This Is How I'm Going to Beat the Market Now

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We all love certainty. We love that our Starbucks coffee will taste the same every day, McDonald's fries will always have the same crispiness, and our reserved parking spot will undoubtedly be patiently waiting for us.

However, when investing, thinking only in absolute terms can be a dangerous habit. If we myopically convince ourselves only one scenario can feasibly happen, we can misjudge opportunity and potentially miss out on big returns. If we think probabilistically, we may be able to make better decisions.

That brings us to the most recent investment I've made in my personal portfolio: Bank TARP warrants. Issued to the U.S. government in the depths of the financial crisis and subsequently

The origins of TARP.

sold on the public markets, these securities are essentially long-dated call options on specific banks. These may sound new to some, but big fund managers like Bruce Berkowitz of Fairholme Fund have been dabbling in these for years now.

So, while I may not be the first to discuss these warrants as potential investments, I believe some of them still offer an attractive value proposition for investors willing to stomach gyrating asset prices.

As I mentioned before, these securities are similar to long-dated call options. So, what does that mean? If an investors buys one warrant today for $X, it gives them the right to buy one share at a strike price of $Y any point over the course of the warrant's life. What makes the TARP warrants unique is their lifespan. Most of them do not expire until late 2018 or early 2019 -- giving investors plenty of time to hurdle that strike price (plus the cost of the warrants) and make a handsome profit.

Most of the banks that received TARP funds have outstanding warrants trading in the public markets. While Berkowitz trumpeted the value of the AIG warrants, and warrants for behemoths like Bank of America and Wells Fargo are usually the ones grabbing headlines, I chose to put my capital behind two smaller, yet burgeoning banks: PNC Financial Services (NYSE: PNC  ) and Capital One (NYSE: COF  ) .

Why these two?
Before we dive into the numbers game, I want to highlight the leaders of these two institutions. PNC and Capital One are run by incredibly prudent and successful bankers in Bill Demchak and Richard Fairbank, respectively.

Bill Demchak and Richard Fairbank.

Demchak just became CEO in April, but the guy has been around the block a few times. After a rock-star career at JPMorgan, Demchak made his rounds at PNC, serving as CFO and running the bank's corporate business. Fairbank's progression is arguably more impressive. He founded Capital One 25 years ago and has turned it into the nation's 6th biggest commercial bank by assets, all while placing the company on Fortune's "100 Best Companies to Work For" list. Fairbank sports an 88% approval rating on Glassdoor.com, and Demchak sits at 86%, while their peers' average is only 75%. Both banks are in good hands.

PNC and Capital One have high marks when it comes to the warm-and-fuzzy stuff, but do they cut it when it comes to actual performance? You bet. Both banks sport a double-digit return on equity for the past 12 months, were approved by the Fed in March to bump up their dividends, and have emerged from the financial crisis with new, long-term strategies.

In addition to buying RBC's U.S. retail operations in 2011 to increase its Southeastern footprint, PNC and Demchak are making waves regarding how they plan to tackle the banking business over the next decade. Demchak has done away with free checking, overhauled retail locations with new technologies, and pounded the tables for the bank to make inroads in the wealth management business. Demchak thinks the banking game is changing -- moving from one that primarily depends on vanilla loans and brick-and-mortar branches to one that's lean and provides services for a clear and transparent fee. I think he's right.

Capital One also has some thoughts on the future of its competitive landscape. For so long, the bank was mainly a credit card issuer, which is a great business when the economy is humming along and you are collecting some fat interest payments. But when the economy goes sour (like it did in 2008), people stop paying altogether, and things get ugly.

Capital One recognized this and has transformed itself into a full-service bank (credit cards only make up around 40% of its business now). By gathering deposits and acquiring low-cost platform ING Direct (now Capital One 360), Fairbank and team now fund over 71% of the bank's assets with deposits, more than Wells Fargo's 70%. The business is now more stable and more diversified, yet still wildly profitable and well-capitalized.

Why the warrants?
If these companies sound so great, why aren't I buying common shares today and becoming an true owner? The answer is because I really like these companies.

I am a relatively young investor with decades of investing ahead of me, and thus, I can afford more risk in my portfolio. As we previously discussed, the warrants allow me to pay a price today (roughly $17 and $32 for PNC (NYSE: PNC-  ) and Capital One  (NYSE: COF-  ) , respectively) and buy the same amount of shares at a strike price in the future ($67.33 and $42.13). If the common stock price is below these prices at expiration near the end of 2018, I lose 100% of my investment. These are a high-risk investment.

But they can also be a high-reward investment, if both continue to grow book value per share, and market multiples continue to push higher, stock prices could sit well above the respective strike prices, giving investors a leveraged return on these two companies.

How confident are you?
It's possible of all that great stuff won't happen. Here's where thinking probabilistically is important. Determine what you believe is the most likely scenario, and give that the largest weighting. I continue to believe the banking sector is relatively undervalued and valuation multiples are likely to creep higher over the next several years, but I may be wrong. These banks could struggle, or crises may crop up -- it's possible.

I pegged my likely scenarios and probabilities for the underlying stock prices as follows:

So, what happens if my probabilities prove correct, and shares of PNC and Capital One give common shareholders an annualized return of just over 5% (excluding dividends)? The PNC and Capital One warrants provide an annualized return of 11% and 10%, respectively. In my optimistic scenario of 12% annualized growth, those annualized returns swell to 31% and 22%. I'd be thrilled, but I'm not banking on it.

Not for everyone
Given the underlying strength of these two banks, the leaders steering the ships, and a risk-reward scenario that tips in favor of patient investors, these particular warrants seem attractive for investors with a taste for risk who think the broader market isn't exactly a glaring value and believe stock investors are due for lower overall returns than what we've seen in the past couple of years. I'm one of those investors, and I'm happy to have my money riding on two great businesses with the possibility of even greater returns.

The next generation of bank stocks
The traditional bricks-and-mortar bank will soon go the way of the dodo bird -- into extinction, that is. This sounds crazy, but it's true. Every single one of the nation's biggest banks are dramatically reducing branch counts and overhauling the ones left behind. But despite these efforts, they're still far behind a single and comparatively tiny lender that's already leapt into the future. Since the beginning of 2012 alone, this company's shares are already up more than 250%. And they're bound to go higher. To download our free report revealing the identity of this stock, all you have to do is click here now.

TARP warrants are complex and have other characteristics not discussed in this article. Click the following links to find the relavant prospectus for each security: PNC and Capital One.


Read/Post Comments (2) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 12, 2013, at 7:26 PM, wouter28 wrote:

    Most TARP warrants have anti-dilution clauses that reduce the strike price once dividends exceed a certain threshold. For PNC, that's 66 cents per quarter. I'm a big fan of the TARP warrants and believe they will do well just by the banks growing their book value and valuations staying the same. I think the real gains come in if the valuations start to revert to their historical averages in 5 years when the warrants expire. Of course I'm not expecting PNC to trade at 3 times TBV, but 2 times TBV may not be out of the question. Third Avenue also owns the PNC warrants and commented on them here:

    http://www.gurufocus.com/news/222923/third-avenue-management...

  • Report this Comment On April 15, 2014, at 9:16 PM, srockaz wrote:

    Hi David,

    How about an update on the warrants. Even though it's been a short while, a followup would be nice.

    Still think it's a viable strategy?

    Would now be a good time to purchase them?

    Thanks, srockaz

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