Everyone likes to buy something on sale, and investors are no different. Value investors have long looked for beaten down stocks that they think have been unfairly punished by the market and are poised to bounce back. Of course, a stock’s price usually falls for a reason, and it can sometimes take quite a while for a company to turn itself around and increase its stock price, if it is able to do so at all. Still, the upside potential to this strategy can be great, as demonstrated by the likes of Warren Buffett and Peter Lynch.

One of the issues common-stock investors face when waiting for a downtrodden stock to rebound is that their capital is tied up and unavailable for other, possibly more productive, uses. However, financial instruments, such as warrants, can help mitigate this problem. A warrant is a derivative security that gives its holder the right to buy another security (typically equity) at a specific price within a specific time frame. Warrants are similar to call options, but warrants are issued by the company whose equity is the underlying security, as opposed to call options, which are exchange instruments not issued by the underlying company. Additionally, the time period attached to warrants is typically much longer than that of call options (think years rather than months).

The good news about warrants is that they give the holder exposure to the underlying security for a fraction of the price of buying the stock directly. The downside, however, is that warrants tend to be more volatile than the underlying stock and can expire worthless if the equity security declines in price. For example, say you spent $10 on a warrant with a strike price of $40 and a five-year time frame. Let’s also assume that the underlying stock traded at $35 a share when you purchased the warrant. In order to turn a profit, the stock would have to increase in price by a minimum of $15 a share (to $50 a share) over the next five years. Any price increase of less than $15 would result in a net loss. Moreover, you would lose your entire $10 investment if the stock failed to rise to the $40 strike price.

Despite the added risk, warrants may be a good option for long-term investors that are bullish on battered stocks or sectors. One such sector that comes to mind is banks and financial companies. Many of these institutions were hit hard during the financial crisis, and some of their stock prices have yet to return to pre-recession levels. For investors anticipating a more vigorous recovery in financials over the coming years, warrants may be a good option.

The Value Line Convertible Survey covers about 80 warrants, including those of financial institutions like Bank of America (BAC – Free Bank of America Stock Report), Capital One (COF), Hartford Financial (HIG), JPMorgan Chase (JPM – Free JPMorgan Stock Report), and Wells Fargo (WFC). Moreover, the common stocks of these companies are covered in the Value Line Investment Survey. Subscribers can use these two resources to find their favorite risk/reward scenarios, though we believe that warrants on timely JPMorgan Chase shares are particularly attractive. 

JPMorgan Chase & Co. is a global financial services firm with operations in over 60 nations. Its businesses include investment banking, treasury and securities services, asset management, commercial banking, retail financial services, card services, and private equity investment. The company’s net loan losses were 3.81% of its average loans in 2010. On March 31, 2011, its loan loss reserve was 4.34% of loans and its nonperforming assets (excluding 90-day past due) amounted to 2.18%.

JPMorgan reduced loan loss reserves in its credit card and investment banking businesses by a combined $2.5 billion in the March quarter, reflecting lower bad loans and declining credit card losses. As economic activity strengthens, Value Line analyst Theresa Brophy believes that Morgan’s loan losses should fall further, but given the significant cuts in reserves in the past year, loan loss provisions in 2011 may not decline as much as in 2010.

All told, the reserve reductions, strong trading income, and higher profits in the commercial bank, treasury/securities services, and asset management divisions more than offset a loss in the mortgage business, caused by foreclosure and mortgage servicing expenses. Moreover, Ms. Brophy thinks that the better-than-expected opening-period performance puts JPMorgan on track to earn a record $5.00 a share in 2011 and looks for a 10% advance in 2012. She notes that mortgage expenses probably will stay fairly high over the rest of 2011, but may moderate in 2012. Retail banking revenue should benefit from an expanded branch network and salesforce, while the investment banking business still has good share positions in its markets and should perform well, even though trading revenue may not stay as strong as in the March quarter. Ms. Brophy goes on to say that the commercial banking, treasury/securities services, and asset management businesses are smaller but generally steady contributors to consolidated results, and that stock repurchases will likely lift share net in 2011 and 2012.

Looking further out, JPMorgan has identified a number of opportunities to grow over the long haul, including expanding internationally and increasing business loan production in the former Washington Mutual branches. Higher interest rates also should boost results. Given all this, Ms. Brophy estimates that JPMorgan stock will trade in the $65- to $95-a-share range over the pull to 2014-2016. Consequently, the bank’s outstanding 2018 warrants could potentially be a profitable investment. The warrant with a strike price of $42.42 trades at about $13.07 a share, and the underlying stock is trading around $40.80 a share. Therefore, the issue would have to rise about 36% (to $55.49) over the next three to five years to become a profitable investment. Investors willing to wait out any recovery in the common may be well served by an investment in JPMorgan’s 2018 warrant.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.