Mohnish Pabrai Boston College Presentation

[Packer16]

The last example makes it clear and easy to calculate.  Thanks.

 

Packer

[ERICOPOLY]

If you buy two 18 calls your committed to $72,.... no longer 36 so the dividend missed is more like 2

 

We are thinking the same way, I just wasn't careful in how I described my example.

 

yes, two shares of upside.  two dividends missed.  twice we "borrowed" $18.  Thus, 1 missed dividend per $18 borrowed. 

 

Therefore, the missed dividend of 1.08 (per call) is 6% of the "borrowed" amount of $18 per call.

 

I get that 1.08 / 18 is 6%.  I just don't understand why we would think we should get the 1.08 in the first place.  If we had bought $18 of shares, we would have got a 3% yield, or .54.  If my choice was to buy the common unlevered or to buy the call, or some combination, nothing was going to give me a 6% yield, so why would I be missing that unattainable 6%?

 

Example 1:  Using portfolio margin

Let's say I only have $18 to my name and I buy 1 share of common stock for $36 using $18 of money borrowed on margin.  I get dividend yield both on $18 of my own capital tied up and on $18 of the borrowed money

 

Example 2:  Using calls

I don't get a damn bit of dividend on my own $18 of equity, neither do I get a dividend on the $18 worth of synthetically "borrowed" money.

 

 

In Example 2, I not only miss out on dividend yield from the $18 borrowed, but I also miss out on the dividend yield from the $18 of my own equity that I contributed.

 

So that's why it's 6% cost and not 3% cost.  Because you synthetically borrowed only 1/2 the price of the stock, but you gave up the dividend on the entire thing!  Your own money got no yield.

 

Normally, if you invest your own $18 into the stock you get a 3% yield.  But that vanishes when you add $18 of "borrowed" money to the deal.  So you multiply it by 2, and thus it becomes a 6% cost of having added $18 of leverage.

 

Yup. But if the writer of the call borrowed money as in example #1 and used it to write a covered call, that double dividend would influence him to  charge less for writing that call, especially compared to writing a put where posting a compensating balance would earn almost nothing --- thus leading to demanding a higher price for writing an equivalent put.

 

I think it's likely just the wording but I don't understand what you are getting at.  So if I repeat what you are trying to say using different phrasing, it's an accident.

 

I think normally if somebody is trying to earn a leveraged dividend yield (buying extra shares on margin) they would want to hedge with a put and pay for the put by writing a call.  That way they would get the leveraged dividend with no price risk to the common.  This would be such a good trade that it would be chased by traders until it skewed the put/call out of parity to the point where the trade no longer had any leveraged benefit for the given interest rate.

 

Is that what you are effectively saying?

[kmukul]

portfolio margin + puts seems like a wonderful thing :), however your interest rates on margin are not locked it could go up and down with interest rates which might be another risk

[yadayada]

So have we figured out already what that mysterious 10-40 bagger is going to be in the next 10 years ?  ;D

[txlaw]

Hmm, based on the discussion above, I think I may have been erroneously calculating the missed dividend effect on the cost of leverage.

 

So taking into account a potential 3% GM dividend (based on current price), do people get that the GM warrants result in a cost of leverage somewhere around 7.3%?

[ERICOPOLY]

Hmm, based on the discussion above, I think I may have been erroneously calculating the missed dividend effect on the cost of leverage.

 

So taking into account a potential 3% GM dividend (based on current price), do people get that the GM warrants result in a cost of leverage somewhere around 7.3%?

 

Correct, based on that 3% dividend assumption on today's market price.

 

People are expecting the stock to go up 40% (or at least Kyle Bass is).  That would put the dividend at $1.72 (at 3% dividend payout yield level), which is 9.55%cost from the lost dividend.

 

So the total cost of leverage would be greater than 10% a year.

 

So it depends on the dividend.

 

I'd personally prefer the portfolio margin approach here, because I see the rising interest rate to be a lesser risk than the rising dividend.

[ERICOPOLY]

There is actually a $3 strike BAC 2016 call option.

 

Imagine how expensive the leverage would turn out to be if they were to pull out a 40-60 cent annual dividend.

