Tuesday, 7 August 2012

AIG, BAC Warrants - Bruce Berkowitz's Thoughts

We have just read Bruce Berkowitz's semi annual letter and was more than glad to see him discussing about the long-dated warrants that we have mentioned in previous posts.

Here is the snapshot of the returns that he is projecting for the different warrants:
Source: http://www.fairholmefunds.com

Both AIG and BAC warrants are high up on the list, offering returns of 752% and 592% respectively.
We have used even more conservative growth rate than his suggested 10% growth in book value through the years. What is interesting here is that Hartford warrants have almost the similar returns as AIG warrants. We will probably do some work on it.

On investing in the warrants, we always have people asking us how come then with such returns, well known value managers are not putting their money in the warrants but instead in the common stocks?

The reason is they can't. There is simply not enough volume of warrants out there in the market for them to buy. Bruce himself already holds close to 25mil of the 75 mil outstanding AIG warrants. That is almost 1/3 of the entire float!

But for retail investors, that is a different case altogether. We can instead buy in to these warrants and hold on till expiry and chances are, you will be getting a huge paycheck at the end!


  1. Nice. I believe his cost basis on the warrants is roughly $8 for AIG and roughly $4 for BAC. Wish he would mention the exact amounts in his letter, but nonetheless it's nice seeing him mention them. Note: he did have to sell out of about 3% of his AIG common but that was due to redemptions.

  2. absolutely, a storied franchise that is traded in the market at half its book value. Don't think we will ever see this kind of opportunity again.

    Bruce will get his revenge pretty soon on all the naysayers!

  3. Assuming his cost basis is $8 on AIG and $4 on BAC, his theoretical return implies that the price of the AIG warrants would be $68 and the BAC warrants $27.

  4. Value Ground, do you think Berkowitz was using current market prices or his cost basis when calculating theoretical returns? I would assume his cost basis as this letter was to his shareholders and they would only be concerned with the theoretical return of their invested money.

    Also, do you agree that his cost basis is $8 on the AIG warrants and $4 on the BAC warrants?


  5. Using his projected CAGR in BV of 10%, and pb of 1, it would seem that he is using fairholm fund cost per warrant to calculate his returns for AIG. We believe his cost is in the range of $7.5 - $8.

    Likewise for BAC warrants, if assuming so, his cost would be in the range of $3.5 - $4.

  6. So, let's take the average of those ranges: $7.75 AIG and $3.75 BAC. Using his theoretical returns he expects a warrant price at expiration of $66.03 AIG ($7.75 * 8.52) and $25.95 BAC ($3.75 * 6.92). Does that seem reasonable?

  7. In fact, we would say, its a very conservative price to begin with.

    Remember, both AIG and BAC got a good number of years to grow and return back to normalized earnings before the expire date.

    And as huge storied franchises, AIG is still today's one of the largest insurance company in the world, BAC one of the largest bank in America, we would really not expect them to trade at price to book of 1.

    AIG could easily go pass $100, and bac above $40.

  8. I agree, especially when you consider the history of P/B for both companies. Well above 1.2 (oftentimes north of 2.0) for both for nearly their entire respective histories prior to the most recent financial crisis. Just some of the reasons that AIG warrants and BAC warrants are my two largest holdings. Thanks for your feedback, VG.

  9. Congratulations! you are on your road to riches!

  10. I was glad to find your site because our portfolio allocations are very similar and your analysis and approach validate my own. The only investments I own are GOOG, BRKB AIG.W and BAC.WA. At today's prices, would you invest new dollars in AIG, HIG or BAC warrants. I try to add to these position with each paycheck given the likely returns. Thanks,

  11. You have a great portfolio over there!
    Though we will not normally consider tech investments, Google is an undeniable great company we have seen.
    At the moment, AIG warrants have run up pretty much over the recent months, such that we believe BAC warrants offer a higher upside at current price of about $3.6.
    With new dollars, we would choose to load up more on bac warrants A for now.
    We are also considering a small investment in Citi warrant A, tremendous upside opportunity!
    You might wish to take a look.

  12. My take on the Citi warrants is that the strike price is too high, making the risk/reward calculation less attractive than the other TARP warrants and most likely the Citi common itself. Have you done much work on the Hartford warrants?

  13. We looked at Hartford warrants too, and you will find that Berkowitz projected returns is pretty high. Nothing interests us though as the upside we calculated is way below, for example, BAC warrants. It could be because Berkowtiz is using his fund's cost price as the base for calculation, which is extremely low when he bought it.

  14. Keep in mind that you need to own 10 Citi warrants for every share you want the right to convert. Each warrant represents 1/10 of a share. If they were 1-for-1 warrants-for-shares I might be a buyer, but 10-for-1 makes it a poor play, in my opinion. Here's the prospectus which explains it: http://www.sec.gov/Archives/edgar/data/831001/000095012311005624/y89178b5e424b5.htm

  15. Here are my thoughts on HIG. AIG and BAC will not fail. If they fail, the entire world economy and capitalism fail. They are far too important. HIG could fail and it would hurt, but their failure would not crush the economy nor the world permanently. Couple that with the excellent and reasonable returns that are likely to be seen with the "too big to fail" AIG and BAC warrants, and you're likely to come to the conclusion that those two companies should be owned instead of HIG.

  16. That is incorrect Mark, each citi warrant allows the right for conversion to 1 common stock of Citi. The strike price and warrant price has already been adjusted for the stock combination.

  17. VG, scroll down to the 3rd page of the PDF at the link below. You'll see the explanation that even with the high strike each warrant only converts to 1/10th of a share...

