“How about MRCB warrant?”

The above question was asked by a participant of my course yesterday after I posted my article on why I retained BIMB Wa as a stock in MyThirdPortfolio.

http://klse.i3investor.com/blogs/kcchongnz/68735.jsp

This guy must have bought some MRCB Wa the last time I wrote about it here:

http://klse.i3investor.com/blogs/kcchongnz/58419.jsp

He must have the value of his MRCB Wa diminished by about 25% now. However he never complains about me as he knew I was sharing of knowledge and the buying of the warrants was solely his own call and he took responsibility of that gracefully.

I would like to respond to his above question as below.

Why did I bought MRCB Wa in the first place?

 “MRCB and its warrant, Wa is at RM1.68 and 27.5 sen respectively on 22^nd August 2014. The exercise price of Wa is RM2.30 and the expiry date is on 16 September 2018, or more than 4 years’ time. The warrant is hence way out-of-the-money with zero intrinsic value. The premium now is 53.3%.” 

“MRCB Wa, with quite a long time to expiry of four years, is trading at an undemanding valuation in terms of premium of 53.3%. Furthermore, it has a high gearing of 6.1 times which would greatly amplify the gain if the underlying share price spikes up before the expiry date.  Hence, if you believe in a company like MRCB as an investment with its various high profile projects, Wa is definitely a good alternative buy.”

What has changed since then?

Updated Valuation of MRCB Wa

Let us look at the profile of warrants of MRCB Wa below as on 21^th January 2015.

Share price of MRCB, S:                RM1.34                

Share price Wa, W:                          RM0.205

Exercise/Strike price, X:                  RM2.30

Expiry date:                                         16/9/2018

Conversion ratio:                             1 for 1

The computations of the properties of the warrants as shown below:

Intrinsic Value of MRCB Wa = Max [0, S – X] = 1.34 – 2.30 = 0

The warrant is hence way out-of-the-money with zero intrinsic value.

Premium P = (W + X) / S – 1

P = (0.205 + 2.30) / 1.34 = 87%

Gearing of Wa = 1.34 / 0.205= 6.5 times

The warrant is hence still way out-of-the-money with zero intrinsic value. Even with a time decay of 5 months since then, the premium has risen to 87%.  The price has become more expensive than before. The value of Wa is purely in its time value of 20.5 sen given by the market. The gearing is 6.5 times which is reasonably high.

So is MRCB Wa still worth investing?

Black-Scholes Option Pricing

With the underlying share price at RM1.34 exercise price of RM2.30, 3.7 years to maturity, risk-free rate of 4% and the past one year historical volatility of MRCB at 38%, the option value of Wa is 21 sen. This shows the market price of 20.5 sen is what the option pricing shows. 

There isn’t seem to be any margin of safety investing in MRCB Wa based on the theoretical option pricing. Is there?

Investing thesis of MRCB Wa

Option pricing model is just a theoretical model based on many assumptions, some are sound, such as value of warrant depends on the volatility of the underlying share price, time to expiry etc, and some are not practical in the real world, such as rationality of investors, lognormal distribution and stochastic behaviour of share prices, constant volatility etc. My thesis on investing in MRCB and its warrant is not so much depending on this theoretical model, but rather what is the prospect of MRCB as a company in the near future which will affect its share price.

MRCB was never a favourite company of mine to invest in mainly because I don’t really like to invest in government-linked enterprise. I was attracted by the change of its management to a more proactive and seemingly more credible management. With the gain from the disposal of the Duke Highway and the achievement of several milestones; the resolution of the dispute with PKNS on P.J. Sentral, the entering of the Definitive Agreement with Kwasa Land for the development of MX-1 Land and the completion of the acquisition of the balance 51% equity interest in Penang Sentral Sdn Bhd, transportation hubs and others, there appears to be some excitements in the near future. Its cumulative three quarters results ended 30^th September 2014 also showed a turnaround from a loss of 111m the previous financial year to a profit of 158m, or 9.34 sen per share.  Rather than just looking at MRCB itself, I have chosen its warrant for the high gearing of 6 times then.

Payoff for MRCB warrant

Table 1 below shows the payoff for Wa for various price of MRCB before expiry of the warrant in less than four years’ time.

Table 1: Payoff

If the price of the underlying share does not move above 72% to RM2.30, the exercise price, when Wa expires, it will be worthless. Even if MRCB share price doubles to RM2.68, the gain of Wa of 85% is still below the gain of the underlying share. The leverage effect of Wa can only be felt positively if the gain of the underlying share is more than 100%. For example, if the underlying share can move up by 200%, Wa would have gained by 3.6 times to 730%. Figure 1 below shows the payoff of Wa with different prices of MRCB.

Figure 1: Payoff for underlying share and warrant of MRCB

With that, I wouldn’t speculate on Wa with too much money as the underlying share has to go up quite substantially before the power of leverage of Wa is positively felt. I would buy it with financial risk management in mind owing to the potential of its future mega projects.

MRCB Wa as a financial risk management

Say we just want to “show up” in investing in the prospect of MRCB with about RM10000.  We buy 50000 shares of Wa at 20.5 sen for RM10250. If MRCB share price goes up to my expected price of RM4.00 within this 3.7 years, the intrinsic value of my warrants would be RM85000, and I would make a handsome RM74750. However, if the share price of MRCB doesn’t move at all, I lose only RM10000 in Wa, the maximum of my exposure which is more bearable.

Conclusion

MRCB Wa, with 3.7 years’ time to expiry, appears to be trading at a fully valued price of 20.5 sen with a quite a high premium of 87%. It has a reasonable high gearing of 6.1 times which would greatly amplify the gain if the underlying share price spikes up before the expiry date. If one believes in its seemingly plausible growth stories, it may be a viable option to invest in it but with a maximum exposure in mind.  

K C Chong (21 January 2015)