 

That call would turn out to be more expensive leverage than today's at-the-money strikes!  Yet without all the downside protection.

 

[txlaw]

Hmm, based on the discussion above, I think I may have been erroneously calculating the missed dividend effect on the cost of leverage.

 

So taking into account a potential 3% GM dividend (based on current price), do people get that the GM warrants result in a cost of leverage somewhere around 7.3%?

 

Correct, based on that 3% dividend assumption on today's market price.

 

People are expecting the stock to go up 40% (or at least Kyle Bass is).  That would put the dividend at $1.72 (at 3% dividend payout yield level), which is 9.55%cost from the lost dividend.

 

So the total cost of leverage would be greater than 10% a year.

 

So it depends on the dividend.

 

I'd personally prefer the portfolio margin approach here, because I see the rising interest rate to be a lesser risk than the rising dividend.

 

I think you're probably right about the potential downside risk (how ironic) to a really nice dividend being reinstated for the GM warrants.  Most likely, I'll be switching to the common.

 

Thank you for your posts on this subject of leverage.

[ERICOPOLY]

Hmm, based on the discussion above, I think I may have been erroneously calculating the missed dividend effect on the cost of leverage.

 

So taking into account a potential 3% GM dividend (based on current price), do people get that the GM warrants result in a cost of leverage somewhere around 7.3%?

 

Correct, based on that 3% dividend assumption on today's market price.

 

People are expecting the stock to go up 40% (or at least Kyle Bass is).  That would put the dividend at $1.72 (at 3% dividend payout yield level), which is 9.55%cost from the lost dividend.

 

So the total cost of leverage would be greater than 10% a year.

 

So it depends on the dividend.

 

I'd personally prefer the portfolio margin approach here, because I see the rising interest rate to be a lesser risk than the rising dividend.

 

I think you're probably right about the potential downside risk (how ironic) to a really nice dividend being reinstated for the GM warrants.  Most likely, I'll be switching to the common.

 

Thank you for your posts on this subject of leverage.

 

You can always wait until that dividend actually arrives -- the warrant decay isn't that big of a deal since you didn't pay much premium for the warrant.

 

EDIT:  But there again, why the $18 strike?  Why not a short-term higher strike call?  That way, if the price of GM does in fact fall hard, one could get in cheaper (below the strike).  My favorite would still be the common+put.

[racemize]

Hmm, based on the discussion above, I think I may have been erroneously calculating the missed dividend effect on the cost of leverage.

 

So taking into account a potential 3% GM dividend (based on current price), do people get that the GM warrants result in a cost of leverage somewhere around 7.3%?

 

Well, I still think the extra cost is 3% and not 7%, but that is based on my comparison between common and option versus Eric's comparison to margin possibility.  So, I'd say, it depends on what exactly you are calculating.  See my previous example comparing the total return of the common versus the total return of the warrant.

[ERICOPOLY]

Well, I still think the extra cost is 3% and not 7%, but that is based on my comparison between common and option

 

Let's say person A has $18 to his name, and person B has $18 to his name.

 

Person A buys 1/2 of a share for $18 and earns 3% yield (assuming it were allowable to own 1/2 share)

 

Person B buys 1 call option for $18 and earns no yield at all, even though he has an entire share of upside (twice the dividend loss)

 

So if the economic loss is twice as much, what are you getting hung up on?

 

 

 

[ERICOPOLY]

Or take two $18 strike call option owners (two different people).

 

Person K owns 1 call option

Person F owns 1 call option

 

The company is going to pay a $1.08 regular dividend the day before the call options expire.

 

Person K exercises the option and collects the dividend (using borrowed money).  His dividend is 6% return on his equity.

 

Person F does not exercise and misses out on the dividend.

 

 

Who has 6% more money?    :D

[racemize]

Well, again, here is my rationale and comparison:

 

Let's put it another way.  I think I've calculated "cost of leverage" in the same way you do when there is no dividends.  Doing this allows me to know how much the common has to return for the warrant to break-even, or in other words, it allows me to directly compare at what point the warrant will return the same amount as the common. 

