Convertible warrants of mortgage lender Housing Development Finance Corp. Ltd (HDFC), which were issued last August, are trading way below fair value.
The warrants were priced at Rs 55 (adjusted for the stock split) at a time when the company’s shares traded at a discount of around 25% to the exercise price of the warrants.
The pricing of the warrant—which is essentially a call option —suggested an implied volatility of around 25%, using the then prevailing dividend payment of Rs 6 a year. Incidentally, the volatility in HDFC shares has been 25% in the past one year.
HDFC shares have risen by around 63% since then and the warrants have almost turned in-the-money. This has resulted in a sharp rise in the price of the warrants to Rs 159 each.
Even so, the price is considerably below fair value. Using the same implied volatility of 25% and the current dividend rate of Rs 7.20 a year, the pricing suggests that traders are factoring in a time-till-expiry of just six months from now. But the warrants are set to expire in around 23 months and their fair value should be Rs 212 apiece, around 33% higher than current levels.
Graphic: Paras Jain/Mint
Does this mean investors should buy the warrants? Yes, but only if they were anyway planning to take a long position on HDFC. The company’s shares need to rise by just 3.5% from current levels for the long warrants position to break even.
What’s more, the downside is limited to the price of the warrant, which works out to 22% of the current share price. And, of course, with warrants, an investor can take around 4.5 times the exposure of a normal cash market position, with the same amount of capital.
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This makes it the most leveraged play on the financial sector, both in terms of the relatively small upfront investment, but also in terms of HDFC’s presence in different segments of the financial sector. Around 40% of the company’s value comes from non-housing business through its various subsidiaries.
Yet, while the warrants provide this opportunity to take a leveraged position on the financial sector, it must be noted that brokers have turned cautious on the stock after a sharp run-up in its share price lately.
“HDFC is trading at 4x F2011e core book and 20.9x core earnings and 3.5x F2012e core book and 17.2x core earnings. We see limited scope for further re-rating in the near term,” Morgan Stanley said in a recent note. The broker changed its recommendation on the stock to equal-weight from over- weight earlier.
Considering that the stock has risen by over 15% since this note means that the chances of a re-rating are even slimmer. Despite this, if investors are considering HDFC for a play on the financial sector, the warrants route would be a far better bet.
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