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http://www.usairwaysmag.com/articles/wa ... arbitrage/
Introduction
One of the great secrets of Warren Buffett’s investment success has been his arbitrage and special situations investments. They have been kept out of the public eye, in part, because there has been so little written about them. Also, because brokerage costs that lay investors are forced to pay are often ten to twenty times that of professional investors, arbitrage and special situations have been the sole domain of professional investment trusts and partnerships, who can command much lower brokerage rates.
Previously, brokerages have had two sets of rates: They have had retail rates for lay investors and institutional rates for professional investors. A trade that would cost a retail customer $3,000 might cost an institutional client as little $150. In the world of arbitrage and special situations, where the per-share profit is often under a dollar, the high retail brokerage rates formed an almost impassible barrier of entry for lay investors, simply because their brokerage costs often exceeded any potential profit in the trade.
In the late 1990s, with the advance of the Internet, brokerages started offering online trading at deep discounts from their full-service retail rates. The absence of a human broker taking the order resulted in greater cost efficiencies, which resulted in the ability to offer individual retail clients lower institutional brokerage rates. With the lower rates, the world of stock arbitrage and other special situations suddenly opened up to the masses. Sitting alone with a computer and an online brokerage account with deeply discounted trading rates, an individual investor could compete in the field of arbitrage with even the most powerful of Wall Street firms.
Warren Buffett is probably the greatest player in the arbitrage and special situations game today. Not because he takes the biggest risks. Just the opposite — because he learned how to identify the bet with the least risk, which has enabled him to take very large positions and produce results that only can be described as spectacular.
In professors Gerald Martin and John Puthenpurackal’s study of Berkshire Hathaway’s stock portfolio performance from 1980 to 2003, they discovered that the portfolio’s 261 investments had an average annualized rate of return of 39.3 percent. Even more amazing was that out of those 261 investments 59 of them were identified as arbitrage deals. And those 59 arbitrage deals produced an average annualized rate of return of 81.28 percent! Warren’s arbitrage performance not only beat his regular portfolio’s performance, it also stomped the average annualized performance of every investment operation in America by a mile. No one — be it individual or firm — even came close. (And people wonder how he made so many people millionaires! With such incredible returns, how could he not?)
Martin and Puthenpurackal’s study also brought to light the powerful influence that Warren’s arbitrage operations had on Berkshire Hathaway’s entire stock portfolio performance. If we cut out Warren’s 59 arbitrage investments for that period, we would find that the average annualized return for Berkshire’s stock portfolio drops from 39.38 percent to 26.9 percent. It was Warren’s arbitrage investments that took a great investor and turned him into a worldwide phenomenon.
In 1987, Forbes magazine noted that Warren’s arbitrage activities earned an amazing 90 percent that year, while the S&P 500 delivered a miserable 5 percent. Arbitrage is Warren’s secret for producing great results when the rest of the stock market is having a down year.
With Warren’s incredible arbitrage performance in mind and the knowledge that the average investor now has access to institutional brokerage rates, we thought it was high time that we took a serious look at the arbitrage and special situation investment strategies and techniques that produce Warren’s mind-numbing results.
Warren Buffett and the Art of Stock Arbitrage is the first-ever book to explore in detail Warren’s world of stock arbitrage and other special situations such as liquidations, spin-offs, and reorganizations. Together we explore how he finds the deals, evaluates them, and makes sure that they are winners. We go into the mathematical equations and intellectual formulas that he uses to determine his projected rate of return, to evaluate risk, and to determine the probability of the deal being a success. In Warren’s world, as you will discover, certainty of the deal being completed is everything. We will explain how the high probability of the event happening creates the rare situation in which Warren is willing to use leverage to help boost his performance in these investments to unheard-of numbers.
So without further ado, let’s begin our very profitable journey into the world of Warren Buffett and the Art of Stock Arbitrage.
CHAPTER 1: Overview of Warren’s Very Profitable World of Stock Arbitrage and Special Investment Situations
The world of arbitrage and special situations is enormous. It can be found anywhere in the world where commodities, currencies, derivatives, stocks, and bonds are being bought and sold. It is the great equalizer of prices, the reason that gold trades at virtually the same price all over the world; and it is the reason that currency exchange rates stay uniform no matter where our plane lands. A class of investors called arbitrageurs, who make their living practicing the art of arbitrage, are responsible for this.
