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On the warrant path

I would like to conclude my discussion of the information contained in the financial pages of the quality press by turning to a personal indulgence of mine, which I believe to be widely overlooked by most other investors – warrants. In particular, I will be looking at warrants in investment trusts, as most of the actively traded warrants on the stockmarket are in this sector.

I must start by stressing that I do not believe warrants should represent a mainstay – or perhaps even a part – of the portfolio for most investors but the principles emanating from investing in warrants can certainly be applied to other areas of portfolio planning.

First, it is probably useful to confirm that warrants, while listed in the share price pages, are not really shares at all. They confer on the holder the right to buy shares in a company. In themselves, therefore, they are worthless except in so far as they give the right to buy something which has value. Even this potential value can be disputed for many “out of the money” warrants, as I will note later.

Warrants are generally noted as being highly volatile and worth consideration only by very high-risk investors. But while this is the most obvious category of people who might consider such investments, they can alternatively and very profitably be used as a defensive investment for a wider range of equity investors.

For example, shares in Golden Blades are quoted in the financial pages at £1. Some months ago, it issued warrants which confer on the holder the right to buy shares in the company for 90p at any time until the end of the 2007.

It should be clear that warrants in Golden Blades have a current intrinsic value of 10p as the warrant holder could buy the shares at 90p and immediately sell them on the market at a 10p profit. This is an example of a warrant which is “in the money”, meaning that it has some value as the exercise price (that is, the price at which the share may be bought under the terms of the warrant) is lower than the current share price. One would therefore expect the warrants to be tra-ded at 10p or more. Why might they be priced higher than 10p? Consider a second example.

Shares in Hillsborough, a pig trader, are quoted in the financial pages at 80p. This company also issued a series of warrants some months ago giving holders the right to buy the company&#39s shares at 90p for each warrant held.

This is an example – not untypical, by the way – of a warrant which is “out of the money”. In other words, it has no intrinsic value at all as only a fool would buy the warrants with the intention of using them immediately to buy shares at 90p when they could simply buy shares on the open market at only 80p.

However, investors might still be interested in these warrants and be prepared to pay a few pence for the privilege of owning them. Why?

Using our Hillsborough example, if the share price were to increase over the next few months from 80p to £1.20, the profit to holders of shares in the company would be 50 per cent. Warrant investors, who might have had to pay, say, 3p when the warrant was “out of the money” (for the benefit of the gamble – see below) are now sitting on a warrant which has moved “in the money” and has an intrinsic value of 30p (the current share price less the strike price of the warrant, representing the potential profit to warrant holders). This represents a tenfold -1,000 per cent – profit for the warrant purchaser compared with only a 50 per cent profit for investors in the shares.

This multiplied percentage gain is due to what is known as the gearing of the warrant, which means that movements in the price of the underlying share – upwards or downwards – have a more pronounced effect on the warrant holder than the shareholder. Note that I have included mention of a possible downward movement in the share price as a warrant can easily and quickly become valueless if the share price continues to fall.

So, who might consider investing in warrants and which warrants might be particularly considered?

Without a doubt, warrants are most attractive to people who would otherwise be tempted to buy the underlying shares and are prepared – or even eager – to accept the much higher degree of volatility in the warrants brought about by their gearing.

There are relatively few warrants issued against ordinary shares on the stockmarket but, as I mentioned earlier, there are many warrants issued against investment trusts. This gives a fantastic opportunity for investors to gain from the collective investment attractions of investment trusts combined with the potential to make significant profits (or losses) from the warrants out of relatively small movements in the underlying investment trust share price.

However, consider the possible attractions of warrants to equity investors who seek to minimise their exposure to losses from a certain market sector while maintaining exposure to profits. Impossible?

Suppose that our second warrant, above, is not Hillsborough pig farmers but an investment trust specialising in Japanese equities.

Suppose also that an investor currently has £10,000 invested in a wide range of Japanese equities through a number of collective investment funds such as unit trusts or bonds but is becoming increasingly nervous that Japanese shares might continue to fall in price and wants to limit his risk.

A possible strategy would be for this investor to liquidate his current holdings in Japan, raising £10,000, and to invest just £1,000 of that money in the Japanese equity warrant.

Put simply, if Japanese equities now rise by 50 per cent, then his previous holding of £10,000 would be worth £15,000 – a profit of £5,000. However, his warrant will have increased in value from 3p to 30p – a profit of £9,000 from a base investment of just 10 per cent of his current fund.

If, on the other hand, Japanese share prices fall over the next few months by 30 per cent, then his current portfolio stands to fall by £3,000 (30 per cent of £10,000) while his proposed warrant investment can only lose him £1,000 – albeit his entire investment but still less than he would otherwise have lost.

In summary, investing in warrants can be used as a defensive mechanism to multiply profits but restrict losses when considered as an alternative to investments in the underlying share sectors. Investment trusts exist in a very wide range of these sectors, so it is highly likely that one or more warrants exist to answer many or most requirements. Happy hunting.

Next week, I would like to return to current and imminent developments in the pension market, with particular reference to important but largely unreported court cases which give pointers to the way in which IFAs can be of great assistance to their clients in different circumstances.

Keith Popplewell is managing director of Professional Briefing

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