Short-Term Opportunity in FFBC Warrants
Nov/100
There is a short term trading opportunity in First Financial Bancorp warrants (FFBCW). A large holder of FFBC warrants is liquidating his stake. FFBC reported a good 3rd Quarter and the stock is rising, but the price of the warrants is flat to down as the holder sits on the offer side of the market. I estimate this large holder has sold ½ to 2/3 of his position. He could finish selling his position Monday or Tuesday. After he is “cleaned up” I would expect the price of these warrants to recover to higher implied volatilities.
The large holder of FFBC warrants could be Castle Point, which is run by Todd Combs. Combs was recently hired by Warren Buffett to run a sizeable portion of Berkshire Hathaway’s investment portfolio. Combs is liquidating Castle Point. According to Castle Point’s 13-HF filed in August, Castle Point owned 304,917 FFBC warrants. There are only a total of 465,117 FFBC warrants outstanding. Castle Point owned 65.56% of the issue!
I estimate Castle Point has sold most of its holdings of FFBC warrants. Since the announcement of Buffett’s hiring of Combs, the volume of FFBC warrants traded has risen substantially. The total FFBC warrants traded since the October 22nd announcement is 220,697. Assuming that a very high percentage of these were sold by Castle Point, the firm could be as much as 50% or 2/3 done selling its position.
I expect the warrant’s price to return to higher implied volatility once Castle Point has completed its selling. Below is a table showing FFBC’s stock price, warrant price and warrant implied volatility on different dates. The first date was June 2nd, which was the date when bids were due in the Treasury auction of FFBC warrants to the public. The next date is September 30th, which was the most recent quarter end and a day when some volume of FFBC warrants traded. The last day is last Friday, November 5th.
| 6/2/10 | 9/30/10 | 11/5/10 | |
| FFBC Stock Price | $15.87 | $16.68 | $17.69 |
| FFBC Warrant Price | $6.70 | $7.65 | $7.00 |
| Days to Expiration | 3084 | 2964 | 2928 |
| FFBC Warrant Implied Volatility | 40.69% | 43.65% | 34.91% |
In the table, we can see the current implied volatility of the warrants is lower than it has been on the previous dates. I believe once Castle Point is doe selling its position that the implied volatility of the FFBC warrants will slowly rise back to somewhere in the low-40’s. If I am correct, a low-40’s implied volatility at the current stock price would imply that the warrants would rise between $1.00 and $1.50. This would be a 14% to 21% increase in warrant value.
My suggestion is to wait on the bid side of the market and let the large seller push the price down to your bid. If the seller does not hit your bid in the next two or three days and volume of the warrants approaches 100,000, then you may want to get more aggressive with your bid. Once the large seller is done liquidating his position, I expect the volume of FFBC warrants to decline materiallyand will be difficult to buy. It is possible that future traded volume will be higher than it was prior to the Castle Point liquidation because the outstanding warrants will be held more widely. Another consideration is hedging your warrant purchase to protect against the stock declining. FFBC has rallied since reporting a decent quarter last week. It is not clear whether the rally will continue or if the recent price move was blip. I would argue the recent rally in the stock has allowed the large seller to exit his position for a decent nominal price even though the relative value price based on implied volatility is low.
Disclaimer: This is not investment advice. Investing in warrants is risky. Please see your financial advisor for independent investment advice. I do not have first-hand knowledge that Castle Point is responsible for the recent selling of FFBC warrants. I have used the mosaic theory to make my conclusions based on Castle Point’s SEC filing, Berkshire Hathaway’s press release, articles in the Wall Street Journal, and volume data from the NASDAQ. If you first read this post after November 9, 2010, the opportunity in FFBC warrants is likely gone.
Disclosure: Long FFBCW
Best One Liners from Buffett’s 2010 Shareholder Letter
Mar/101
I always enjoy getting up the first Saturday in March to read Warren Buffett’s annual letter to Berkshire hathaway shareholders. Here are my favorite one liners from this year’s letter:
“I subtly indicated that I was older and wiser…I was just older.”
“If Charlie, I and Ajit are ever in a sinking boat – and you can only save one of us – swim to Ajit.”
“We shouldn’t expect our regulators to live up to their end of the bargain unless we live up to ours.”
“It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.”
“There were three ways to cure this overhang: (1) blow up a lot of houses, a tactic similar to the destruction of autos that occurred with the “cash-for-clunkers” program; (2) speed up household formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers or; (3) reduce new housing starts to a number far below the rate of household formations.”
“Our first venture was also christened Berkadia. So let’s call this one Son of Berkadia. Someday I’ll be writing you about Grandson of Berkadia.”
“It’s been an ideal period for investors: A climate of fear is their best friend.”
“In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.”
“It has not been shareholders who have botched the operations of some of our country’s largest financial institutions.”
“In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control.”
“Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy.”
“our recommendation in respect to the use of advisors remains: ‘Don’t ask the barber whether you need a haircut.’”
“P.S. Come by rail.”
If you didn’t see your favorite Buffett one liner from this year’s letter, please tell me yours and why in the comment section below.
You Don’t Want Berkshire to Pay Dividends
May/090
This year Carol Loomis asked the question whether Berkshire should start paying dividends since the stock price hasn’t risen in 5 years. This was in reference to Buffett longstanding quote that he will pay a dividend when he thinks he can’t create at least $1 of market value for each $1 of retained earnings. Jeff Matthews refers to this as a question that Buffett avoided answering in this thought provoking blog post.