The classic explanation and example of arbitrage are the London and Paris gold markets, which are both open at the same time during the day. On any given day, if you check the price of gold, you will find that it trades virtually at the same price in both
markets, and the reason for this is the arbitrageurs.
If gold is trading at $1,200 an ounce on the London market and suddenly spikes up to $1,205 on the Paris market, arbitrageurs will step into the market and buy gold in London for $1,200 an ounce and at the same time sell it in Paris for $1,205 an ounce, locking in as profit the $5 price spread. And arbitrageurs will keep buying and selling until they have either driven the price of gold up in London, or the price down in Paris, to the point that the price spread is gone between the two markets and gold is once again trading at the same price on both the London and Paris exchanges. The arbitrageurs will be pocketing the profits on the price spread between the two markets until the price spread finally disappears. This goes on all day long, every day that the markets are open, year after year, decade after decade, and probably will until the end of time.
Up until the late 1990s the exchange of price information and buying and selling in the different markets was done by telephone, with arbitrageurs screaming or-ders over the phones at traders on the floors of the different exchanges. Today it is done with high-speed computers and very sophisticated software programs, which are owned and operated by many of the giant financial institutions of the world.
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Stock Arbitrage
A very similar phenomenon occurs in the world of stock arbitrage, only instead of arbitraging a price difference between two different markets, we are arbitraging the price difference between what a stock is trading at today versus what someone has offered to buy it from us for on a certain date in the future — usually anywhere from three months to a year out, but the time frame can be longer. The arbitrage opportunity arises when today’s market price is lower than the offer to buy, which lets us make a profit by buying at today’s market price and selling in the future at a higher price.
As an example: Company A’s stock is trading at $8 a share; Company B comes along and offers to buy Company A for $14 a share in four months. In response to Company B’s offer, Company A’s stock goes to $12 a share. The simple arbitrage play here would be to buy Company A’s stock today at $12 a share and then sell it to Company B in four months for $14 a share, which would give us a $2-a-share profit.
The difference between this and your normal everyday stock investment is that the $14 a share in four months is a solid offer, meaning unless something screws it up, you will be able to sell the stock you paid $12 a share for today for $14 a share in four months. It is this “certainty” of its going up $2 a share in four months that separates it from other investments.
The offer to buy the stock at $14 a share is “certain” because it comes as a legal offer from another business seeking to buy the company. Once the offer is accepted by Company B, it becomes a binding contract between A and B, with certain contingencies. The reason that the stock doesn’t immediately jump from $8 a share to $14 a share is that there is a risk that the deal might fall apart, in which case we won’t be able to sell our stock for $14 a share and B’s share price will probably drop back into the neighborhood of $8 a share.
This kind of arbitrage might be thought of as “time arbitrage” in that we are arbitraging two different prices for the company’s shares that occur between two points in time, on two very specific dates. This is different from “market” arbitrage where we are arbitraging a price difference between two different markets, usually within minutes of the price discrepancy showing up.
It is this “time” element and the great many variables that come with it, that make this kind of arbitrage very difficult to model for computer trading. Instead, it favors hedge fund managers and individual investors like Warren, who are capable of weighing and processing a dozen or more variables, some repetitive, some unique, that can pop up over the period of time the position is held. It is this constant need to monitor the position and interpret the economic environment that brings this kind of arbitrage more within the realm of art than science.
CHAPTER 2: What Creates Warren’s Golden Arbitrage Opportunity
The arbitrage opportunity is created by the price spread between the current market price of the security and its fixed future value. If the future value at some fixed time is greater than the current market price, a positive price spread is created, which can be exploited as an arbitrage opportunity.
There are two reasons for the price spread developing. The first is that every deal has some possibility of not happening. The greater the chance of the deal not happening, the greater the price spread. The less the chance of the deal not happening, the smaller the price spread. A great deal of mental power goes into ascertaining whether or not the deal is going through, and the investing public’s perception of the risk involved plays heavily in determining the price spread. As the deal nears completion, the price spread will start to close.