 

In the ridiculous case of $0 cost, the break even is right when I buy it, everything else is levered upside.  Let's say the price goes absolutely nowhere for a year, and a dividend of $1 is instituted.  Ok, now I need to make up for the $1 in total returns in having bought the warrant instead of buying the common, right?  So, the total return for the common is now 1/36 = 2.7%.  In order to break even with that, I need the warrant to go up to 18*1.027 = 18.5, or just $0.50 and not the $1.  So, it seems like if I "punish" the warrant by requiring a 5.4% yield or the full $1 dividend, it no longer provides the total return comparison I've been calculating.

 

If I'm putting $18 in and I'm comparing whether I buy the common or the warrant, I'm comparing the expected future total return of those two vehicles.  I do lose 3%, because I would have bought the common, which would have paid me 3% dividend in addition to the appreciation (which is already accounted for).  I do not lose 6%, as I could never have gotten it with that $18.  The math above shows this, and it does not show a cost of 6% (or the full $1 dividend). 

 

I'm looking for the annualized rate that makes the TR of the common the same as the TR of the warrant.  After going back and forth on this, I do not think we are measuring the same thing.

 

Your example of exercising before the option requires $36--I don't have $36, so I don't see how it applies.  The other example should correspond to my math above.

[ERICOPOLY]

Your example of exercising before the option requires $36--I don't have $36, so I don't see how it applies.

 

You are unable to borrow money to leverage your equity?  I don't see why.

 

What would it cost to purchase an out-of-the-money $18 strike protective put (to protect your loan) that expires the next day?  So this can't be confused into a put/call parity discussion again (the very reason why I framed it as 1 day before expiry).

 

And 1 day of margin interest isn't even worth discussing.

[ERICOPOLY]

Oh yeah, and forgot this really obvious one...

 

The call options only miss out on regular dividends.

 

Special dividends result in an option strike adjustment.

 

And that option strike adjustment on the special dividend amounts to TWICE the economic value that you would enjoy if you just had your $18 invested in the vanilla common stock.

 

So if call options can have TWICE the profit of earning a special dividend, why can't they have twice the COST of missing a regular dividend?

 

What do you say?

[ERICOPOLY]

If I'm putting $18 in and I'm comparing whether I buy the common or the warrant, I'm comparing the expected future total return of those two vehicles.

 

How come the expected return from a $20 increase in stock price is higher in one vehicle versus the other, if you only have $18 invested in each one? 

 

I'm sure you will agree that it's because you are leveraged to twice as many underlying shares.

 

Then why don't you agree that you are also leveraged to twice as many dividend payments?  Only, you are getting none of them  :( 

 

You seem to believe that you are entitled to twice as much upside in stock price (even though you only have the cash for half that much), but not twice as much dividend.  Why the distinction?

[racemize]

Again, I am measuring something different--I'm comparing total returns and not margining. I agree with all of your examples if I was thinking of it in your way, but I am simply not.  Or said another way, I am comparing what price the common has to get to for my total return of the option to match the total return of the common. I cannot consider borrowing simply because I am not comparing common to margin, but common to calls.

 

The math in my dividend example shows exactly why I only missed the yield when comparing common to calls. Perhaps I am the only one who thinks this way, but it makes a lot more sense to me.

 

Is there any flaw with my example? 

[racemize]

If I'm putting $18 in and I'm comparing whether I buy the common or the warrant, I'm comparing the expected future total return of those two vehicles.

 

How come the expected return from a $20 increase in stock price is higher in one vehicle versus the other, if you only have $18 invested in each one? 

 

I'm sure you will agree that it's because you are leveraged to twice as many underlying shares.

 

Then why don't you agree that you are also leveraged to twice as many dividend payments?  Only, you are getting none of them  :( 

 

You seem to believe that you are entitled to twice as much upside in stock price (even though you only have the cash for half that much), but not twice as much dividend.  Why the distinction?

 

We'll, I'm simply not entitled to the dividends--that's what the contract says. Like I said, I'm comparing total returns--if I do it your way, then the total returns are not the same.

[ERICOPOLY]

Is not being entitled to a regular dividend a cost or a benefit?

 

It can be written in a contract like you say, or it can be on a cave wall, or on a golden tablet, or it can be written on the Rosetta Stone.

