Warren Buffett and the art of stock arbitrage

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Warren Buffett and the art of stock arbitrage

Proven Strategies for arbitrage and other special investment situations (2010) By Mary Buffett and David Clark

There are so many new things mentioned in the book, that I am not sure whether I can grasp all. It is a book, that one have to re-read it a few times to really understand the concepts.

In this book, it is interesting to note that Warren Buffet does not speculate or guess which deals or companies are for takeover or mergers. He is only interested in deals that he is certain that will be completed. Usually, he will wait after the official public announcement has been made.

There is a formula that one runs, as an arbitrage investor to review the different variables that help to determine the “certainty” of the deal.

PP : Projected profit
I : Investment
PPR : Projected rate of return
LDH : Likely hood of the deal happening, use experience.

Example, if tender offer for share is $55, we can buy the stock at $50 a share. The projected profit is $55-$50 = $5. Our investment is the $50.

Step 1 : Find projected rate of return, PPR.
PP ($5) / I ($50) = PPR (10%)

Step 2 : Figure likelyhood that the deal will go through as a percentage.

Adjustment equation : PP ($5) * LDH (90%) = $4.50
New PP ($4.50) / I ($50) = New PPR (9%)

The adjusted projected rate of return is now 9%.

Step 3 : Calculate our risk, projected loss.

Asssume that the per-share price of the stock will return to the trading price if deal falls through.
Example share was $44 before announcement, and we are able to buy the share at $50 after announcement. There is a downside risk of $50-$44 = $6 if the deal falls apart.

Since there is a 90% chance of the deal happening, and only 10% of the chance of deal falling apart, with the loss of $6 a share.

PL ($6) * Probability of deal not happening (10%) = Adjusted projected loss ($0.60)
Adjusted projected profit = Adjusted projected profit $4.50 – Adjusted projected loss ($0.60) = $3.90

$3.90 / $50 = 7.8%.

The final risk-adjusted projected rate of return is 7.8%. Now you must decide whether the rate of return of 7.8% is an enticing enough return for you to take the risk.

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Historically, Warren Buffet focused on seven classes of arbitrage and special situations :

1. Friendly mergers
2. Hostile takeovers
3. Corporate Self-tender offers
4. Liquations
5. Spin-offs
6. Stubs
7. Reorganizations

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 1. Friendly mergers
Of all the arbitrage deals, friendly mergers are the easiest to identify and follow. Large corporations have long ago figured out that if they are going to grow, they are going to have to either merge with or acquire other businesses.

First, determine which is the dominant and the subdominant company in the merger. Second, determine the terms of the deal as followed :

i) Shares-For-Shares
Example Company A and B agreed to merge in 6 months time. Company A has offered 2.5 shares of its stock for every 1 share of Company B’s stock. If A has $23 a share, and B has $45 a share.

1. Find the value of A’s stock : $23 * 2.5 = $57.50
2. Difference of the stock = $57.50 – $45 = $12.50. (If positive, you have an arbitrage opportunity)

The next move is to lock in the profit. The reason we lock in the profit rather than wait for the actual closing deate is that “all stock” deals will often see the price spread between the two companies diminsh as the closing date approaches. This will work against us.

To lock in our profit, we would buy one share of Company B and short 2.5 shares of Company A’s stock. Then, on the closing date of the merger, we would exchange our one share of Company B for 2.5 shares of Company A. We would then take the 2.5 shares of Company A’s stock we got in the exchange and use them to close out our Company A’s short position.

It may sound good, but I think you need lots of money to do it. Cos there are also transaction charges for the buying and selling. There are other deals such as stock and cash for stock deal, and the cash for stock deal.

In the arbitrage world of mergers and acquisitions, there are 2 kinds of buyers – strategic and financial buyers. Warren prefers a strategic buyer, the bigger the better. Strategic buyers are companies that grow by making acquisitions, they are buying to expand their operations.

Financial buyers are the private equity and leverage buyout firms, which use lots of borrowed money to buy a company solely for the purpose of taking it private, and then in 4-5 years, taking it public again. Warren Buffet is particularly skeptical of such buyers especially in an unstable economic environment.

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Corporate Self-tender offers  

When corporation decide to buy back their own securities there are several ways they can go about it. They can buy back the securities in the open market, which is okay if they are only after a small number of hares. But if they are after a large number, they run the risk of artificially driving the security price up beyond what they were initially willing to pay for it.

To avoid the risks of an open market purchase, companies will often make a tender offer directly to existing shareholders. This lets the company get a lower price than if it were in the market slowly driving prices up, and it lets it avoid extreme general stock market fluctuations.

Tenders come in basically two forms : an offer at a fixed price; and an offer to buy via a Dutch auction. In both scenerios, the current market price is lower than the price of the tender offer, which creates arbitrage opportunity.

 

 

 

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