Rarely a day goes by in which I don’t spend significant time thinking about investing, diving into investing research, or making investments. This year I’m making it a priority to share more of my outputs and engage with others on investing topics.
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If you’re interested in being on my personal email newsletter list, you can sign up here. And here’s a recent post if you’re curious about the style of content.
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Cheers,
Travis the StockGeek
P.S. - Someday I will write a long post-mortem on the SPAC warrant trades. I had some multibaggers (CRHC, HPX/AMBI, RBAC, RONI, SMR, etc) and also a number of zeros/total losses. Net net the warrant portfolio has been a negative outcome and certainly worse than I anticipated. Thankfully I sized it small (they are options after all) but there were still some painful lessons learned about the shortcomings of mathematical models in a world dominated by human incentives & emotions!
If many pre-deal SPAC warrants are truly underpriced (as I currently believe), why does this opportunity exist? I think there are four main factors driving the mispricing:
Pessimism surrounding SPACs ability to get deals done
Pessimism around how deSPAC share prices will perform
End of year tax loss selling driving prices down
Low liquidity which keeps sophisticated arbs / quants / hedge funds from being interested and/or able to trade warrants in size
Let’s address #3 and #4 first. Tax loss selling is a temporary phenomenon which tends to reverse itself with time. Other investors’ losses from buying too high during periods of SPAC frenzy can benefit opportunistic investors who swoop in when sentiment is terrible. One of my favorite investing mantras is “buy fear & sell greed” because everyone knows it but few are able to actually do it in practice.
Low liquidity in warrants is both a blessing and a curse for individual investors, since it creates exploitable inefficiency but also makes trading challenging. That being said, I’ve been able to build pretty decent size in some individual warrants utilizing frequent small limit orders. I also diversify across a number of different underlying SPACs, so my overall warrant portfolio is a meaningful “position” within my greater investment portfolio.
Too Much Pessimism?
I mentioned in Part 1 that I expect more SPAC liquidations in 2022 and 2023 due to the sheer number of SPACs seeking deals and a more hesitant pool of target companies willing to go public via SPAC transaction. Despite that belief, I still expect many SPACs to announce and complete deals in the next 1-2 years for several reasons:
Venture Capital & Private Equity portfolios are stuffed with highly valued private companies for which they seek exits
SPACs are getting more creative and playing a role in corporate spinoffs
Many SPACs have been quietly working on deals behind the scenes for months (there is a timing/backlog effect)
SPAC sponsors are incentivized to get deals done; they have levers to pull such as paying shareholders to extend deadlines
CB Insights keeps a great list of “unicorn” startups with valuations $1 Billion or higher. Today there are 958 companies on that list, and more startups will likely join the list within the next year. Many of these companies will remain private. Some of them will choose to sell to a strategic or financial acquirer. Some of them will go public via the traditional IPO route. And I do believe some of them will go public via SPAC. Although the majority of startup exits tend to be acquisitions, public listings are a common exit for larger successful startups and dominate exit dollar volume:
What benefits does a company get by going public via SPAC versus the traditional IPO? SPACs are often faster and the valuation can be more efficient since it is negotiated by the company rather than left to guesswork by investment bankers who are incentivized to lowball in an IPO. Bill Gurley, one of the most prominent and successful VCs of all time, laid out these argumentswell.
Beyond startup unicorns, there are thousands of seasoned companies owned by private equity firms which might be candidates for SPAC deals. Many PE owned companies have significant debt on the balance sheet, making a SPAC transaction intriguing from a de-leveraging standpoint. While not as clean as an outright sale, fresh capital and a public listing provide liquidity options for private equity firms. These firms are starting to embrace this option:
IPOs are cyclical and public markets have shut to new offerings during periods of market turmoil in the past. I could see a scenario where SPACs become a countercyclical provider of capital and exit opportunities.
Even if that is a stretch, SPACs are starting to become a vehicle for corporate spinoffs. Within the past month two spinoff transactions with SPACs have been announced, with Harley Davidson spinning out its electric motorcycle division (Livewire) via $IMPX and Fluor spinning out its small module nuclear reactor division (NuScale) via $SV. Julian Klymochko, a SPAC expert & arbitrageur, predicted this back in March 2021:
The point here is that there’s theoretically still a large supply of potential SPAC targets. Even if the pool is smaller today than it was a year ago, the pool is not zero. SPAC sponsors will adapt, get creative, and extend deadlines if necessary.
SPAC Selection Strategies
Still, an investor doesn’t have to shotgun capital across the entire SPAC warrant universe. My view is that being selective with SPACs plays a big role in reducing risk and maximizing upside.
Some sponsors are already proving their prowess at getting multiple deals done per year (Eagle Equity, dMY, Gores, Churchill, Social Capital, etc). Unfortunately their warrants do not tend to be on the cheap end of the spectrum. What else could one focus on when looking for value priced warrants? Here are some possible criteria:
Sponsor / SPAC executive team background
Professional background (VC / PE? Operator? Industry connections?)