 

Regardless, it's either a cost or a benefit.

 

 

[racemize]

Is not being entitled to a regular dividend a cost or a benefit?

 

It can be written in a contract like you say, or it can be on a cave wall, or on a golden tablet, or it can be written on the Rosetta Stone.

 

Regardless, it's either a cost or a benefit.

 

It is a cost. But, in my comparison, the total return of the common is what defines that cost. The math of the common total return indicates a loss of only the dividend yield.

 

If I compared a vehicle that did get the dividend yield, then it would get 2x the dividend, as you say, but I am not comparing that vehicle.

[ERICOPOLY]

Is not being entitled to a regular dividend a cost or a benefit?

 

It can be written in a contract like you say, or it can be on a cave wall, or on a golden tablet, or it can be written on the Rosetta Stone.

 

Regardless, it's either a cost or a benefit.

 

It is a cost. But, in my comparison, the total return of the common is what defines that cost. The math of the common total return indicates a loss of only the dividend yield.

 

If I compared a vehicle that did get the dividend yield, then it would get 2x the dividend, as you say, but I am not comparing that vehicle.

 

Why don't you run the calculation again, but this time do it for the special dividend?

 

You will wind up with twice the return for the warrant versus the common.

 

Agreed?

[ERICOPOLY]

The condensed version is this:

 

The warrant holder enjoys TWICE the yield of a special dividend (compared to the unleveraged common stock investor)

 

The warrant holder similarly should enjoy TWICE the yield of an ordinary dividend (compared to the unleveraged common).  But he instead gets ZERO yield -- therefore, there must be an offsetting cost eating it completely up.  Thus, this cost must be equivalent to TWICE the yield of the ordinary common shares.

 

 

Let X = cost

 

6% - X = 0

[ERICOPOLY]

If I compared a vehicle that did get the dividend yield, then it would get 2x the dividend, as you say, but I am not comparing that vehicle.

 

Yes you are comparing that vehicle.

 

Because it's 2x in the case of the special dividend, as well it should be 2x for the ordinary dividend as well -- were it not for the cost that also is 2x in size.

 

[bmichaud]

Race,

 

I've been following this entire discussion, as it's been a months long project of mine to figure out how Eric thinks (he is utterly brilliant, and we are extremely lucky that he takes the time to explain soooo much!!).

 

I'm dumb, so it took me until now to figure it out. I was struggling with the whole if you only have $18 and can't margin thing. BUT this entire thing makes perfect sense when you view it in terms of the stock price doubling, as Eric pointed out....

 

Say I have $36 in an IRA where margin is not allowed. If I buy one share of GM and the stock goes to $72, then I make $36, or a 100% roe.

 

Now say I put $36 into two $18 calls. If the stock doubles to $72, then each call is worth $72 - $18 strike - $18 cost, or $36, and since I own two calls then my proceeds are $72 net of strike and option cost. Roe = 200%.

 

Modifying Eric's BAC warrant leverage calculation for the dividend...

 

GM stock price $36

GM divy $1.08

GM option price $18

Strike $18

 

36 stock price - 18 option price = 18 leverage

 

Assuming no dividend:

18 leverage x (1+x) = 18 strike. X = 0%.

 

With dividend, the $1.08 gets added to the strike:

18 leverage x (1+x) = 19 adj strike. X = 6%.

 

So it's like the warrant dividend adjustment in reverse. Where the warrant strike gets adjusted downward, the option strike gets adjusted upward (in Eric's leverage calculation).

[ERICOPOLY]

ordinary dividend:

 

COMMON STOCK:

Stock trades at $36.

$1.08 ordinary dividend is declared.

Stock now trades at $34.92 on dividend-EX date.

$1.08 + $34.92 = $36

 

WARRANT/CALL:

Option trades at $18

$1.08 ordinary dividend is declared

Option now trades at $16.92 on dividend-EX date (because the stock dropped by $1.08 on div-EX dates)

 

 

Better example?

 

Value of common stock portfolio didn't change one bit.

Value of option/warrant portfolio DECLINED by 6%

 

That 6% decline happens to be TWICE the dividend yield.