Option/Warrant Overhang
With junior exploration companies you should be aware of the capital structure and timing before investing. Before investing you should know any stock holds as well as options/warrants outstanding.
In this article I'll attempt to break the impact of these down in terms of market flows and value distribution. I'll then use an example of a company I was looking at recently to apply some of this analysis.
Company Background
Sitka Gold drilled a hole that got my attention. Maybe this company could qualify for a small high risk position in my portfolio.
220.1 meters of 1.17 g/t gold from 6.0 to 226.1 meters
In the Yukon those kinds of grades from surface can be economic open pit mines. Neighboring (claim blocks adjacent) mine Victoria Gold has a grade of 0.65 g/t. Banyon Gold has a market cap 4.5x Sitka's and has a pit constrained resource at 0.54g/t.
257 gram meters crosses my discovery hole threshold (200) that greatly increases the chances that this results in a 2Moz resource. 2Moz resource is my threshold for an invest-able project in Canada. That's big enough to justify the permitting and to build a mill with enough scale to make the project AISC reasonably low.
They are now building a road and camp from the access roads that go through their property. So no more helicopter support. 30km to power lines.
Market Flows
In the short-run, the stock market is a voting machine. Yet, in the long-run, it is a weighing machine. - Benjamin Graham
For every buyer there is a seller, and for every seller there is a buyer. One of the large forces in the stock market is that investors tend to sell a company when they think the shares are priced at higher than a company is worth and they tend to buy when they think the shares are priced lower than a company is worth.
But that's not always true. For example, when discussing company management buying or selling I've long said that there is only one reason management buys, because they think the price will go up. But there are lots of reasons management sells. Maybe they want to diversify their wealth, maybe a kid is starting college, maybe they want to buy that lake house they always dreamed of.
In the junior mining sector there are several such reasons to sell that aren't the reason that the company is overvalued.
Sell The Stock Keep The Warrant
I'm not giving this as investment advice, but it is a common strategy for private placements. Buy the stock in a private placement, wait the hold period, then sell the stock and keep the warrant so you have upside without as much capital risk. As a result around 4 months after a private placement closes the stock price has some extra selling pressure. The price may go down a little early as traders sell shares in hopes of buying them back from the extra sellers and they might go down a little later as the sellers might not sell on the first day they are allowed to. The selling might be stronger if the shares have gone down and it is December so the investors can lock in tax losses. If the investors were American they might try to hold the shares for a year to get long term capital gains tax rates.
In Or Out Of The Money Warrants
If the Option/Warrant strike price is below the current market price (out of the money) they don't get exercised. If they don't get exercised there isn't selling pressure from the shares. The farther below the current stock price the warrant is the more likely the holder of the warrant will exercise the warrant and sell the shares to lock in their profit. Most investors like to hold the warrants until close to the time they would expire, but some will get exercised earlier.
Expiring Warrants
If a Warrant is below the stock price and is about to expire it is almost certain it will get exercised. And much of that stock from exercised warrants will get sold.
Hands On
I will use the above spreadsheet to discuss practical application.
Let's say my valuation of Sitka was higher than the $0.14/share CAD it trades at current. Should I buy today or wait?
You can see 13% of the shares outstaning are under a 4 month hold and become free trading April 13. Let's add a couple weeks for selling to occur. So do I think probability favors the shares being higher or lower between now and the end of April?
There are some pending drilll results waiting on assays but they aren't from the zone the really good drill hole is from, so maybe we think they are unlikely to move the stock up. The area we are excited about they have to make an access road, build a camp, drill some holes, and wait for assays back. It's probably unlikely they can do all that in that timeframe.
So, I could be very wrong, but I'm going to set a price alert on the stock at a lower price and put a calendar entry on my calendar for April 27th to look at Sitka stock again. If it hits my lower price I'll buy it with a better safety margin, if it gets to April 27th I'll consider paying a little more. There's a chance the stock price runs up before then and I miss out, but there are no called strikes in investing.
With Sitka there is a big warrant/option overhang in future years, but none in the short term and none in the money (though some are close). So we don't expect selling from warrants to suppress the price now while we are buying, but there is a good chance that when we want to sell in the future those warrants could suppress the price. The hope is that the increased value of the company will outweigh the selling pressure from the warrant overhang. That's another reason to want to buy at a lower price, to have some room for gains between my buying price and the strike price of the outstanding warrants.
Detour - Extending Warrants
Let's take a bit of a detour that has no relevance to investors, since they have no control over it, but is interesting to me.
Sitka, and many other juniors, will often extend the end of the warrant period on outstanding warrants. Why would a company do this? Well, if they know they are going to need to raise more money they'd rather not pay finders fees and raise at prices below current market. Also, the holders of those warrants are sometimes insiders or their friends, and you'd like to do your friends a favor.
How should you feel as a common shareholder when a company extends warrant expiration? As a rule I'm against it. If the price of the stock goes down it is even harder to raise money with extra warrant overhang that would have been gone had you let it expire and you won't raise money on the warrants either. It can also depress your common stock price because investors know a lot of their upside will be shared with warrant holders. If the stock goes up even accounting for finders fees you can raise money at better terms. It's a bit of crony capitalism, I'll scratch your back now by extending these warrants and you'll scratch my back later.
I'll still invest in a company that extends warrants, but I see it as something to write down in the negative column when evaluating management's capital allocation ability.
Value Distribution
Let's say Sitka does incredibly well. Who benefits and how much?
Let's say Sitka stock price were to go up from $0.14 to $1.40 as they drilled out great hole after great hole and then accepted a buyout offer. The 10x is the white whale of junior resource investing. That's a 900% gain. Sweet. Common shareholders would collectively make $161m.
But wait, those options and warrants would all get exercised. The company get just over $13m in cash and give out stock valued at $104m. If those warrants were't there that $91m profit the option/warrant holders just made would have gone to common shareholders. That 10x gain for common stock holders could have been a 15x gain.
Of course, some of those options were given to management in lieu of cash and we want management to get paid if investors get paid. And some of those investors in private placements took a chance betting on the company when it was strapped for cash, so they probably earned their bite. But if you are a common stock holder you have to realize that your upside will be shared pretty heavily.
What about the downside, if Sitka finds out that hole was an anomoly and goes back down to $0.09 where it was an explorer with some prospective property but not major discovery? Those warrants and options get wiped out as they expire. Management will probably get a new set of options at a lower price again to keep them aligned with shareholders. Meanwhile it will take years for those warrants to expire and clean up the cap table.
Summary
Stock Holds, Warrants, and Options all present potential future selling volume that can depress a stock price. Warrants and Options also can really dilute the upside of successful companies. Before investing it's worth looking at the outstanind stock holds, warrants, and options and to take them into account when deciding if and when to invest.