Personal network footprint
Reputation / track record
Size of team
Industry or niche focus
Trust size
Underwriting bank partner
Warrant redemption or related legal terms
Time to deadline
Recent quarterly expenses trend
Rising trading volume
Current warrant price vs all time high price
I choose to focus a lot on SPAC executive backgrounds because ultimately people and relationships are key to getting transactions done in my opinion. Competition for deals can be fierce and sponsors need an edge. That edge could be a large sourcing pool, deep industry connections, expertise that might benefit the target company, ability to drum up excitement with public market investors, resources to do a fast transaction close, etc. Assessing this is tough and subjective. I don’t have precise prescriptions for how it should be done, but here’s how I think about filtering down:
When it comes to SPAC teams with predominantly finance backgrounds, I tend to favor top tier VC or PE backgrounds because they’ll (ideally) have broad networks with connections to many private companies. I personally shy away from sponsors from lesser known firms with low AUM. Hedge fund and public market backgrounds don’t seem as relevant for sourcing deals with private companies, but there are always exceptions to these rules of thumb (Oaktree, Pershing, etc). Celebrities such as pop stars and athletes don’t seem to offer much benefit based on what I’ve seen thus far, and I doubt many of them are spending their time hustling on behalf of a SPAC.
Many SPACs have an initial industry or niche focus, such as healthcare & biotech, tech & software, sports & fitness, media, travel, education, or energy & sustainability. This can be an advantage when the sponsor has deep industry knowledge and connections, particularly if the sponsor built or ran a company in that area. It can also work against the SPAC if the niche is out of favor, the sponsor is not well liked by industry, and/or when a deadline is approaching. Generally I think niche focus is a positive when the sponsor’s background aligns with the niche.
Large trust sizes help on the margin because of the capital they can bring into the target company, possibly even reducing the need for a PIPE. I’m not convinced the initial SPAC underwriters matter all that much in the end, but I’m open to arguments. Most warrant terms tend to be fairly standardized, though redemption terms can vary somewhat. I always check the terms, but rarely do they alter my investing decision.
Time to deadline is an interesting factor to consider. Most SPACs are going to need at least a few months if not longer to get to the finish line on a deal. For SPAC deals announced and completed in 2020 & 2021, the average time from SPAC IPO to deal announcement was roughly nine months. Of course any SPAC nearing their wind-down deadline presents a major risk to the value of the warrants. Therefore downside risk might be mitigated somewhat by avoiding warrants on SPACs which are within 1-3 months of their deadline. There tends to be a “sweet spot” for SPACs that have been trading awhile but not so long that they are very close to their deadline.
Trading volumes and SPAC expense trends (from their quarterly 10-Q filings) can sometimes be a “tell” that a deal is soon to be announced, but they also give off a lot of false positive signals. Deals do get leaked occasionally, but there are also frequent false rumors (ex: Discord/$IPOF and Northvolt/$CRHC recently). Many arbitrage funds traffic in SPAC shares and warrants, occasionally causing trading volume to spike for purely technical reasons. Meanwhile quarterly expenses can rise due to deal negotiations or due diligence that don’t end up in a definitive merger agreement. How one utilizes these signals probably depends on strategy and time frame, i.e. trading versus investing. They don’t typically drive my own investment decision, but I’ve FOMO’d into a larger position on occasion after seeing expenses and volumes rise.
Modeling Potential Risk & Return
Let’s take a look at some possible scenarios for a single SPAC warrant. I showed earlier in Part 1 that the majority of SPAC warrants trade at or above $1.00 on an initial deal announcement. But how do we think about other outcomes? Below is a hypothetical set of outcomes and associated probabilities for a SPAC warrant currently priced at $0.50:
Avoiding SPAC warrants which are nearing their deadline might reduce the chance of a total loss (-100%), but I’m not ruling out the possibility of some bad outcome where the SEC restricts most SPACs or a legal challenge thwarts a particular SPAC. Therefore I think it’s reasonable to apply a 10% probability to an outcome of 80% loss from purchase price, even though these are quite rare in recent history. I also think it’s reasonable to apply meaningful probability to a negative outcome (-50%) due to SPAC warrants trading down on general pessimism and low deal announcements and/or the situation where exiting a warrant at a loss is prudent as its deadline approaches. Those deeply negative scenarios make up about one-third of my overall probability table.
In the table above I also assume some probability of a breakeven outcome, where one exits the position for zero gain/loss due to a deal announcement that the market really dislikes. Roughly a third of total probability is then applied to the scenario where a deal announcement or stronger SPAC market generally causes a warrant to trade up to the $0.85 level. This is well below the level of the median post-deal warrant in 2021, and more in line with the worst month of 2021. I also apply about 20% of the total probability to some positive right-tail outcomes for those SPAC deals that the market gets excited about. I do not assume any wild DWAC/LCID/CHPT style outliers. Nonetheless, the mean expected return is almost 50% under these scenarios. Variance is quite high and the Sharpe ratio is not awesome, but these can be improved by combining different warrants in a warrant portfolio and also by combining the warrant portfolio itself with other non-correlated assets within a larger portfolio. These warrants are “event driven”, so they can be uncorrelated with the broader stock market, which is a very valuable characteristic.