The second reason involves what is called the time value of money. Money, over time, if held in interest-bearing investments, earns more money. So if Company A offers to buy Company B in a year’s time for $100 a share, and we spend $100 to buy a share on the day that Company A made the offer, we would be making our $100 back when the deal closed in a year. Doesn’t sound too great, does it? In fact, we would also be losing the opportunity cost on the money, since that $100 could have been put to work earning us interest during the year we had it tied up in Company B’s stock.
Because of the time value of money, with a cash tender offer, the seller’s stock, in theory, will always trade at a value that is slightly less than the value of the buyer’s offer. The price spread is at its widest at the beginning and grows closer and closer together as the closing date draws near. If the deal closes in a year, the offer is for $100 a share, and interest rates are in the 12 percent range, on the initial date of the offer the stock should trade at a 12 percent discount to the value of the $100 offer. Then, in theory, each month that passes, as the closing date draws near, the price spread should close by 1 percent a month, with the price spread between the market price and offer completely closing on the date the deal finally closes.
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In Summary
The arbitrage opportunity arises because of a positive price spread that develops between the current market price of the stock and the offering price to buy it in the future. The positive price spread between the two develops because of the risk of the deal falling apart and the time value of money.
CHAPTER 3: Overview of the Different Classes of Arbitrage That Warren Makes Millions Investing In
Historically, Warren has focused on seven classes of arbitrage and special situations. In the classic arbitrage category, he invests in friendly mergers, hostile takeovers, and corporate tender offers for a company’s own stock. In the class of special situations, he invests in liquidations, spin-offs, stubs, and reorganizations. Though we will go through each of these classes in great detail later on, it would serve us well to quickly touch on each of them before we delve into their finer points.
Friendly Mergers
This is where two companies have agreed to merge with each other. An example would be Burlington Northern Santa Fe (BNSF) railway’s agreement to be acquired by Berkshire for $100 a share. This presents an arbitrage opportunity in that BNSF stock price will trade slightly below Berkshire’s offering price, right up until the day the deal closes. These kinds of deals are plentiful, and Warren has learned to make a fortune off of them.
Hostile Takeovers
This is where Company A wants to buy Company B, but the management of Company B doesn’t want to sell. So Company A decides to make a hostile bid for Company B, which means that Company A is going to try to buy a controlling interest by taking its offer directly to Company B’s shareholders. An example of a hostile takeover would be Kraft Foods Inc.’s hostile takeover bid for Cadbury plc. This kind of corporate battle can get ugly, but it can also offer us the opportunity to make a fortune.
Self-tender Offers
Sometimes companies will buy back their own shares by purchasing them in the stock market, and sometimes they do it by making a public tender offer directly to their shareholders. An example of this would be Maxgen’s tender offer for 6 million of its own shares. Warren has arbitraged a number of these self-tenders in the past and has found them both plentiful and bountiful.
Liquidations
This is where a company decides to sell its assets and pay out the proceeds to its shareholders. Sometimes an arbitrage opportunity arises when the price of the company’s shares is less than what the liquidated payout will be. An example of this would be the real estate trust MGI Properties liquidating its portfolio of properties at a higher value than its shares were selling for. It’s hard to believe it happened, but it did, and Warren was there.
Spin-offs
Conglomerates often own a collection of a lot of mediocre businesses mixed in with one or two great ones. The mediocre businesses dominate the stock market’s valuation of the business as a whole. To realize the true value of the great businesses, the company will sometimes spin them off directly to the shareholders. Warren has figured out that it is possible to buy a great business at a bargain price by buying the conglomerate’s shares before the spinoff, as when Dun & Bradstreet spun off Moody’s Investors Service. Spin-offs come under the category of special situations.
Stubs
Stubs are a special class of financial instrument that represent an interest in some asset of the company. They can also be a minority interest in a company that has been taken private. An arbitrage opportunity arises when the current stub price is lower than the asset value that the stub represents and there is some plan in place to realize the stub’s full value. Warren’s earliest arbitrage play involved buying shares in a cocoa producer, then trading the shares in for warehouse receipts for actual cocoa, which he then sold. The warehouse receipts were a kind of stub. Though they are known under many different names — minority interests, certificates of beneficial interests, certificates of participation, certificates of contingent interests, warehouse receipts, scrip, and liquidation certificates — they still present us with many wonderful opportunities to profit from them.
