Ken Kam's Best Ideas Blog

One my best ideas stocks, U.S. Global Investors (nasdaq: GROW) was hit hard after a report in a leading business journal stopped just short of accusing the company of using lightly traded securities called warrants to manipulate the performance of one of its mutual funds -- the Gold Shares Fund (USERX) up over 29% so far this year.

The article reported that the fund held 1.1 million warrants issued by Goldcorp (GG) which doubled in value between June 12 and August 30 when Goldcorp's stock rose just 21%. However, between August 31 and September 29 (the date of the article), Goldcorp's stock dropped 21% but the warrants fell only 11%.

The reporter does not state it, but seems to assume that the price of the warrants should always move in tandem with the price of the underlying stock. Therefore, if a 21% gain in the underlying stock results in a 100% gain in the warrant, a 21% loss in the stock should have caused the warrant to fall by much more than 11%.

The reporter leads readers to conclude that the reason the warrants fell only 11% is that GROW owns 75% of the entire issue and somehow prevented the price from falling. The reporter never states this conclusion. But, by failing to provide an alternative explanation, he gives readers the impression that it is the only possible explanation. It isn't.

When a warrant is "in-the-money" (meaning that the price of the underlying stock is above the warrant's exercise price) its price will change the way the reporter assumed. However, the relationship is different when a warrant is "out-of-the-money" (the warrant's exercise price is above the underlying stock's price). Here's why.

A warrant's value can be broken down into two parts -- its time value, and its intrinsic value. Its instrinsic value is the difference between the underlying stock's price and the warrant's exercise price. If the stock is selling for $20 and the warrant gives you the right to buy the stock at $15, the warrant is "in-the-money" and has an intrinsic value of $5. A warrant's intrinsic value does move in tandem with the price of the underlying stock -- just as the reporter assumes.

But what happens when a warrant is out-of-the-money? To continue this example, if the stock traded down to $10, a warrant with an exercise price of $15 would have $0 intrinsic value. It would not, however, be worthless because at some point during the warrant's life, it could trade at more than $15. This is the warrant's time value and it depends on how much time is left before the warrant expires.

If tomorrow the underlying stock drops from $10 to $8 the warrant's intrinsic value which was $0 before would still be $0. The warrant's time value would decline a little because the passage of time will have reduced its remaining life. But, if the warrants had a 5 year life (as the warrants in question did), then the passage of 1 day would not have a great impact on the warrants time value. In this case, it is perfectly reasonable to expect the price of the warrants to fall less than the price of the stock. Nothing unsavory or illegal is required.

The whiff of scandal was enough to cause GROW to drop from the low $30s just a few weeks ago to around $22. I don’t think the drop was warranted by the facts reported in the article. Unless the newspaper has some actual evidence, this episode will soon blow over. I'm not selling.