The price paid for a warrant does affect potential returns quite a bit. If we assume the same outcomes and probabilities as before, but a 30% higher initial price for the warrant, the expected return drops significantly to just 15%:
I must point out that higher quality SPACs often have higher priced warrants and higher quality SPACs probably have different probabilities of upside versus downside. If you want to play around with different return scenarios & probabilities, check out the “Single Warrant Analysis” tab in my SPAC Warrant data spreadsheet (just make sure total probability sums to 100%!). Here’s an example of a higher priced warrant where the probabilities shift more in favor of positive outcomes:
Summary Thoughts
Sentiment around SPACs is currently terrible, which has driven most pre-deal warrants down to fresh lows. I think the current setup and potential returns are compelling, especially as we head into a stronger seasonal period for both trading and deal announcements. Diversifying exposure across a subset of strong SPAC teams and avoiding SPACs with approaching deadlines could help lower downside risk.
Further Resources
Some of you may ask which specific SPAC warrants I currently own. Because warrants tend to be illiquid and I want to avoid giving specific investment advice, I think it’s best that I avoid presenting the full list here. I will say however that I’m currently diversified across roughly 30 different pre-deal SPAC warrants. You can probably figure out some of the ones I own from the criteria I discussed earlier. I really like combining criteria such as reputable sponsor with strong VC/PE/exec networks, niche or geographic focus, trust size above $200 million, sweet spot until deadline, low warrant price, etc. For example: one of my first big wins in pre-deal SPAC warrants was with RedBall Acquisition Corp ($RBAC) in October 2021. The executive team included heads of a large private equity firm focused on sports, trust size was $500+ million, the SPAC was just over a year into its two year life, and the warrants traded as low as $0.70 in early fall. After its deal with SeatGeek was announced in October, the warrants traded as high as $1.90 over the following month. I nearly doubled up my capital on that particular position…not bad!
Spactrack.io is a really useful starting point for finding potential warrant ideas in my opinion (I have no ties to them, I’m just a fan). I occasionally post about warrants & SPACs on my Twitter account. I also maintain a Twitter List of SPAC focused accounts which I find helpful in tracking what is happening across the SPAC universe. Many of those accounts also discuss and share their trade ideas. I’m hoping to be more active in Twitter discussions myself going forward.
Lastly, I do discuss specific SPAC teams, warrants, and ideas in our private Discord / subscription community at Skill Incubator. There I cover stocks with weekly market updates, potential trade ideas, fundamental analysis, livestreams, and more. My business partners also cover crypto and personal finance. If that’s something of interest to you, feel free to check it out.
As always, if you have any follow up thoughts or questions on SPAC warrants, let me know in the comments! Cheers 🍻
Surprise! You probably thought this newsletter was dead. I apologize for not writing here since 2020. Thankfully there’s been an explosion of great investment newsletters in my absence. My own intention is to write more in 2022 and beyond. I believe there’s still a need for thoughtful investing content online, particularly serving the individual investor. We’ll see how I progress going forward. Thank you to those of you who choose to stick around.
The TL:DR
On to today’s topic: pre-deal SPAC warrants. I personally believe a number of them are significantly underpriced. The risk-reward looks asymmetric and tilted to the upside in my opinion. I aim to illustrate the potential opportunity here.
[Disclaimer: I personally own a portfolio of select pre-deal SPAC warrants. Warrants are risky and have the potential for loss. I have done my own diligence and accepted the risks. Your investments are your responsibility alone. The intent of this post is education and not investment advice.]
Current Background on SPACs
If you aren’t familiar with SPACs (special purpose acquisition companies), have you been living under a rock? 😁 I kid. These “blank check” companies have existed for a long while but SPAC fundraising boomed in 2020 and 2021. SPACs raise capital with the intent of using that capital to buy into a private company and take it public via the SPAC’s own public listing. There are many nuances to this process which are beyond the scope of this piece. The amount of capital which has flowed into SPACs within the past two years is stunning (nearly $300 Billion raised!):
Over 250 companies have successfully completed SPAC transactions and gone public through SPAC deals in the past two years. SPACs have become an alternative route to going public and in conjunction with a strong traditional IPO market have helped reverse the decade long trend of a shrinking universe of publicly traded US stocks. That’s the positive viewpoint. The negative viewpoint is that SPACs have allowed many low quality companies to come public despite weak financials, overly optimistic future projections, and general unsuitability for public markets.
