Confused About Warrants? Using Goldcorp to Explain

Warrants are being mentioned more and more in the traditional media as the U.S. government moves to receive warrants in connection with some of the bailout/rescue plans for the Big Three auto manufactures and also with AIG back in September.

Warrants have a long history going back into the 1920s, but the average investor has absolutely no idea what this investment vehicle is all about.

So let’s make this simple and provide you with a brief understanding of warrants and why you should perhaps consider warrants in your investment plans. (After all, this is not rocket science!)

Warrants are a security issued by a company usually in connection with a financing arrangement or a public offering of shares giving the holder the right, but not the obligation, to acquire the underlying security at a specific price and expiring on a specific date in the future. Sounds a lot like a call option, doesn’t it? Yes, very similar but with a few important differences, namely, how they are issued and how they are traded.

While understanding the term warrants is essential, the next most important question is a warrant on what? The underlying company is of utmost importance because if the company does not perform, execute on its business plans and thus the shares price rising in the markets, then the warrants can not be expected to go up and we are all about making money.

A common question from investors is why would I buy a warrant when I just want to own the common shares of the company? Good question and we have a very easy answer. An investor would purchase a warrant because of the expectation of a greater gain than purchasing the common shares and this term is usually referred to as leverage. See our analysis below on Goldcorp (GG). We would normally suggest investors attempt to seek a leverage of 2 to 1, meaning if the common shares rise by 100% we would expect the warrants to increase by 200%. Another benefit of buying the warrant is that it will cost you much less money thus lowering your investment cost and potentially increasing your return on your investment.

Perhaps a detailed example would clarify any questions you may still have on warrants.

Let's say you are a believer in the return of the long term bull market in the precious metals and commodity sector and you are aware that one of the major gold producers is Goldcorp which trades on the NYSE and the TSX. As you hear many analysts commenting on Goldcorp, you are thinking maybe this would be a good addition to your portfolio. You do some more research (due diligence) and find that Goldcorp, a Canadian company headquartered in Vancouver, Canada, employs more than 9,000 people worldwide has has 16 world class operations and development projects focused throughout the Americas with over 70% of reserves in low risk NAFTA and they do not hedge or sell forward its gold production.

Now you are excited. You have found that Goldcorp meets all of your criteria and you see the potential for the shares to rise perhaps to $70 to $100 due to your bullish views on the precious metals markets within the next 2 years.

This is where we encourage investors, before purchasing the common shares, to ask the question, does Goldcorp (or any other company you are considering in your portfolio) have a long-term warrant which is trading which may provide me with a better return on my investment? We know that Goldcorp does in fact have a warrant which is trading and the issue now becomes, what is the exercise price, when does the warrant expire and does this warrant offer me great upside leverage as the common shares increase in price?

As of the close on Friday, December the 5th, Goldcorp common shares were at C$27.85 and the warrants at C$7.34. The warrants have an exercise price of C$45.75 and will expire on June 9, 2011. At a projected share price of $100 you would have a gain of 259% and with the common at $100, the warrants would have a minimum gain of 639% for a leverage of 2.5 times.

We would like to stress that this is an example and not a recommendation of the Goldcorp warrants. However with the warrant trading on Goldcorp if the answers to your questions are answered satisfactorily the warrant should then be purchased in lieu of the common shares after performing your due diligence and consulting with one's investment advisor.

Currently there are warrants trading on some of the large producers as well as many of the smaller junior mining companies with expiration dates of 2011 and out to 2017 providing investors with some incredible opportunities.

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