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Monday, 12 March 2018

WANT TO TRADE BURSA MALAYSIA CALL WARRANTS? HERE'S A GUIDE AND CHECKLIST

There are hundreds of call warrants on Bursa Malaysia now. Even if you're the most sensible value investor in the country with as much personality as a dry wall, you should still have a look at them as a viable way to express your market views. Call warrants are many things, but they do not exclusively belong to speculators and those with an inclination to get poor quick (although most of the time that's what happens to speculators).


To mitigate the odds of making mistakes - you will make them, but hopefully under very strict parameters - you'll need a guide. Trading warrants is more than just about following the herd. You can be reactive (following the herd) as well as proactive (letting the herd follow you).


Contrary to popular belief, call warrants are usually issued to highly reputable and highly profitable companies. They can be a speculative instrument, but they shouldn't be compared to penny stocks where syndicates are just waiting to tempt you into parting with your money.



 When searching for call warrants in the wild, bring binoculars. Image link.


In this post I will share that guide. It's a list of important parameters and characteristics and broadly covers three things:


1) The call warrant identification stage (choosing the best one).


2) The 'mother share' fundamentals filter (things to watch out for when identifying a company to trade. This is supposed to complement your number crunching and typical fundamental analysis activities).


3) Managing the trade (this is about setting parameters. You have to control the trade, or the market will do it on your behalf with terrible results).


CALL WARRANTS ARE A FILTER FOR GOOD COMPANIES


I like call warrants as they tend to be a filter of the best companies (to trade) on Bursa Malaysia right now. Investment banks that issue these things have to be choosy when it comes to picking a company to attach their call warrants to. Among the criteria for issuing call warrants, as far as I know, are as follows:


1) The company must have an average market cap of above RM1 billion over a period of three months. This is especially important for small/mid cap companies whose market value has just exceeded that mark (this was why HIBISCUS warrants had just been released in the market).


Incidentally, having new call warrants mark these companies as a serious player in the market. They've hit that RM1 billion mark and they stand a chance of maintaining that mid-cap classification, which then allows institutional funds with such a mandate to buy into them. Obviously that would be very supportive of price and momentum.


2) There must be substantial trading interest in the company or sector. I've covered this before with the oil and gas downstream sector, where PETRON started getting attention as soon as they recorded decent quarterly earnings. The IBs issued HENGYUAN call warrants as soon as they could, and look how far we have come over the past 9 months!


3) It must be reasonably easy for the IB to conduct market making activities and to hedge its exposure to the call warrant's underlying stock. Market making means the automated buy and sell queues that you see in the warrant every day : the spreads must be tight and they must reasonably reflect real prices; otherwise nobody will trade the call warrant. Note that IBs typically do not take a directional position associated with the call warrant; they only hedge.


4) It most likely reflects the market's prevailing biases. Hey, it's supply and demand. I offer a product that I think you will buy and make me profitable. That's why everybody's issuing HENGYUAN call warrants. Everybody and their grandmother has an opinion on Proton now; that's why DRB-HICOM is so popular. If you can think of a stock that's arguably getting 'hot', rest assured there is (or will be) a call warrant to trade. It's a natural filter for good companies and good stocks.


If you're new to call warrants here's a crash course before we get into the details:




THE TRADING GUIDE AND CHECKLIST


Note : A checked item does not necessarily mean it is good for trading. It's just the little things to care about when you're looking for a good call warrant. I've included my personal preferences as a rough guide; e-mail me if you want the printer-friendly version.




SECTION ONE : THE CALL WARRANT IDENTIFICATION STAGE

  • (  ) Is it one of the first call warrants to be issued for this presumably promising company? 

  • (  ) Is the mother share priced at RM3 and above? (Stocks above this price point exhibit more volatile characteristics, which makes it good for expressing a short term viewpoint)

  • (  ) Is the call warrant less than a month old? (Good if it is. There's a chance the call warrant is undervalued due to lack of interest. This is important if you're accumulating a position before the stock rallies)

For the following items, read my previous post. It explains why I look at these traits.

  •  (  ) In terms of liquidity, volume and price, is it the best call warrant available?

  • (  ) Was there a previous disconnect between the call warrant and the mother share due to some short term event? (Better if there was none)

  • (  ) Is the call warrant cheap in absolute terms? (My definition is typically anywhere between 9 sen and 19 sen. It's cheap enough to accumulate a large position and attractive enough to entice the herd) 

  • (  ) Has the warrant undergone a slump due to a recent weakness in the mother share price? (Better if there was none. An easy example is the usual post-earnings decline for strong momentum stocks. Even if the earnings were fantastic, there is a better-than-average likelihood of profit taking at this point. This can seriously hurt the call warrant's value, of course)

  • (  ) Has there been a share split/revaluation exercise in the mother share during the call warrant's tenure? (I will not trade a call warrant that references a stock's pre-split exercise price/breakeven values. The valuation is no longer precise; the warrant is simply reduced to a pure speculative instrument. An example of this was the recent spinoff of SIME)


SECTION TWO : THE MOTHER SHARE FILTER

 Take good care of your call warrant.