The performance of deSPACs (companies that have completed their going public transactions via SPAC) in 2021 has been rather abysmal on average. One way to visualize this is to check out the chart on the $SPAK ETF, which holds a portfolio of mostly deSPACs, over the past year:
There are plenty of positive performances among completed SPACs such as Vertiv, Lucid, DraftKings, BeautyHealth, Matterport, MP Materials, etc. But there are many others which have quickly traded well below the initial SPAC deal valuation (typically calibrated to an initial $10.00 per share price), including such gut punchers as Talkspace, Metromile, Beachbody, CarLotz, Clover Health, AppHarvest, Desktop Metal, and ATI Physical Therapy. All of the latter are down 50% or more from their initial deal price. The deSPAC universe now sports a negative return from inception!
Another concerning issue in SPAC world is that there are almost 700 SPACs with $200+ Billion of capital competing for the pool of companies willing & ready to go public via this non-traditional route. Recent deSPAC performance has been poor and professional investors have been increasingly pulling their capital out of SPAC deals before the deal completes (via redemptions and/or de-committing from PIPEs). This reduces the capital available to a target company upon completion of a deal, which is not ideal for companies needing growth capital alongside their public market debut. It sows doubt in the minds of private company management teams. It seems likely that the target company pool is shrinking at the worst possible time for SPACs.
Did I mention the clock is ticking for SPACs still seeking a deal? Most SPACs have a 1-2 year window to complete a deal or else they are obligated to wind down and return their initial investors capital. A significant portion of existing SPACs have deadlines approaching by mid 2023:
In 2021, there were typically 15-20 SPAC deal announcements per month, though there were as many as 40 (February ‘21) and as few as 10 (October ‘21) in a given month. At the average pace of around 20 per month, 240 deals per year would be announced. One or two announced deals are terminated each month however, and that number appears to be rising in late 2021 (four terminations in December ‘21). That leaves about 150-200 deals completed annually at the existing rates. With more than 600 new SPACs raised in 2021, only about half of the 2021 SPAC class would complete deals within a two year window at the current pace. I very much agree with Andrew Walker of Yet Another Value Blog (a fantastic investment newsletter & podcast in my opinion) who has predicted rising SPAC liquidations in 2022.
Background on SPAC Warrants
Given these dynamics, why on earth would I see opportunity in pre-deal SPAC warrants?
Let’s first get the basics of SPAC warrants out of the way. Warrants are essentially long term call options, and therefore a leveraged bet on underlying stock performance. With SPACs, warrants are sold to both insiders and investors in the SPAC IPO at prices typically ranging from $1.00-1.50 per warrant. Most SPAC warrants have an exercise price at $11.50 per underlying SPAC share which allows the holder to acquire underlying shares for $11.50. Recall that SPAC shares are usually sold at $10.00 per share and the number of shares sold varies based on how much capital the SPAC is raising. Therefore, a strong performing deSPAC stock that goes up to say $15+ would make the option to acquire shares at $11.50 pretty darn valuable! SPAC warrants typically have a five year term that starts ticking after an initial business combination deal is consummated by the SPAC. One of the most important features of SPAC warrants is that they expire worthless if the SPAC winds down without completing a deal.
There are other wrinkles to SPAC warrants, including the ability for the company to redeem the warrants from their holders early if a deal is completed and the underlying deSPAC company shares reach a trigger price for a certain amount of time (typically $18.00 per share for 20 out of 30 trading days). In most of these redemption scenarios, the warrants would be worth multiples of their initial sale price, despite the holders losing out on future upside.
You can imagine that a five year call option on a stock, particularly a stock with high volatility and/or growth potential, is pretty valuable even when that call option is not yet “in the money” (underlying stock not yet trading above the option exercise price). With traditional listed call and put options, the longest term an investor could buy an option for is typically just 2-3 years out into the future. For example: if you want to buy a call option to purchase Apple stock at a level slightly higher than where it trades today, expiring in early 2024 (~ 2 years from now), it’s still going to cost you a sizable outlay. That’s due to “optionality” or “time value” which makes the option worth something today given reasonable probability of the stock being much higher in two years time. And that is despite the fact that there is non-zero probability that the underlying Apple stock could be lower over the next two years and therefore the option can expire worthless (100% loss of purchase price). The important thing to understand is that warrants, which are similar to five year call options, can have significant value due to future potential performance of underlying stock.
SPAC warrants typically start trading publicly soon after a SPAC raises its initial capital, before any deal with a target company is reached. Given 600+ existing SPACs are still out there seeking deals, there are hundreds of “pre-deal” SPAC warrants currently trading on public exchanges. As of 12/30/2021, pre-deal SPAC warrants are trading at a median value of $0.70 per warrant (average ~$0.90 per warrant)by my calculations. Nearly 500 pre-deal SPAC warrants trade below $1.00 per warrant and almost 200 pre-deal SPAC warrants currently trade at $0.60 or below.
The Opportunity in SPAC Warrants
Are some of these pre-deal SPAC warrants cheap/underpriced? We know most of them currently trade below their initial purchase price ($1.00-1.50) where insiders and institutional investors purchased them. But where should they trade and what is the potential upside in a successful SPAC deal scenario? I’m going to tackle this from several angles:
Theoretical option pricing models (Black-Scholes, Monte Carlo simulation, etc)
Actual historical performance of warrants with successful SPAC business deals
This will get in the technical weeds for a few minutes but stick with me and I think it will make sense.