  18. Warrant share number prior to adjustment:
    one share of common stock
    Exercise price prior to adjustment:

    Warrant share number after adjustment:
    1/10th of one share of common stock
    Exercise price after adjustment:

    The adjustment was a double-whammy (strike rises, conversion ratio drops) and many mistakenly believe the adjustments moved in tandem. Probably one of the major reasons Berkowitz doesn't own Citi warrants.

  19. Hi Mark,

    Great thanks for pointing out, we went back to recheck and found out you are right. The warrant price has not been adjusted, and the conversion would now be 10-1.

    You save us from making a foolish bet on citi warrants!

  20. You're welcome! And thanks to you for your great blog and information on AIG and BAC.

  21. VG, any thoughts on SHLD?

  22. Mark, SHLD is a long term declining business. Though we have great respect for Eddie Lampert, the fact is, turnarounds usually dont turn around!

    Eddie has done a lot in terms of creating value for shareholders through numerous spinoffs and transactions. We believe there is little left in terms of upside going forward.

  23. VG, with all due respect, those are some of the exact reasons I think Wall Street is missing the real story here. Here's a brief summary of my thesis:

    Why Sears? They stink, right? Who shops there anymore? Nobody does. Yes, they stink. But this is not a retail investment. It is an investment based on their real estate. That is a major difference. For all I care they could have ice rinks or sell tulips or be huge skate parks, whatever, the retail aspect of Sears is not the investment thesis.

    Just a couple points:

    -real estate: SHLD is selling unprofitable/weak stores at about $20M each at the beginning of the real estate recovery (we're in about the 2nd or 3rd inning of the real estate recovery if you want to think of it in baseball terms... so there's a long way to go until real estate is fully valued which is good for those investing now).

    -real estate: SHLD owns about 850 stores that might eventually be on the chopping block. At $20M each that's $17B. Let's cut that in half (good to do that for margin of safety)... that's still $8.5B, let's round down to $8B.

    -business operations: SHLD auto, appliance repair, parts direct business, interest in Sears Canada, K-Mart, etc. is worth roughly $12B-$18B. I am placing $0 value on this, so it's all bonus. HUGE margin of safety by doing that in my analysis.

    -Eddie Lampert (CEO) is in position to copy-cat the JCPenney model if it proves to work (the shops concept is working) and he can implement that later if he wants to. Again, I am placing $0 value on this, so it's all bonus.

    -stock price: SHLD's market cap (number of shares multiplied by share price) is $6B ($58 per share * 103M shares). Here's the kicker... valuing only the real estate at firesale prices (1/2 of what their real estate is actually being sold for... cutting $17B down to $8B), completely dismissing any value of their business operations, ignoring their Sears Canada stake, and ignoring everything else, that still places a value of $8B. $8B is a 33% jump from the current $6B the stock is being valued at. So, I'm buying a business (it's good to think of it as buying a business instead of buying a sheet of paper/stock, because in actuality you are buying a business by investing) in which I will make money even if the company never sells another item, the real estate only sells for 1/2 of what it's currently selling at (at the beginning of a real estate recovery, by the way). And the company is being led by one of the smartest investors of all-time, and he's been buying shares like crazy. This is the general investment thesis (there's more to it than this but this is the most important stuff).

    If you watch the media or ask a friend they won't be able to tell you any of this regarding the real estate, they'll just go on and on of how "nobody shops at Sears," thus missing the point of investing in SHLD completely. And that is exactly the thinking of the average investor that gives us such an amazingly attractive share price. Want a fun experiment? Ask your wife or a co-worker or a friend if they'd ever invest in Sears and then ask why not... I'll bet you a nickel you won't hear any mention of the valuation of the company, Lampert as CEO, real estate advantages, etc.

  24. yea we do aware there lies tremendous value in their real estate portfolio. However, look at what happened to Kmart in the past, they are force to fire sale their real estate, and some of them dont even fetch up to 25% of their projected market value!

    Besides that, what you accounting for is the assets they have, if you take a look at their liabilities portion, you will find that they have equally huge liabilities to pay off.

    Total borrowings of about 3.7bn, pension liabilities of 2.6 bn, giving them an EV of 11+bn at current market cap of 5.2bn.

    Another concern is essentially, Sears is a black box retailer. They incur very high fixed cost and with declining sales, margins will collapsed and thus they will incur huge losses. Its tough to look at them as a real estate play, as they cant fire workers overnight and start selling off their estates. Its not as simple as that.

    The only way for Sears to survive, would be a turnaround, with improved sales going forward.

  25. VG, have you taken a look at the balance sheet from a guarantor vs non-guarantor perspective? It gives major clues where SHLD is heading and answers some of your concerns above.

  26. It would help if you could elaborate more on the Guarantor vs non-guarantor you are referring to.


  27. Pages 20-26 of the most recent 10-Q. The health of the "non-guarantor" subsidiaries is excellent, very little debt. Not noticing this or recognizing the distinction between "non-guarantor" and "guarantor" is a major miss by those studying SHLD... especially those predicting bankruptcy for the entire SHLD enterprise. Let me know if you see anything alarming in the "non-guarantor" financials... I'm trying to 'kill' my long-thesis but it's very difficult to do.

  28. VG, have you looked at this yet? SHLD is truly a "drop everything and study this thing a bunch" type of opportunity. SHLD bankruptcy is simply not in the cards, it's just not going to happen if you look at the guarantor vs non-guarantor. Sears retail could flop, sure, let it die... but Sears Holdings is where the value is and is the part of the equation (the only part that really matters) that Wall Street is missing.

  29. Have you been keeping your eyes on the BAC warrants (A) --- they seem really mispriced right now. Any thoughts???