  • (  ) Is this the best company in its sector? (This typically means that its shares tend to outperform its peers. An example is TOPGLOVE - it is by far the sector beating glovemaker)

  • (  ) Is the sector within your sphere of competence? (No matter how good you think you are, you're never going to know all the sectors all the time. Stick to what you know best; perhaps a sector in which you've repeatedly demonstrated an ability to make profitable investments from fundamental analysis)

  • (  ) Are the dynamics of the sector easily understood? (The earnings prospects of glovemakers, manufacturers are relatively easier to analyse from a short-to-medium term perspective. Conglomerates, tech - not so much)

  • (  ) Presumably the stock has a catalyst. Can you attach some solid, actual figures to it? ('Company A to bag jobs from a Jibby infra project this year' isn't good enough. It has to be 'Company A to bag RM500 million worth of jobs this year') 

  • (  ) Is this sector beating the broader market? (Very important. It means the company will outperform during good times. During the bad times, assuming the catalyst is intact, the company will not decline as much as the KLCI itself)

  • (  ) Would this sector story/theme last beyond a single quarter? (Better to identify long term themes. An example is the recovery in the refineries segment last year)

  • (  ) IS THE STOCK FLIRTING WITH A PRICE BREAKOUT SOON? (Very important. It's a gauge of the existing enthusiasm in the stock)

  • (  ) Market beating profit margins? (This must not be hard to explain or a result of one-off gains. It must be fundamentally backed) 

  • (  ) Market beating revenue growth? (Relative to sector peers and the broader market)

  • (  ) Net asset value (NAV) growth on a year-on-year basis? (This shows that the company's earnings performance was not diluted from rights issues, for example. Long term growth supports the case of long term momentum for a really good company)

  • (  ) Is it nearing a dividend or rights ex-date of some sort? (This may mean that the recent momentum is because of some interest in shares acquisition before the ex date; it's not a good sign since the trade is supposed to be fundamentals oriented)

  • (  ) Is it a stock in a previously unfancied sector? (Higher upside potential with the earnings recovery theme)

  • (  ) Is it a contrarian or conventional pick? (Contrarian picks offer higher upside potential but you may have to wait longer, leaving your call warrant vulnerable to time decay)

  • (  ) Is it gaining momentum pre-earnings or consolidating/gaining new momentum post-earnings? (Important to factor in the short term cyclical nature of momentum stocks) 

  • (  ) What is the MAJOR SHIFT that could propel the company to greatness? (Always better to list down and properly articulate what the catalysts are)

  • (  ) Is the stock clearly undervalued by most fundamental measures? (Good if it is. But it's also important to have the right call warrant) 


SECTION THREE :  MANAGING THE TRADE ONCE IT HAS BEEN MADE


  • (  ) It's been a few days/weeks. Is the stock still trading within 5% of its recent high? (This is a gauge of whether the trading interest in the stock is sustained)

  • (  ) Is there a sensible time loss or stop loss for capital preservation purposes? (Always have these and follow them strictly; no room for flexibility if you want to avoid severe losses)

  • (  ) Was the position fully accumulated at the start or is there room to build up on it? (This is an indicator of confidence at the start of the trade. Never acquire more shares when the position is showing a loss)

  • (  ) Can you withstand a 1.5-2 months' slump in the stock price? (No big deal if you just buy the stock itself. But if you buy call warrants, this can be fatal. This is a variation of the time stop)

  • (  ) Is there another call warrant which is exhibiting better characteristics? (This implies that your original choice was wrong. Some call warrants outperform others based on volume and trading activity alone. If yours is seeing little trading interest and performs worse than other call warrants of the same stock, that's a warning sign)

  • (  ) What is the deadline for this trade to show profitability? (You can be right and still lose money if your timing is wrong. The stock can be undervalued longer than you can remain solvent. If you're not profitable by this date which you have, then your trading thesis is wrong. Ditch your ego and take your losses) 

  • (  ) Have you missed an opportunity to take profits? (Call warrants can be volatile by nature. If your paper profits completely evaporate, don't try to hope for a recovery in prices. Acknowledge your mistake and sell the position. The paper profit essentially validates your trading thesis. When it's gone, you're no longer operating within the same parameters)

And that's it. Try to think rationally and always detach your ego from the trade. Know your limitations and don't waste time things you can't control. Keep the decision making to yourself; never let the market do it for you.