Option Pricing Models
The Black-Scholes-Merton (“BSM”) model is the most widely known model for pricing simple call and put options. It’s most critical inputs include option exercise (“strike”) price, time to option expiration, current underlying stock price, and underlying stock volatility. It’s not the most accurate option pricing model out there and it can’t account for exotic features in options, but it’s not bad for giving ballpark price estimates for some options. If we ignore the complexity of SPAC warrant features, we can use BSM to get a ballpark estimate of what a five year call option would be worth on day 1 for a SPAC that has completed a business combination with its target. [Note: I assume 45% annualized stock volatility despite many recent deSPACs displaying annualized volatility above 50%]
With the underlying SPAC stock at $10 (and assuming a consummated business deal), the simple five year call option would be worth about $3.61. Now we know many SPAC warrants can be forcibly redeemed once the underlying stock trades above $18.00 for about a month. Giving up some upside optionality above $18.00 on the underlying stock is sort of similar to selling a call option at that strike. Using the same inputs as before, but an $18.00 strike price, we get to a $2.34 value for that call option:
Thus a buyer of a five year call struck at $11.50 who is giving up their upside above $18.00, might be willing to pay a net cost of $1.27 ($3.61-$2.34). Paying $1.27 for this option spread is surprisingly close to what insiders are actually paying for SPAC warrants upfront when SPACs raise initial capital. It’s also well above where most pre-deal SPAC warrants are currently trading.
However, there are multiple problems with using Black-Scholes approximations to price SPAC warrants. The BSM model is used for “European style” options that can only be exercised at expiration, yet SPAC warrants can often be exercised “American style” at any time after deal completion (which makes them more valuable). Furthermore, I way overestimated the option value hit from the warrant redemption feature in the paragraph above. The warrant redemption feature does not necessarily lead to giving up all upside above $18.00 per share, as the underlying stock must trade above that level for 20 out of 30 trading days, during which time the warrants can be exercised or sold to capture upside before redemption. The true value hit from the redemption feature is a fraction of the previous estimate and therefore the value of SPAC warrants at deal completion is theoretically higher than $1.27.
So given the complex/exotic nature of SPAC warrants, is there a better valuation model? Yes, sort of. Complex options do not have simple pricing equations (closed form solutions), but approximations and simulations are used. Most accounting firms that work with SPACs utilize Monte Carlo simulation to value warrants. I’m not going to bore you with the details, but I put together my own Monte Carlo simulation model in Python. I’ve run tens of thousands of simulations and the average warrant value tends to end up around $2.90 (with the SPAC stock trading at $10.00). I don’t believe there are any obvious errors in my code, but please let me know if you spot one.
If the value of an average SPAC warrant should theoretically be $2.90 on the day the SPAC completes a deal, but pre-deal SPAC warrants are trading at an average of $0.70, that would seem to imply the market believes the liquidation rate going forward will average about 76% (expected value calc here is 76% x $0.00 + 24% x $2.90 = $0.70). Historically the SPAC liquidation rate has been less than 10% judging by the data from S&P, spactrack, spacinsider, and spacanalytics. In fact there were only a few SPAC liquidations in the past several years. I said earlier that I do expect the number to increase going forward…but is 76% the correct figure? I doubt that.
Real World Warrant Returns
It’s interesting to look at the current & historical warrant prices of SPACs that have completed business combinations in the past two years, of which there are roughly 260 based on the data (via spactrack.io). Not all SPACs have warrants, and historical pricing on warrants is not widely available, but I’ve been able to get historical warrant prices for about 230 of these SPACs through my own stock price database.
Today the median post-deal SPAC warrant price trades around $1.15 (average is ~$1.60). This understates the potential for warrant upside since 1) it excludes the best historical performers whose warrants were redeemed at high prices (in many cases between $5.00-$20.00 per warrant) and 2) warrants have generally sold off in the past two months because of seasonal tax loss selling as well as current negative sentiment towards deSPACs. If I include redeemed warrants in my calculations at their prices just prior to redemption (not all time highs), the median post-deal SPAC warrant rises to ~$1.40 and the average balloons to ~$2.70. Roughly one-third of post-deal warrants trade above $2.00 or were redeemed above $2.00. Almost two-thirds trade above $1.00 or were redeemed above $1.00. Using all time high prices or prices from earlier in the year would skew things further to the upside. Either way, these numbers are closer to the theoretical warrant values from the Monte Carlo simulations and much higher than today’s average pre-deal warrant prices.
