Here’s the idea:
- Find options or warrants where the implied volatility (according to the Black-Scholes model) is very low. I consider implied volatilities slightly above the IV of the S&P 500 index to be low. Anything under 30 is low.
- Among that universe of long-term options, find the ones with underlying businesses that are able to compound their intrinsic value at very high rates.
Compounding is very powerful over long periods of time. Options are generally a leveraged way of playing a stock. If a stock is mispriced, the options may be even more mispriced.
Let’s try an example.
Suppose we have an option that expires in 2 years and that the implied volatility is 25%.
If the share price and strike price are $100 (and risk-free rate 0.375%), then the option will cost $14.356.
If the share price compounds at 15%/year, then the stock will make 32.25%.
The same investment through options will make 124.64%.
Suppose that the time period is 3 years instead of 2. The risk-free interest rate is 0.9% and the option costs $18.277.
The common stock will make 52%.
The options would make 185%.
The longer-term the options get, the more mispriced they become. The opposite applies too. Shorter-term options are less mispriced.
Stock volatility and multiple expansion/contraction
Suppose that a stock has a 50/50 chance of seeing its earnings multiple expand/contract. This would make the options in the above example even more valuable.
Suppose that the stock has a 50/50 chance of gaining or losing $100 before the options expire in 3 years.
The common stock will have the same expected return: 52%. (The stock will be priced at $252.0875 or $52.0875.)
The options’ return would increase to 316%.
The lesson here is that any volatility is good for the options.
In practice, it is difficult to predict expansions and contractions in the earnings multiple. However, over long periods of time, I think it is reasonable to expect that undervalued stocks will see their multiple expand more often that not.
Kinder Morgan
The concepts above apply to Kinder Morgan. In my opinion, the valuation of the Kinder Morgan warrants should be driven mainly by the following factors:
- Growth in the underlying business.
- Volatility of the stock price due to the whims of Mr. Market.
- The likelihood of multiple expansion.
#1 is difficult to predict accurately. However, management has given conservative estimates as to Kinder Morgan’s distribution growth (8%) excluding the impact of accretive acquisitions.
#2 is impossible for me to predict. However, any volatility is good for the warrants.
#3 is somewhat easy to predict. The company is buying back shares. Insiders are buying back shares. Richard Kinder is not the kind of CEO who buys back shares when the share price is high and stops buying back shares when the market is in a panic. He is buying back shares because they are underpriced. I think that multiple expansion is more likely than multiple contraction.
Some example valuations of the Kinder Morgan $40 warrants due May 25, 2017
Let’s make some fairly conservative assumptions.
- 8% growth. In the Black-Scholes model, plug in 8% as the risk-free interest rate.
- 18% volatility. Roughly the same as the S&P 500 index.
- Stock price $33, strike price $40, time to maturity rounded down to 3 years
- No multiple expansion/contraction.
The warrants would theoretically be worth $4.806.
How about some more aggressive assumptions?
- 10% growth / risk-free interest rate.
- 22% volatility.
- No multiple expansion/contraction.
The warrants would theoretically be worth $6.601.
I don’t think that I can make very accurate predictions about what the warrants ought to be worth. However, it seems to me that they are mispriced.
(*I ignore the effect of dividends and changes in the dividend rate.)
(**EDIT 4/27/2014: I forgot to account for the dilution from warrants. See the end of this post for the necessary adjustment.)
(***EDIT 4/27/2014: Over time Kinder Morgan’s growth will slow down, so you could make the argument that its multiple should fall.)
Please be careful and do your own homework
I am not an options expert. Options can definitely get you into a lot of trouble.
Warrants and options aren’t quite the same. The Kinder Morgan warrants have a dividend adjustment feature not normally found with stock options. In theory, Kinder Morgan can screw the warrant holders by increasing its dividend. The dividend adjustment feature of the warrants only places a cap on how much Kinder Morgan can screw the warrant holders. In my opinion, it is unlikely that Kinder Morgan will try to do this. The FAQ on the website doesn’t even mention the dividend adjustment feature.
With options, there are various ways in which you can get screwed.
- You can take on an incredible amount of leverage with options. Too much leverage can get you into trouble.
- High-speed computerized traders will mercilessly pick off orders that are based on slower quotes. This likely will not happen that often with the Kinder Morgan warrants because (A) they are difficult to price accurately and (B) they are fairly liquid.
- Various forms of front-running may occur on the options exchanges (e.g. rebates, price improvement, etc.).
- Spreads on options are often unnecessarily wide, especially on options that are quoted in increments of a nickel or a dime. (I personally think that this exists to the benefit of market makers. If stock markets are rigged, the options markets are even more rigged.)
- The Options Clearing Corporation may make decisions that benefits market makers more than investors.
- Brokers tend to charge much higher commissions for options than common stock.
- With retail brokerages, order execution on options trade may be atrocious. (But I really have no idea about this. I use Interactive Brokers.) You should be wary of any broker that receives kickbacks via payment for order flow (virtually all of them).
- Your broker likely will not remind you to exercise your deep-in-the-money options early if it would be beneficial for you to do so.
- Theoretically, there is clearing risk with options.
- Etc. Etc.
I normally don’t like talking about options on this blog because you can do a lot of degenerate things with options. Please don’t blow yourself up.
Links
My original write-up on Kinder Morgan.
My post on Berkshire Hathaway’s derivatives contracts.
You can find Black-Scholes calculators through Google. Here is the one I used.
*Disclosure: I own a lot of KMI warrants. I own a few LEAP call options on KMI (the warrants may or may not be more attractive). I do not own any KMI, KMP, KMR, or EPB common. If I did own the common stock, I would have to pay withholding tax because I am Canadian. My decisions may or may not be driven by personal tax consequences that may not apply to you.
Warrant Dilution
(This section added 4/27/2014.)
- At the end of YE2013 (10-K), 347,933,107 warrants were outstanding.
Approximately 31 million warrants repurchased in Q1 2014 (press release).
That leaves 317M warrants outstanding. - At the end of Q1 2014, 1,036M common shares were outstanding (press release).
If the warrants are exercised (assume no cashless exercise), then the combined number of shares would be 1,353M. Common shareholders would own 76.6% of the shares (1,036 / 1,353).
The bottom line is that everything above $40 gets diluted to 76.6%. So if the shares would normally go to $50 without dilution, they should instead go to $47.66 ($40 + $10 * 76.6%). Similarly, the value of the warrants should be multiplied by 76.6% to account for dilution.
The Kinder Morgan warrants currently trade around $1.80.
Example valuation #1 puts the value at $4.806 * 76.6% = $3.68
Example valuation #2 puts the value at $6.601 * 76.6% = $5.06