VALUE: After Hours (S08 E01): Strategic Catalysts: How Warner Bros. Created an Auction for Its Assets

During their recent episode, Taylor, Carlisle, and Gary Mishuris discussed Strategic Catalysts: How Warner Bros. Created an Auction for Its Assets. Here’s an excerpt from the episode:

Gary: This is a family show. So, I don’t want, I don’t know how all the folks are listening, so I’m not going to say it. But I think you can imagine what’s in between the S and the T. And they’re going to get rid of the bad co and just keep the good co. And I said– And that like light went on, okay, this is a catalyst. You had this potential energy or what is the business theoretically worth? That didn’t matter because the market’s like, “I don’t care what you theoretically worth. Nothing is changing. No one is forcing me to value it differently. So, I, Mr. Market, will value however the heck I want. And right now, I’m mad at the management. I hate the industry they’re in. I hate the decline in the cable network. I’m going to value it low and you can’t do anything about it.” Management says, well, no, actually we’re going to do it. And so, they announced these plans and that plan–

Again, I would say it’s in a kind of soft catalyst category because it’s not a hard catalyst. Like when the separation happens, the market doesn’t have to change the price. It’s not like a return of capital or something like that, but it was a pretty good bet that once the main reason for the hate and negativity was going to be know funnel off separately with the law of debt by the way that their main co or the good co would be valued a lot differently or perhaps would be attractive to other to a different set of shareholders. And if nothing else, the cash flow stream from that company would be very valuable and they could just return it. And if that valuation didn’t change, they could buy back shares. In this case you had Dr. Malone on the board, so you had a pretty good guess that they were going to be smart about capital allocation, not just going to blow it.

So, you kind of put all those things together. And the last thing, I’m almost hesitant to mention this because when I’m going to mention this, people are going to think like this. Gary sits and does this all the time. This is the exception, not the rule. Caveat emptor, buyer beware, whatever yellow triangle warning attached, but occasionally this might be heresy like value investors can use options within a long-term value strategy. And again, when I started investing, I used to think all options were complete gambling. And I by the way think that if you never touch an option in your life, you probably are fine. You can still do very well as an investor, but there are times, there are probably four or five different patterns where you can use them well within the intrinsic value framework, especially if you’re disciplined how intrinsic value ranges and have processes and position sizing and all of that dialed in.

In this case, there was an accelerated time horizon which kind of made sense to align with options strategy because like what’s the biggest downside of options? It’s like time. As an investor you ideally want time on your side. So, like the number one, two and three terrible thing about buying a call option is time is against you. If something doesn’t happen within the time frame of the option, you basically get nothing even if you’re right eventually on your insight as opposed to holding the equity. And how do you offset that disadvantage? Occasionally, the option is much, much more mispriced than even the equity. And in this case my rough estimate was the option was trading below 10 cents on the dollar of fair value for that option. And so, you had like a catalyst, you had a pattern for where value is likely not guaranteed to be unlocked. You had this good co, bad co situation. And so, I actually expressed that position in options because I thought that was the most mispriced kind of security related to this event. So again, hesitant to mention it because, I don’t want the blurb to be Gary trades zero-day options. I really don’t. But once in a while, this is maybe the second or third time in 10 years I’ve done this. You can have a very big mispricing stacked on top of a already big mispricing.

Tobias: So, you bought a call? Is that the–

Gary: Yes. And so, the other thing I should have mentioned is I bought LEAPS. So, LEAPS, if you’re listening, you’re not sure it’s like just longer-term call options. So, in the US they probably go up to 30 months, but definitely you can get them for 24 months out. And so, if you think about how options are priced, in the market, are priced by something called the Black Scholes formula. And that assumes basically random movement around the current price with a drift term at the risk-free rate, meaning that the price moves in time forward at whatever, let’s say four percent, the current risk-free rate.

That’s about right for like a short-term option. The longer the time frame of the option, the more wrong that becomes. But that’s still how it’s priced. And so, the longer options are partially mispriced based on that. I don’t want to geek out, but essentially, it should be moving forward in time by something like 10% if they’re not paying a dividend, not by three or four percent, so that spread adds up over time.

And also, market makers who sell you these options, they’re not sitting there and looking at fundamental events. So, if you look at Black Scholes, you have this normal distribution, I assume and promise, this is the most math I’m going to use in this conversation. Mostly because despite my MIT background, I’m not that good at math. But here you have kind of a binary event that changes the probability distribution. And you have this very binary situation where you could have a much higher price, but that’s not priced in.

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VALUE: After Hours (S08 E01): Strategic Catalysts: How Warner Bros. Created an Auction for Its Assets

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