It is also insightful to look at warrant prices just prior to and just after SPAC deal announcements this past year. This was a difficult data set to wrangle, but I did it manually for you dear readers. Here’s a link to the raw data in Google Sheets. The median price of warrants just after deal announcement was $1.30 in 2021, with a median percentage change of 15% on deal announcement. Averages skew much higher due to outliers such as DWAC, CCIV/LCID, ACTC/PTRA, CAPA/QSI, etc. Here’s a view of the data by month (1=January, 2=February, etc):
A few things to note here:
This data does not capture upside/downside beyond the deal announcement day
Pre and post deal warrant prices have come down significantly on average
December 2021 has been a weak month for post-deal warrant prices
Warrants still seem to exhibit large avg. % increases upon deal announcements
Even in December 2021, 60% of the SPACs which announced deals saw their warrants go up in price. With pre-deal warrant prices down significantly in recent months, one could imagine the forward returns have improved, even if the post-deal pops are not as exciting as they once were. The aggregate data on post deal announcement returns also shows the highest returns on average accrue to warrants trading well below $1.00 prior to deal announcements.
Quick recap before moving on: most pre-deal SPAC warrants currently trade below $1.00, with hundreds trading as low as $0.60 or below. When SPACs get deals done, their warrants tend to trade up well above $1.00 on average, which makes sense when we look at how long term call options are priced using various models. The market is pricing a very high implied SPAC failure rate. If one believes that will not occur then some of these warrants have high return potential.
In Part 2 of this post, I will look at some potential return scenarios and focus on ways to reduce risk through SPAC selection and portfolio diversification.
This week the market rallied over 10%, and judging by the reactions online and in various media outlets many people seem to be LOSING THEIR MINDS
All of a sudden people seem pissed off about the Federal Reserve taking action to prevent a depression, and about the state of capitalism generally. Whether it was Chamath Palihapitiya’s widely shared CNBC rant about letting companies fail, the r/wallstreetbets subreddit melting down, or seemingly everyone on Twitter complaining about rigged markets, there’s clearly widespread anger about the stock market and intervention in the economy:
A lot of it sounds like whining from people who were either positioned to profit from a bearish outlook (i.e. the wallstreetbets idiots who have been buying expensive OTM put options on stocks) or people who sat out the recent market rally.
The Barstool Sports guy Dave Portnoy losing millions trying to daytrade this volatile market would be funny if it weren’t so damn sad. It’s turned him into a classic pessimistic permabear who screams about the Fed and puts up awful returns
Dave has been consistently losing money in the past month. He needs some training & education
Many of the permabears were screaming about how the Federal Reserve was “out of bullets” when the central bank cut their benchmark interest rate to 0% in mid March. On the “We Talk Money” podcast on March 18th I tried to dispel that myth. Now these people are **shocked** that the Fed is taking more aggressive actions like lifting some restrictions on banks so they can lend more, helping support fiscal stimulus and loan programs, and even purchasing bonds of companies that have fallen from investment grade status to high-yield (“junk”) status. In the permabears’ eyes, the Fed is wrong and the market is headed for either 1) a crash or 2) hyperinflation, depending upon how the stock market is trading that week. There’s no nuance or middle path.
I saw this same dynamic play out in 2008 and 2009 during the Global Financial Crisis. The permabear viewpoint is seductive, especially to people who are affected by financial crisis and see the injustices in the current economic system. But it is a dangerous one for serious investors looking to grow their wealth over time.
I believe a more rational & nuanced perspective is helpful. Let’s look beyond headlines and take a deeper look at some of the issues at hand. That will provide some needed perspective so we can make decisions that are less rooted in volatile emotions.
Is The Stock Market Detached From Reality?
Thinking that the market (and every stock therein) should trade lockstep with the short term state of economic affairs is naive. If you know anything about equity valuation, then you know that the value of a company and therefore it’s stock is based on the sum of all the company’s future cash flows it will generate for shareholders many years into the future (discounted back to the present by a discount rate that accounts for uncertainty & risk).
That is exactly why a stock’s value (and by extension an index of companies like the S&P 500) is said to be forward looking. Obvious short term events that reduce a company’s cash flows or earnings do matter, but not nearly as much as the long term cash flow generation potential of the underlying business. We know that the economic shutdowns due to coronavirus are severe but also relatively short in nature. Investors must consider what surviving companies will earn when things return to a level of normalcy, particularly in years 2021, 2022, and beyond. So that’s one important factor that can create divergences between the current state of the economy and stock prices.
Second, many people measure the performance of the stock market through the performance of broad indexes such as the S&P 500 and NASDAQ 100. But it’s crucial to know that the large well-capitalized tech companies such as Amazon, Apple, Google, Microsoft, and Facebook currently represent a disproportionally large share of the value of these stock indexes. These large tech giants have net cash on their balance sheets to weather the current storm, and some of them such as Amazon and Microsoft are even seeing an increase in some of their businesses (cloud, e-commerce, gaming, etc) during this tough economic environment. These businesses were growing faster than the average business prior to the economic shock as well.