Tuesday, 6 March 2018

STORY TIME : LOTTE CHEMICAL TITAN AND THE PERILS OF SHORTSIGHTEDNESS

The events described below occurred from July 2017 onwards. It was a while back but there were a lot of valuable lessons, including the perils of a panicky market, the ignorance of fundamentals, and how to profitably trade off of these two things. When the same thing happens again, you'll know what to do.



Not this one.




Let's look at the background of Company A and the situation it found itself in :


1) Company A is a petrochemical giant. It is a solid, cash flow positive, margins busting firm. It gives out 50% of its annual earnings as dividends. Its annual earnings are in the hundreds of millions of ringgit per year.


2) Company A had a lousy bookbuilding exercise and was forced to lower the asking price for its IPO. Nonetheless it had cornerstone investors who were salivating at the prospect of a %3.3 annual dividend yield.


3) Company A achieves listing. But surprise! An earnings shock causes an immediate collapse in the share price.


4) The company's market cap falls by 25% within weeks. Yet with a lower share price its dividend yields become more attractive. Aside from the one-quarter earnings surprise, the company is in no immediate danger of lower profits over the long term.


5) The share price decline wipes about RM5 billion from the company's capitalisation. It even falls below book value!


Now that all this has happened, who looks silly? It's the investment bankers (who overestimated the market demand for the IPO), the cornerstone investors (who were trapped during the immense price decline), and the company's management (who had no excuses for not foreseeing the one-time surprise and not disclosing them as a potential risk in the prospectus). A lot of people were left embarrassed by this ordeal, but there was no malice intended. It's just a normal screw-up, but the overreaction was intense.


But other than that, did anything change? Did this company suddenly lost its earnings potential and competitive advantages? You already know Company A is Lotte Chemical Titan. It's a petrochemical giant with the backing of an even bigger international group.


Petronas Chemicals is also a petrochemical giant with the backing of an equally big parent. What if PetChem was Company A? Do you think those guys would have experienced what Lotte did under similar circumstances? Surely not.


So who benefits from this decline? It's the fund managers (who can enter the stock at much more attractive prices), the analysts [who can easily initiate coverage on the stock with a target price near the IPO price of RM6.50 - low downside risk. The business hardly requires sophisticated analysis ;) ], and last but not least, retail investors.


The last group can max out their margin accounts to hold a long term position with great dividend prospects. Short term punters can buy the stock with the expectation of a quick upside recovery (a 25% decline in two weeks? Too much). And then there are the call warrant traders who are aware of the apparent existence of an artificial mispricing in the company's stock (me among them).


The shocking decline in Lotte's share price presented a good trading opportunity because the immediacy of the selloff points to some kind of panicked trading activity (possibly disposal of shares at any price). Plus, the punitive financial punishment (loss of billions in market cap) does not match the crime (a one time negative earnings surprise).


This imbalance causes the company to be valued at much less than it's arguably worth, even though the underlying fundamentals remain exactly the same.


THE STARS ALIGN.... IN A BAD WAY


Before we get into the trading process let's have a closer look as to what exactly happened in July-August 2017.


There were clues abound that the IPO was botched. Expectations were too high, the market's sentiment was tepid, and investors no longer put a premium on the upside potential of sizeable IPOs on Bursa Malaysia (you can thank ASTRO, AAX, and FGV for that).




In a sucks-to-be-you moment, Lotte's cornerstone investors were appalled that the stock only traded at the RM6.50 level on the first day - it never returned there since. When a stock struggles immediately after listing, its bankers step up to 'stabilise' the share price in what is known as a 'greenshoe'. The investment bank does this by simply buying up millions of shares to mitigate price shocks. But there's a catch : they can only do this within 30 days of the stock's listing. You know where this story leads; during the greenshoe period, Lotte's stock still fell 6%.


So you have a struggling stock and bankers trying to assure the market that the struggle is not so real. Your 30 days is up. The next thing that comes up is the stuff of ( Lotte's IPO subscribers' ) nightmares - the company reports a 72% year-on-year fall in net profits. Needless to say this was unexpected. The stock falls 25% in two days. If there's a time to pity investment bankers, this was it.



Waiiit a minute... this is a petrochemical product.



A botched IPO, a steadily declining stock, and a negative earnings surprise. But this is where it's important to think rationally.


Here's a list of what caused the net profit decline. The actual numbers are : RM113.62mil for Q2FY17 versus RM404.03mil in Q2FY16 :


1) Lower output due to an unplanned water interruption by Syarikat Air Johor during the quarter.
2) Sales dip due to the festive holiday period in June 2017.
3) Fair value losses on derivatives of RM22mil.
4) Write-offs and share of losses from associates amounting to RM36mil.


