment instruments are rarely risky in themselves; rather it is the strategies that use those instruments that are risky.

Complexity

Warrants are certainly more complex than shares, and this can put many investors off. Large losses are possible in the market if one does not understand what one is doing. Some investors inevitably dip their toes into the warrant market without adequate preparation, get burnt, and retire never to look at warrants ever again. This is a shame. Understanding the topic does require some basic mathematical analysis, but it's far from rocket science. In fact, many investors are drawn to warrants precisely because of the seemingly more objective mathematical analysis, than the subjective analysis required by some other types of investment. Besides, complexity sometimes breeds opportunity. Rewards are there for investors who take the time to study the topic properly and diligently apply the right analysis.

Liquidity

The total size of most warrant issues is very small, which leads commonly to low turnover and wide bid-offer spreads. This can cause difficulties with dealing, and is probably the biggest problem with warrants. It is a particular problem for large fund managers and short-term traders, while less of a problem for individual investors with a longer-term outlook. It is important for all investors to be aware of the potential problem, and to realise that their room for maneuver may be limited. (This is dealt with in more detail in the later section: 'Dealing in warrants').

No income

Warrants are pure speculative, capital gain plays. Warrant-holders get no dividends or any other type of income. They are therefore not appropriate for all investors - especially older investors who are typically interested in income. (It sometimes seems that for every rule for warrants, there's a counter example. In this case, there have been some innovative warrants that do offer income. However, they are still very rare. As always, make sure you read carefully the warrant terms).

Note: While warrants themselves may offer no income, there are various strategies, involving warrants, that do offer income.

Limited rights

Warrants do not form part of the issued share capital of a company and therefore confer no rights beyond the right to buy shares at the stipulated price. Therefore, warrant-holders cannot vote, attend AGMs or benefit from other shareholder perks. In most cases, this will not worry warrant holders, who are invested purely for the speculative gain. However, one area does need watching: takeovers.

Takeovers

In a takeover situation, the target company's warrants will be annulled. Warrant holders will therefore be forced to exercise their warrants, or sell the warrants, at that time. This has the effect of immediately realising the intrinsic value of the warrants, but losing the premium (time value). In the case where the bid price is below the warrant's exercise price (i.e. there's no intrinsic value), the warrants would become worthless. In the past, there was little formal protection in the warrant documents for warrant-holders to guard against it. And the consequent threat of this led to a permanent low rating for some warrants. Fortunately, more and more warrants now have a formal compensation scheme for warrant-holders in the case of a takeover. But, obviously, this is an important issue that investors should be aware of.

Limited range

The size of the warrant market expands and contracts according to the mood of the wider stock market. In a bull markets, the number of warrants issued tends to expand, while vice versa in a bear market. But overall the number of listed warrants is far smaller than the number of listed shares, leading to a limited range of warrants available for investment.

Lack of information

It can be frustrating trying to find information about warrants. Not all prices are listed in the FT, and information, and certainly analysis, is scarce even on the internet. Although the situation is a little better for investment trust warrants. But a common refrain throughout this course is that where one investor sees a problem, another sees opportunity. The dedicated warrant investor is perfectly happy that the warrant sector is partially hidden, and information difficult to come by!

Dilution

This is not directly a problem for warrant investors, but a side effect of warrant issues that affect the underlying shares. When warrants are exercised, new shares are issued, which dilutes the holding of existing shareholders with the consequent impact on figures such as the earnings per share and net asset value. Most company analysts will take this potential dilution into account, and therefore its impact is usually reflected in the share price already.

Summary

The above catalogue of disadvantages of warrants may seem a formidable disincentive to investors thinking of investing in warrants. However, of the above, only the liquidity issue is a significant problem. Of the rest, they can all be dealt with by careful planning. Indeed, the shrewd warrant investor can use these 'disadvantages' to his benefit.

1. Introduction 2. What is a warrant? 3. The warrant market 4. Advantages of warrants over shares - the magic of gearing 5. Further attractions of warrants 6. Disadvantages of warrants 7. Fundamentals - warrant terms 8. Fundamentals - intrinsic value and parity ratio 9. Basic analysis 10. Analysis - time value and premium 11. Analysis - gearing 12. Analysis - break-even and capital fulcrum point 13. Analysis -sample spreadsheets 14. Analysis - summary 15. Investing strategies 16. Dealing in warrants 17. Warrant exercise 18. Further topics 19. Further information 20. Conclusion

• Andrew McHattie on Covered Warrants