Note the high concentration of big tech in the NASDAQ-100 (QQQ) and S&P 500 (SPY) indexes:
So part of the resiliency of the US “stock market” can be attributed to this concentration. If you look at the year-to-date performance of the Russell 2000 index, which is made up of many smaller companies, it has performed much worse than the S&P500 or NASDAQ-100. The Russell 2000 is still down 25% year-to-date:
Many individual stocks, particularly those in affected sectors such as retail, airlines, hotels, energy, and banking, are still down over 50% year-to-date despite the recent market rally.
It’s also very possible that the stock market as a whole has rallied too quickly and we will see some correction or choppiness in the next couple of months as earnings reports and economic data give investors a better picture of the economic situation and recovery speed. This happened during the GFC as well, with the market initially rallying after the first wave of fiscal stimulus package announcements, before sinking to its final lows in the spring of 2009. Of course we know the market eventually recovered to deliver solid returns over the following decade. Longer time frames provide important perspective!
The Bailout Boogeyman
Now some people will say the market’s recent rise is due to the government “printing money” and company “bailouts”. Let’s address the topic of corporate bailouts first, since the topic is widely misunderstood and also the focus of Chamath’s widely publicized CNBC rant.
I personally dislike the term bailout because it implies a direct, no strings attached transfer of money to companies that never gets paid back. In the vast majority of cases where the US government has provided assistance to distressed companies and industries in the past, the form of that aid has been through loans or senior preferred stock that is paid back with interest. The rescue financing packages usually come with significant stipulations for how the money can be used as well as restrictions on the companies ability to pay dividends and executive compensation. The US government actually generated net profit on its rescue financing programs during the Global Financial Crisis of 2008/2009.
The primary recipients were the eight largest banks (JP Morgan, Bank of America, Goldman Sachs, Morgan Stanley, Citigroup, Wells Fargo, Bank of NY Mellon, and State Street) as well as AIG, Fannie Mae, Freddie Mac, Ally, GM, and Chrysler. Some smaller banks also utilized the TARP programs, but overall very few companies received direct assistance from the federal government. Fannie Mae and Freddie Mac were actually nationalized and the government has been tied up in court for years due to accusations that the government has made TOO MUCH money from those forced takeovers.
Well what about this time around? Chamath was incorrect when he stated that the federal government is bailing out cruise lines. That has not happened yet, and I think that it’s very unlikely cruise lines will receive any assistance from the US government. Royal Caribbean is incorporated in Liberia, Carnival is incorporated in Panama, and Norwegian Cruise Lines is incorporated in Bermuda. The actual ships are registered in various island nations. These cruise ship companies pay very little corporate income taxes to the US government. To bridge them through the crisis period these companies will have to raise debt & equity capital from their own investors. And in fact this is already happening! Just this week Carnival went to market and raised $5.75 billion of expensive debt (11.5% interest rate) as well as $500 million of new equity:
But what about the airlines? The US aviation industry has lobbied hard for the federal government to provide loans and/or grants to keep the airlines from falling into bankruptcy. Airlines have seen revenues plummet 90%, and yet they have significant fixed costs that create massive cash burn while air travel is halted. The CARES Act, the $2.3 Trillion dollar fiscal stimulus bill, includes provisions that will specifically give aid to the aviation industry. One major piece of that aid is $25 billion in cash grants, but those grants are specifically for keeping workers paid and on payroll. It also remains to be seen what strings could still be attached to this money, as the aid package details are still being finalized. There may also be some loans or forced equity stakes required to receive this aid. At the end of the day it’s not going to be a windfall for shareholders of airlines, but it might help some airlines stay out of bankruptcy which does preserve some equity value for current shareholders.
So why do it? Why not let airlines go through the restructuring / bankruptcy process? As Chamath said, the US has a good set of procedures for companies to restructure their debt in bankruptcy. But that is under normal circumstances. In normal times an individual company can go into bankruptcy and if the business is viable, get a Debtor-In-Possession (“DIP”) loan to continue operating while they restructure debt. It is a long and expensive process (lawyer fees charged at $1000 per hour, many negotiations between creditors, court hearings, etc) but it is generally doable. However these are not normal times. Without aid, the entire airline industry would likely fall into uncontrolled bankruptcy AT THE SAME TIME. Our courts probably don’t have the capacity to deal with that, and our commercial banks do not have the capacity (or risk tolerance) to provide $25-50 billion of DIP loans at once to a single industry. Many jobs would be lost and many other downstream businesses (airports, restaurants, hotels, etc) would be permanently harmed. It is better for the government, which has massive balance sheet capacity and low cost of capital (govt bond rates under 1.0%!), to provide needed capital to bridge the airlines through this difficult period.