Reorganizations
These special situations offer some very interesting arbitrage-like opportunities. Warren has invested in a number of them over the years, the most notable being ServiceMaster’s conversion from a corporation to a master limited partnership and Tenneco Inc.’s conversion from a corporation into a royalty trust. We will examine his successful investments in both these reorganizations.
Moving Forward
Now that we have briefly outlined some of the different kinds of arbitrage situations that Warren invests in, we need to spend a few pages going over some of the criteria that Warren uses to screen these opportunities for potential returns and probability of success.
CHAPTER 4: Where Warren Begins — the Public Announcement — the Beginning of the Path to Arbitrage Riches
One of the great secrets to Warren’s success in the field of arbitrage and other special investment situations is that he will only consider making the investment “after” the deal has been announced to the public.
Understand, there is a whole area of risk arbitrage where money managers stare at their computer screens all day long, trying to figure out which companies will be taken over next so they can invest in them “before” the public announcement. You can make an enormous amount of money in a very short period of time if you have the foresight to invest in the right company before it has announced that it is going to be taken over.
An example: Before Berkshire Hathaway announced that it was buying the Burlington Northern Santa Fe Corporation, BNSF was trading at $76 a share. After Berkshire announced that it was offering to buy BNSF for $100 a share, BNSF’s shares jumped to $97 a share. If we had bought BNSF shares for $76 a share and sold them for $97 a share, we would have made profit of $21 a share, which equates to a rate of return of approximately 27 percent on our investment. Not too shabby. But to earn that 27 percent, we would have had to be either very lucky or blessed with the foresight to see it coming. And few people have that kind of foresight; mostly they are just trading on rumors and tidbits of inside information.
Warren isn’t interested in trading on rumors or inside information. For Warren, a very iffy $21-a-share profit is not as good as an absolutely certain $3-a-share profit, which is what he would have made had he arbitraged Berkshire’s buyout of BNSF at $97 a share ($100 – $97 = $3). It may not seem like much, but the certainty of the deal allows him a quick and certain return and the prospect of using great amounts of leverage to more than triple his initial rate of return on his real out-of-pocket cost. It is the “certainty” that allows him to be comfortable leveraging up on the transaction. And it is leverage that adds rocket juice to his return. We’ll get more into the power of leverage in arbitrage situations later on.
Risk Arbitrage
To better understand Warren’s unique perspective on arbitrage, we should spend a moment talking about the negative aspects of risk arbitrage as it is practiced on Wall Street and how that contrasts with Warren’s strategy.
The world of risk arbitrage is enormous, with most large-scale Wall Street risk arbitrage operations having as many as fifty potential deals going on at once. They operate on the theory that if most of the deals go bad, the few winners will more than make up for the losses. However, a large-risk operation requires a constant monitoring of fifty or more positions, which means reading the financial press and SEC filings for fifty or more deals. Besides being an enormous amount of work, the great number of positions also escalates the probability of error. And error, in the risk arbitrage game, is what can lose us serious money.
Warren’s Perspective
Warren has discovered that the secret to consistently winning in the arbitrage game is to concentrate on just a few deals that have a high probability or “certainty” of being completed. Through careful analysis before he goes in and by keeping a watchful eye on the deal after he invests, he can confidently take significant positions, which can produce meaningful results.
While this affords Warren the possibility of great financial gain, it also presents the potential for significant loss. The potential for loss occurs when the deal falls apart. This can send security prices back to their pre-announced deal status, which is usually much lower than the price he paid after the deal was announced. This is why Warren has to be as close as he can be to “absolutely certain” that the deal will reach fruition, because if he isn’t, he could end up losing a bundle.
In Summary
Warren is only interested in investing in deals that he is certain will be completed. He is not a man who plays in the gray areas of arbitrage or other special situations; he leaves those to the speculators. He is about making sure the event will occur within the time frame he is predicting it will. It is the certainty of the deal that reduces the risk and allows him to take meaningful positions that can result in superior results.
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