My opinion is who cares whether Buffett answered the dividend question. If you are even asking the question, you should sell your Berkshire stock. The reason to own Berkshire is to get access to Buffett’s capital allocation decisions. Based on his well-documented track record and his well-know thought process, most Berkshire investors think Buffett can make better investment decisions and/or has access to better investment opportunities than they do. The last thing Berkshire investors should want is to have Buffett return the cash back to them in a taxable transaction. Then, the investors will have to decide how to allocate the returned cash.
Historically, investors have wanted management teams to pay dividends because they don’t trust management to spend the free cash flow from the business wisely. The business may be not need capital reinvestment, like Coca-Cola, or it may be a business in secular decline where the best thing to do is harvest the cash rather than reinvest. Shareholders of these businesses probably want managements to pay dividends to make sure they don’t destroy value.
Since the main reason to own Berkshire is to get access to Buffett’s capital allocation skills, if an investor wants Berkshire to pay dividends, then they should sell the stock instead because they obviously don’t believe in Buffett’s ability to create value by allocating capital.
There is a scenario where it makes sense for an investor to want Berkshire to pay a dividend. Maybe an investor thinks Buffett destroys value but think Berkshire is so undervalued that they can make a return by owning the stock and getting him to change his dividend policy. I don’t think Berkshire is anywhere close to a valuation level where this would make sense. At $91,500 per share, Berkshire trades at 1.4x tangible book. It would have to trade below tangible book value for this strategy to make sense.
The reason to invest in Berkshire is get access to Buffett’s skills as a capital allocator. If you want him to pay a dividend, you shouldn’t own the stock. You should ignore the 5-year rolling test about whether he adds more $1 of value for each $1 of retained earnings. He is never going to pay a dividend because he’ll never admit that he can’t add value. If he ever does decide to pay a dividend, you won’t want to own Berkshire.
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Signals from Berkshire Hathaway’s Buyback Announcement
Sep/113
Yesterday, Berkshire Hathaway announced a share repurchase program. This is an important milestone announcement in the history of the company because it signals many things to current and prospective shareholders. It signals that the Oracle of Omaha thinks his stock is undervalued. It signals that the stock may perform well over the short-to-medium term. The most important signal is Buffett has setup a framework for buybacks that his successors could use in the future.
Buffett Thinks His Stock is Undervalued
To me, the buyback announcement clearly shows that Buffett thinks Berkshire’s stock is undervalued. On a price-to-book ratio, the stock is the cheapest it has been in the past twenty years. Buffett would not repurchase shares unless
he was getting more value than he was paying. I think this is an uncontroversial point and has been made by other commentators such as Morgan Housel’s Buffett Gets Bullish at the Motely Fool and Jason Sweig and Jonathan Cheng’s Buffett Spots Fresh Bargain: Shares in His Own Company at the Wall Street Journal.
Potential stock outperformance
The last time I can remember Buffett offering to repurchase Berkshire shares was in the 1999 Annual Report which was issued on March 11, 2000. In the 1999 Chairman’s letter, Buffett included a section (starting on page 16) with his views about share repurchases. The letter is famous among value investors because not only did it mark the bottom in Berkshire’s stock, but it also marked the all-time closing high in NASDAQ Composite Index at 5048.62.
The March 2000 mention of share repurchases by Buffett was a great signal to buy Berkshire’s stock. Here’s a table comparing Berkshire’s stock to the S&P 500 over the next few time periods
In 2000, the stock had strong performance over the next year on both a relative and absolute basis. Even though the stock was up 8.6% yesterday, which is weirdly similar to its 1-Day performance after the 2000 repurchase offer, the stock could go on to additional gains in the coming time periods. I believe this is due to the market anomaly that stocks under react to good news because investors have a tendency to sell shares to lock-in gains in spite of good news.
Allocate Capital from the Grave
The most important signal from Buffett’s announcement of a stock repurchase plan is it sets up a major part of Berkshire’s capital allocation framework for the post-Buffett time period. In Buffett’s announcement of the share repurchase, he added three unique guidelines that:
The combination of these three guidelines will allow the Board and his successors to execute the share repurchase program after Buffett has passed without argument or second-guessing.
The worse scenario post-Buffett for Berkshire shareholders would be for the stock to trade at a discount to intrinsic value and have a Board argue that the company shouldn’t implement a stock repurchase program because Buffett had never had one. The cash would continue to pour into the company’s coffers and be trapped. The stock would trade at a higher and higher discount as cash was trapped. Even worse, his successors could try to use the capital to make acquisitions when repurchasing the stock would be a better capital allocation decision. The only way out of such a situation would be the break-up of Berkshire Hathaway.
This announcement takes away this downside risk of Berkshire’s Buffett premium turning into a post-Buffett discount. Buffett’s successors will have a clear framework as to how to evaluate stock repurchases. It could put a floor on the company’s valuation. I believe it could put the company’s capital allocation decisions on auto pilot for decades. If the stock trades close to book value, Buffett’s successor will probably use excess cash to buyback more and more shares and not make additional acquisitions.
Changes My Opinion of Berkshire’s Stock
The Berkshire share repurchase announcement changed my opionion of the stock. Prior to yesterday’s announcement, I had thought Berkshire’s stock was uninvestable due to Buffett’s inevitable death. With the framework that Buffett setup for share repurchases, the downside scenario of Berkshire trading at a steep discount to intrinsic value post-Buffett is nearly eliminated.
Based on how the stock performed in 2000 after Buffett’s last repurchase offer, I would guess there is still more upside to the stock.
If you have a different opinion or perspective please comment.
Disclosure: Long BRK-B
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing Berkshire. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.