Should You Buy Big Banks the Way Hedge Fund Giants Do?

Investing in financial stocks has been one of the most rewarding ways to put your money to work over the past five years, as most big banks and other financial institutions have rebounded sharply from the depths of the financial crisis that threatened their very existence. Buying shares of American International Group (AIG 0.56%), Citigroup (C 0.26%), and other well-known financial companies has produced impressive returns since late 2008 and early 2009.

But what many people don't realize is that there's another way to invest in Citigroup, AIG, and several other big banks and other financial institutions. By following in the footsteps of hedge fund manager Seth Klarman and his well-known Baupost Group, you can invest in financials in a way that gives you a much different risk profile from simply buying the shares.

How Baupost bet big on AIG and Citi
In Baupost Group's most recent 13F -- the quarterly report that lists the hedge fund's latest positions, per SEC regulations -- Klarman revealed that he had increased his exposure to Citigroup and AIG. Specifically, Baupost boosted its position in Citigroup by about 17%, and its holdings in AIG climbed by 20%.

But Baupost doesn't hold regular shares of those companies. Instead, Klarman has chosen to buy warrants on the two financials, giving the hedge fund the potential for higher profit if the stocks climb, as well as the risk of amplified losses if the stocks drop.

Many investors aren't familiar with warrants, but the way they work is pretty simple. A warrant gives its owner the option to buy shares at a predetermined price within a certain time frame. Once the warrant expires, it no longer has any value, and if the stock price on that date is lower than what the warrant specifies, then Baupost will simply let it expire worthless. If the stock has risen above the specified price, though, then the hedge fund will either exercise the warrant and buy shares of stock or sell the warrant to some other investors who will exercise it.

By using warrants, Baupost can take a leveraged position in the two companies. As of the end of last quarter, the hedge fund had more than 122.5 million warrants in Citigroup, corresponding to a number of shares that would be worth more than $6.4 billion at current prices. Yet the value of those warrants was only $75 million, or just over 1% of the underlying stock.

The reason for the big disparity is that the terms of the Citigroup warrants will require the bank's stock to climb substantially from current levels in order for them to have any value. The Citi warrants expire in early 2019, and they call for investors to pay $106.10 per share for the bank stock. With shares trading for just half that, Citigroup would have to double in less than five years for those warrants to have any value at all. But for every $1 per share that Citigroup rises above that level, Baupost will reap an additional $122.5 million in profit, providing a huge potential payoff over the current value of the fund's investment.

Source: AIG.

Baupost's situation with AIG is much different. The hedge fund owns almost 800,000 warrants worth about $21 million, corresponding to shares currently worth about $43 million. Here, the leverage is relatively small -- roughly 2-to-1 versus the 85-to-1 leverage that Citigroup warrants offer -- because AIG stock currently trades above the $45 per-share price specified in the warrants. That reduces the potential payoff if AIG stock continues to rise, but it also improves the odds that Baupost will actually earn that profit before they expire in 2021.

Do warrants make sense for you?
One downside of warrants is that you don't receive the dividend paid by the underlying stock. In Citigroup's case, that hasn't been a big problem, as the bank still pays only a penny per share in quarterly dividends. Even AIG still has a yield below 1%, which compares unfavorably to other financial stocks that have boosted their dividends substantially since the financial crisis.

Yet in this case, warrant holders like Baupost do get some participation in future dividend increases. The warrants have special provisions that adjust their exercise prices downward if dividends exceed a certain amount. That effectively allows investors to get credit for those dividends, even though they won't actually get the benefit of that credit until they exercise the warrants.

Baupost clearly believes Citigroup will make big strides toward profitability despite its ongoing challenges over recent years, and it also seems confident that AIG will continue its impressive rise after its monumental bailout from the federal government back in 2008 and 2009. If you feel equally confident and are looking for a way to magnify your possible profits, then warrants are worth considering. For those with a more conservative bent, though, ordinary shares are a perfectly acceptable way to participate in any possible upside -- even if hedge funds like Baupost might think those potential returns are too tame.