KEY POINTS:
Two weeks ago we looked at managed funds which are listed on the sharemarket.
These companies are known as closed-end funds (CEFs) and while they have a lot in common with unit trusts, they are a good deal different too.
This week we look at CEF warrants and
why CEFs' share prices are usually lower than the value of their assets per share.
October saw the listing on the NZX of a new CEF investing in smaller Australian companies, Barramundi (BRM), managed by local fund manager, Fisher Funds.
Initial subscribers to BRM received one free warrant for every two shares they bought. The warrants can be exercised to purchase a new ordinary share at a price of $1 in October 2009.
Warrants may have an intrinsic value for three reasons:
* The exercise price of the warrant may be less than the share price. In BRM's case you can turn your warrant into a BRM share by paying an extra $1 per warrant. BRM's share price at $1.08 suggests that the warrants should be worth at least 8c.
* Because you don't have to exercise your BRM warrants until 2009 you can put 82c on deposit and at 7 per cent a year compound you will have $1 by October 2009. So having to pay $1 in 2009 is about the same as paying 82c today. The time value of the warrants is thus worth about 18c.
* Because their price is usually less than the share price, warrants allow investors to achieve a leveraged position - $1000 buys you 1000 BRM shares but 4000 warrants. If the share price goes up by 5c and the warrants follow, you make much more money by owning the warrants and of course vice-versa. The lunatic fringe who discover the sharemarket from time to time (right now perhaps) are primarily attracted to the speculative and low priced stocks, warrants etc. This can have the effect of pushing prices higher than they should be.
The magic of warrants is illustrated by the Barramundi float: the shares have listed at $1.08 and the free options (one for every 2 shares) are trading at around 26c. Initial subscribers are already ahead by about 20 per cent so they are feeling smug, Kingfish Management just got an extra $100 million or so to manage so they are laughing and the brokers and advisers who organised the deal have got their fees.
Everybody wins, for now anyway. Unfortunately free options aren't really free and don't in themselves create wealth. They just move it from ordinary shareholders to option holders.
The stockmarket can choose to ignore the transfer today but it will have to face it eventually.
Because options generally have a dilutory effect on the assets of the fund, in terms of the present value of the exercise price being below the share price, options are a cost to shareholders. Back to Barramundi again: Barramundi has 100 million shares and 50 million warrants exercisable by October 26, 2009. After initial startup costs BRM shares had 98c in assets but the options, if exercised, would add 50 million more shares to the company as option-holders come up with $50 million (to exercise their warrants) in October 2009.
But as we know, $50 million in October 2009 isn't the same as $50 million today. To see what it is worth today we must discount the $50 million by an appropriate discount rate. Technically this discount rate should reflect the riskiness of the shares but that is much too complicated and boring and if we use the current call rate (7 per cent) we get an equally useful answer.
Doing the maths suggests that receiving $50 million in 2009 is worth about $41 million today. So we can work out what BRM assets are worth, adjusted for the free options as follows: (100 million shares x 98c) + ($41 million from the options) divided by 150 million shares (after the options are exercised) = 93c.
BRM shares are now about $1.08 so the market appears to be betting that Carmel Fisher and Co will be able to add significant value via management, as the firm has already done with its NZ investments. Good luck!
Anyway so much for options, there are lots of other reasons why CEFs should trade at discounts. In fact there are so many good reasons the wonder is not why CEFs trade at discounts, it is why unlisted managed funds trade at net asset value (NAV)!
Lots of academics have pondered the tendency of CEFs to trade below asset backing. In fact, our old friend Professor Dimson at the London Business School has co-authored a 60-page report cataloguing the reasons. Of these the one which resonates most is that the discount of the fund simply reflects the value which is lost by shareholders to fund manager fees: economics says the value of an asset is the sum of the future cashflows discounted at the appropriate rate. Using this model the higher the fees the greater should be the margin between NAV and price. Barramundi, for example, owns a portfolio of smaller Australian companies producing dividends but shareholders don't get all those dividends - some go to Fisher Funds by way of annual management fees.
A rough and ready way to estimate the total cost of these fees over the life of the fund is to apply the management fee of 1.25 per cent to the $100 million in assets, discount this number by a risk adjusted rate of return, then sum the present values of the cashflows over the life of the asset. Doing this suggests that the management contract is worth at least $5 million. Taking this off the $98 million in assets means the shares should trade at about 93c.
That they are trading at $1.08 in spite of the warrant dilution and the impact of the annual fees tells us one of two things: Carmel is the next Warren Buffett and/or we are in a bull market!
