Traditional corporate equity warrants

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14. Analysis - summary

The section on analysis in this course started by looking at the simple indicator time value, and then step-by-step refined the analysis by -

1. adding further factors affecting the value of a warrant (such as the life of the warrant), and
2. normalising the factors to allow for easy comparison between warrants.

This culminated in the formulation of the CFP indicator, which in its calculation accounts for a warrant's time value, parity ratio and time to expiry.

We then have the problem of knowing which indicators are the best to use, and how best to use them? Unfortunately, that question has no simple answer. No one set of indicators is either right for everyone, or best-suited for all periods in the market. For example -

• short-term traders will be strongly affected by fluctuation in the time value, and will focus on an indicator such as the warrant premium, whereas
• long-term investors will be more interested in the warrant's intrinsic value, and therefore will watch the CFP and analyse the growth prospects of the underlying shares.

Similarly, during bull markets investors may be happy to assign a high analytical weighting to the gearing indicator, whereas in more uncertain times, a low CFP may be the more prudent filter.

The table below lists some of the major technical indicators and factors affecting warrants.

Note that it is not necessary to follow each of the indicators listed in the table individually. For example, the CFP indicator encapsulates pretty much the premium, which in turn encapsulates the time value.

As indicated above, one cannot take one set of indictors as providing the formula for finding the best warrant. The best approach is to select one (or a few indicators) most appropriate to your investing style or market conditions at the time, and use that indicator as a first filter to identify a small set of potentially interesting warrant. This small set can then be filtered further using whatever criteria an investor prefers.

For example, a first filter may be to select only those warrants with a CFP less than 10%. (At the time of writing, this would select 29 warrants from the total market of over 130). Focusing on these 29 warrants, further filtering may be to select only those warrants with a maturity of over 3 years; or where the underlying equity has a PER of under 12; or where the underlying stocks are in one or two specified sectors.

Warrant speculation

There is the temptation for many warrant investors to buy warrants purely on the basis that the warrants have a low premium and high gearing. This is a mistake. Speculatively buying warrants purely for technical reasons is not a sound strategy. Warrants should not be bought speculatively, unless you have a view on the underlying equity. Just because a warrant has a low premium doesn't mean its price will increase. In fact, quite often the opposite will apply - a warrant premium is usually low for some very good reason. So, when speculating in warrants it is always necessary to look at the fundamentals of the underlying equity.

Analytical precision

Some investors may be put off by the complexity of, say, the CFP calculation. Other investors, however, may positively relish the seeming mathematical exactitude they find with warrant analysis. After the frustrating subjectivity of company analysis, warrants may seem mathematically precise and objective. But the warrant market is far from efficient, and all the calculations and indicators must be used with a degree of circumspection. They are tools to be used sensibly in context, not blindly as a short cut for serious research. Also be wary of spurious precision. Just because an indicator like the CFP can be calculated to 4, or more, decimal places, doesn't mean that it is sensible to do so. In practice, there is negligible difference between a warrant with a CFP of 12.24% and one with a CFP of 12.29%.

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