The summary of my analysis of these reasons - so what ? These are not systemic risks. These do not affect Lotte's earnings potential over the next 10 years. It's a bit of an overreaction to cut RM5 billion off of the company's market value just because you didn't like a one-quarter unpleasant surprise. Yet it happens all the time in the market.


I'd put a premium on the following : Lotte's profit margins are in the double digits.  It ended up earning RM1 billion in net profit last year - half of that to be paid out as dividends. By several key measures, it remains the cheapest petrochemical stock in the continent. But let's go back to August 2017 when the stock price hit a low of RM4.14.


A series of unfortunately events resulted in volatility and mispricing of the stock. This created an event driven opportunity - so it's time to trade.


TRADING THE UPSIDE VOLATILITY


Lotte's share price decline coincided with the issuance and price collapse of its accompanying call warrants. The volatility meant that upon issuance, some of the call warrants lost up to 70% of their value in three trading days. It is worth noting that their exercise price was reasonable enough - some are close to RM7, or just an 8% premium to the IPO price. The company was expected to be a safe, boring petrochemical play. No such volatility was expected.




So what do you get when you have a supposedly boring stock that's trading like Bitcoin? You get a chance to capitalize on the downside volatility with a favourable risk-reward proposition. It doesn't matter if you'd bought the mother share or the call warrants - both were set for a strong and immediate recovery, at least according to my trading thesis at the time.





Trading volatility requires some specific rules. For example, I will construct a trading angle when a company loses more than a quarter of its market cap in a short period.


Chances of profiting from a recovery is good when the activity clearly points to panic selling. It's even better when the entire decline itself is overdone. And even better yet when there's a warrant to amplify the earnings potential of this trade.


In a volatile situation, a recovery occurs about as quickly as the decline. There will be a period of bargain hunting and accumulation at recent lows, also known as setting the floor.


LEFT - Here's what the floor looks like. The consolidation period lasted eight trading days or so. There was initial volatility amid the bargain hunting, and this occurred in the call warrants as well.




 









I got this little souvenir while attempting to accumulate a call warrant position.




What happened was that the call warrants continued to fall despite the stock achieving some stabilisation. This wasn't exactly a surprise - a call warrant's volatility is amplified relative to the mother share's. I was pushed out of my position, but it didn't mean my trading thesis was wrong.


The next step was to try again. My analysis of the trade points to a limited downside - among other justifications, the stock was trading at a shocking 10% discount to book value. It's like paying Fiat prices for a BMW.


From August 14 onwards, the stock skyrocketed by 25% in just four trading days. I had another position which I exited from too early, so I didn't benefit from the majority of the price rally. But the payoff was decent.








This may be a low return figure for some of you high rollers. But that's a 24% payoff from a single trade lasting all of five days. The best part - this trade can be replicated the next time another botched IPO causes the stock to collapse for silly reasons. Developing and executing the game plan was the real reward.


FIVE MONTHS LATER.... DISCOVERING VALUE AND TRADING SHORT TERM VOLATILITY


And now for something completely different, other than the fact it's the same stock and the same trading philosophy (event driven).



I've written previously on how to choose a call warrant out of many by putting a premium on certain aspects of their characteristics. In January 2018, Lotte's call warrant flips the argument - the market puts a premium on the call warrant by simply existing.


Here's a different type of mispricing and premium. LCTITAN-CG was the only call warrant available to trade at this point. Forget the call warrant's terms - it has done nothing since issuance and was trading at 4 sen as at 12:30PM on January 30th.


During the afternoon market break, Lotte released its 4QFY17 figures. It reported a net profit of RM378mil versus RM290.86mil in 4QFY16. Disregard the company's fundamentals outlook, the fact that the bump was due to higher non-operating income, etc. The most important kicker here is the 23 sen dividend that it announced.


This shouldn't come as a surprise given that it's a clearly stated dividend policy. But it validates prior assumptions that the stock has been trading below its real value. If you like your charts, you may also notice that the stock has been rallying since December, so there was a reasonable level of accumulation activity and anticipation of positive earnings.


                                                                 Boom - January 30th




This trade is described in further detail here. The payoff:




PRESENT DAY...

Fast forward a little bit and guess what? This was from last week:

Via Bloomberg.


So again, in the grand scheme of things, that one-quarter earnings blip is totally insignificant. In fact, it was a blessing for those who were able to get in near the bottom of the market. An investor who bought the shares at August 1, 2017 would have enjoyed a 34% gain as of March 2, 2018. That's the reward for ignoring market panics.