Reader’s Question on Arbitrage

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 Reader’s Question

Please post your question rather than email directly to me (unless you do not get a response within two days) because (1) Other readers probably have similar questions and (2) your email may go into spam or be overlooked.

Don’t be embarrassed. If you ask, “What is a balance sheet?” I won’t give you the answer but I will tell you where to look and how to learn on your own.

Question

I’ve mentioned this before but I’m an avid reader of the blog. I’m currently going through your old posts one by one and learning a lot. Yours is one of 2 or 3 other blogs that I am reading the archives.

My question is about arbitrage (tenders and merger arb). I’ve been reading through Buffett’s old letters and in the late 1980’s he had quite an impressive run with his arbitrage investments (I think in 1987 he made around 80% on his arb investments).

Both he and Graham seem to have had long time success for decades using merger arb and other arbitrage techniques. Buffett mentioned in one of his letters that during the 63 years that Graham, Buffett LTD, and Berkshire practiced arbitrage, they made 20% annually on that strategy.

I’m wondering how often you employ any of these strategies in your portfolio? I’m also wondering if it’s more valuable to spend time working on tradition valuations of companies before treading into this highly specialized area? I think you mentioned you look for liquidations when the market gets too high, which I would group into this special situations category. It seems like a specialized area, but also seems like an area that would add uncorrelated returns to the portfolio, and serve as a great substitute for cash when markets begin to become overvalued.

Would love to hear your thoughts on merger arb if you have time… Thanks

My Reply

First, you should learn about arbitrage because all investing involves some form of arbitrage. Typically, the average investor takes an immediate to 6 month view but value in equities must be measured over the company lifetime (equities are perpetual securities) so value investors use time arbitrage to benefit. Also, spin-offs are one area to find uneconomic selling. Pursue your studies.

Read Klarman’s book Margin of Safety, Greenblatt’s Genius Book, Berkshire’s letters and then look at past deals. Then go where you have the least competition–micro-caps going private, liquidations, etc.  Oddball Stocks is one blog and there are others to learn from.

I am opportunistic, but I have found over the past few years there has been so much money with low-to-zero interest rates competition that the spreads have been too narrow. Then when there were deals like Burlington Northern buyout from Berkshire back in 2009, the spreads were OK–18% annualized but at that time you could buy MMM at or under $50.

MMM

Pursuing merger arb depends upon your opportunity set. Also, don’t compete against the big trading desks on Wall Street–it isn’t worth the risk/reward.

I had a successful merger arb in Burlington Northern but I took my eye off ball in not investing more in the obvious. If I bought around $50 to $55 per share, today I would have a 5% growing dividend yield and a double plus tax deferral.

Today, I feel the environment for many stocks is like this:

However, there are sectors like small gold and silver mining stocks that are in a huge bear market–and for good reasons–but there are opportunities in the areas with the most hatred and plunging prices. Meanwhile the mania in cloud stocks like CRM continues.

There have been companies like NVDA and Intel that offer a more than fair price, but risks are higher than owning a NVR or SYK in the $50s.  My first goal is to find compounders–franchises that can compound capital over time (rare), then buy franchises at slight discounts (20% to maybe 30%) and sell when the margin of safety disappears like today with NVR.  Then I look for special situations or net/nets.

You have to be flexible and go where you find opportunity but understand the drawbacks of each approach and your own limitations.  So recently, I have few special situations in my portfolio but that shouldn’t stop you from pursuing special sits. Just know why you have an edge.

Good luck.

 

7 responses to “Reader’s Question on Arbitrage

  1. Two questions for John or fellow readers that have been on my mind – any guidance would be greatly appreciated.

    1. What happens for preferred shares with accumulated dividends if a company is bought out? Is it treated like a liquidation in terms of hierarchy with par + accumulated dividends needing to be paid out in full before equity holders get anything?

    2. How do people track liquidations? I was hoping to do some case studies but have had trouble finding how people normally figure out what assets/stuff eventually sells for to calculate final results.

    • Hi Scott,

      I’m not too sure about US law, but generally based on UK company law (I may be a bit out of date, hopefully not…), my answer to the first question is:

      1. Firstly, it is important to define what you mean by “company being bought out”. This is a very vague terms and can range from anything from an outside investor taking a controlling stake (i.e. largest shareholder, but less than 51%) or a >51% to a 100% stake in the ordinary shares of the company.

      2. In a situation of an outside investor taking over 100% stake in the company, there is a presumption that this investor intends to privatize the company. In such a case, generally Stock Exchanges’ and the Securities Commissions’ usually would have regulations to protect minority shareholders. In the case of your example, it is likely that a proposal to buy out the preference shareholders would be made. Likely, the preference shareholders will be paid out in full provided the acquisition of the ordinary shareholders goes through.

      3. In the case where only a controlling or majority stake changes hands but the company stills maintains its’ listing status, then it is status-quo. The new shareholder is NOT obliged to do anything. The only situation where I envisage that payments needs to be made to the preference shareholders if the legal instrument creating the preference shares has a specific clause triggering payment where there is a change in the majority shareholder. This would be a very specific situation.

      Hope it helps, but John can correct me if I am mistaken.

  2. Also, when you look at Buffett’s returns with special situations keep in mind I think he mentioned in his letters that sometimes he would use reasonable amounts of leverage for those investments.

  3. John, thanks for taking the time to share your thoughts. It seems like risk arb spreads get wider when the market gets panicky, making risk arb more profitable, but as you say, when the market drops there are better opportunities. So is it accurate to say that you don’t really seek out special situations as a separate strategy (like Buffett in his partnership days using merger arb as a cash like substitute)? You’re just looking for opportunities wherever they are?

    The thing that interests me most about risk arb or other short term liquid strategies is that it allows you to keep the “optionality” aspect of cash and still gives you a return while you’re waiting for better opportunities. Buffett’s partnership was up 13% in 1962 when the Dow was down 7%. His “generals” lost money that year, but he made money on risk arb, and then was able to reallocate out of that into cheap stocks after the market dropped, further increasing his returns the next year.

    I guess I’m attracted to it as a portfolio management tool more than a strategy in and by itself.

    How do you think of your overall portfolio in times like this. Do you like to hold cash to give you a chance to buy stocks cheaper later, or do you prefer to look at your portfolio from the bottom up and just invest as you find opportunities?

    Another interesting point, schloss didn’t really use much special situation strategies, he mostly just bought cheap stocks, and his performance was remarkable. Graham was well hedged, but his special situation/hedging was a drag on performance relative to his “private owner bargain” category if you look at his old letters and results…. Interesting to think about.

    Maybe holding cash is overrated in the long run.

  4. Pingback: Merger Arbitrage for Value Investors

  5. You’re welcome Scott 🙂

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