Look, I get that many businesses (including airlines) should in retrospect have had less debt and more cash to weather a storm. But most individuals and businesses did not plan for a situation in which most of the economy was literally shut down for two months. We have planned for recessions but not this. That probably changes our planning calculus going forward into the future, but it’s the reality we have to deal with now. And the truth is, most of the US federal stimulus IS being targeted at helping small to medium sized businesses as well as individuals who become unemployed/underemployed:
It’s a larger and faster effort than in 2008. I think that’s ultimately a good thing. Why would we want to let the economy spiral into depression? It’s impossible to cleanly clear out weaker companies and create stronger remaining companies during a broad crisis like this. We can argue about the structure of the stimulus programs, and whether individuals should get larger direct payments and certain businesses less. I think Canada actually did a better job than the US at simplifying their assistance programs and getting cash in the hands of individuals rapidly. The US had issues with the PPP program out of the gate which is unfortunate. Bottom line, there are valid criticisms of the fiscal and monetary stimulus programs, but let’s not misrepresent what the goal is here or pretend that we can allow entire industries to fail without serious long term consequences for all of us.
What Happens Next?
So with the economic damage occurring as a result of the virus, the offsetting impacts of stimulus, and financial markets alternating between fear and greed, how do we make sense of it all?
We are dealing with many uncertainties. No one really knows how this will all play out in the short run. But here are some things to think about as we move forward:
Earnings reporting season for Q1 2020 starts up in about two weeks. Prepare for volatility especially in individual stocks. Investors’ focus will be cash burn levels, sources of available capital, and expectations of forward looking demand (signs of/shape of potential recovery)
Will we see a new low in the market again? I can’t say for sure. I do think some stocks may have already seen their low for this cycle. Others still have 100% downside. Understanding balance sheets and liquidity are still VERY important
Should investors go to cash or invest more here? Picking perfect tops and bottoms in the stock market is nearly impossible. The data from multiple studies suggests that trying to be “all-in” or “all-out” is a recipe for poor long term returns. Personally I have some short index hedges and cash reserves but mostly I’m just trying to be patient and scale into (dollar cost average) undervalued companies for the long term. Don’t let daily market movements dominate your emotions and decision making. If I’m a little early on accumulating something that does well over the next 5-10 years it doesn’t matter all that much in the end
Government deficits will be eye popping this year. We are getting our first experiment in broad scale “MMT” style or Basic Income style policies in many countries such as the US. This will shape policy and attitudes about money, deficits, stimulus, etc for many years to come. Whether it leads to inflation/reflation after the crisis depends on many factors. Don’t listen to the fearmongerers calling for hyperinflation. For now there is deflation in the economy offsetting the money created by deficit spending
Expect the backlash against central banks and federal government to continue. This will have implications which may affect elections this year
States are going to be facing some funding crises and this will open up opportunities in industries such as cannabis and gambling
This crisis will also likely lead to more restrictions on companies’ capital allocation. Think less buybacks, dividends, and debt going forward
Watch how hard money hedges such as gold and Bitcoin perform. These may provide uncorrelated sources of return to a broader portfolio
Remember that most human economies & communities find a way to grow and thrive over the long term. We will get through this crisis too
Stay healthy & sane out there! I leave you with an optimistic view on the world:
I apologize for being so quiet over the past few months as I’ve been heads down on personal projects and investment research. The newsletter has taken a backseat, but I’m hoping to share more with you all in the coming months!
These are obviously wild times in financial markets. I won’t bore you by rehashing coronavirus news or anything along those lines. What I will say is that I’m finding incredibly interesting situations and dislocations in certain areas of the markets. There are liquidations and investment fund de-leveragings happening, which is creating pockets of value I haven’t seen since 2008/2009.
Markets like these are not super common (although seemingly more common in the past 30 years), and while they are scary in many ways, they also offer opportunities to generate tremendous wealth. There’s no avoiding uncertainty, as we can’t know the future exactly. If we wait too long for blue skies and certainty, the juiciest opportunities will be gone. So I am actively hunting big game in financial markets because the window is likely small.
There’s no doubt that we have entered a new economic phase and that means some stocks which look like bargains are really just value traps. In other cases, there are stocks which will be 5-10 baggers in three years from current levels. One of the keys to investing during this time frame (as in 2008-2009) is knowing how to assess balance sheets, credit agreements, and capital structures. This can mean the difference between “catching a falling knife” that ends up severely damaging one’s portfolio, and owning something that will survive the crisis period and go on to thrive.
Again, certainty is impossible to attain with investing, but we can apply probabilities to possibilities and pick situations that have high probability adjusted reward-to-risk levels, or said another way, asymmetric upside optionality. I believe I have several of those in my portfolio now. Today I want to share one of those with you.
The stock is actually a publicly traded real estate investment trust, or REIT, which owns high quality shopping centers in the US. That REIT is Macerich, trading under ticker symbol MAC. It closed last week just above $5 per share and I think it has the potential to be a $15-$30 stock (3-6X return) in a few years.
Yes I know that malls are currently shut down and people are calling for the retail-apocalypse to wipe out most brick-and-mortar retailers and malls in the near term. But there’s more to this story than meets the eye, especially with MAC and especially at these prices.
I’ve created an hour long video that walks through some of the ins and outs of my investment thesis. It will do a better job of explaining the situation than I can write about here. So if I’ve piqued your interest, check it out here:
And if you want the TL;DR version, here’s my quick tweetstorm on MAC: