Showing posts with label arbitrage. Show all posts
Showing posts with label arbitrage. Show all posts

Monday 13 January 2020

Areas of Opportunities for Value Investors: The Cycles of Investment Fashion - The Risk-Arbitrage Cycle

Many participants in specialized areas of investing such as bankruptcy and risk arbitrage have experienced inferior results in recent years. 


  • One reason is the proliferation of investors in these areas. In a sense, there is a cycle of investment results attendant on any investment philosophy or market niche due to the relative popularity or lack of popularity of that approach at a particular time. When an area of investment such as risk arbitrage or bankruptcy investing becomes popular, more money flows to specialists in the area. The increased buying bids up prices, increasing the short-term returns of investors and to some extent creating a self-fulfilling prophecy. This attracts still more investors, bidding prices up further. While the influx of funds helps to generate strong investment results for the earliest investors, the resultant higher prices serve to reduce future returns. 
  • Ultimately the good investment performance, which was generated largely by those who participated in the area before it became popular, ends and a period of mediocre or poor results ensues. As poor performance continues, those who rushed into the area become disillusioned. Clients withdraw funds as quickly as they added them a few years earlier. The redemptions force investment managers to raise cash by reducing investment positions. This selling pressure causes prices to drop, exacerbating the poor investment performance. Eventually much of the "hot money" leaves the area, allowing the smaller number of remaining investors to exploit existing opportunities as well as the newly created bargains resulting from the forced selling. The stage is set for another up-cycle. 


Risk arbitrage has undergone such a cycle during the past several years.

  • In the early 1980s there were only a few dozen risk arbitrageurs, each of whom managed relatively small pools of capital. Their repeated successes received considerable publicity, and a number of new arbitrage boutiques were established. The increased competition did not immediately destroy the investment returns from risk arbitrage; the supply of such investments increased at the same time, due to a simultaneous acceleration in corporate takeover activity. 
  • By the late 1980s many new participants had entered risk arbitrage. Relatively unsophisticated individual investors and corporations had become significant players. They tended to bid up prices, which resulted in narrower "spreads" between stock prices and deal values and consequently lower returns with more risk. Excess returns that previously had been available from arbitrage investing disappeared. 
  • In 1990 several major takeovers fell through and merger activity slowed dramatically. Many risk arbitrageurs experienced significant losses, and substantial capital was withdrawn from the area. Arbitrage departments at several large Wall Street firms were eliminated, and numerous arbitrage boutiques went out of business. This development serves, of course, to enhance the likelihood of higher potential returns in the future for those who continue to play. 
It is important to recognize that risk-arbitrage investing is not a sudden market fad like home-shopping companies or closed end country funds.

  • Over the long run this area remains attractive because it affords legitimate opportunities for investors to do well. 
  • Opportunity exists in part because the complexity of the required analysis limits the number of capable participants. 
  • Further, risk arbitrage investments, which offer returns that generally are unrelated to the performance of the overall market, are incompatible with the goals of relative-performance-oriented investors. 
Since the great majority of investors avoid risk-arbitrage investing, there is a significant likelihood that attractive returns will be attainable for the handful who are able and willing to persevere.

Areas of Opportunities for Value Investors: Investing in Risk Arbitrage

Risk arbitrage is a highly specialized area of value investing.

Arbitrage, as noted earlier, is a riskless transaction that generates profits from temporary pricing inefficiencies between markets. 

  • Risk arbitrage, however, involves investing in far-from-riskless takeover transactions. 
  • Spinoffs, liquidations, and corporate restructurings, which are sometimes referred to as long-term arbitrage, also fall into this category. 


Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company.

  • The principal determinant of investors' return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed. 
  • The downside risk if the transaction fails to be completed is usually that the security will return to its previous trading level, which is typically well below the takeover price. 
The quick pace and high stakes of takeover investing have attracted many individual investors and speculators as well as professional risk arbitrageurs. 
  • It is my view that those arbitrageurs with the largest portfolios possess an advantage that smaller investors cannot easily overcome. 
  • Due to the size of their holdings, the largest arbitrageurs can afford to employ the best lawyers, consultants, and other advisors to acquire information with a breadth, depth, and timeliness unavailable to other investors. 
  • As we have learned from recent criminal indictments, some have even enjoyed access to inside information, although their informational edge was great even without circumventing the law. 
The informational advantage of the largest risk arbitrageurs is not so compelling in situations such as long-term liquidations, spinoffs, and large friendly tender offers.

  • In the largest friendly corporate takeovers, for example, the professional risk arbitrage community depletes its purchasing power relatively quickly, leaving an unusually attractive spread for other investors. 
  • A careful and selective smaller investor may be able to profitably exploit such an opportunity. 
At times of high investor uncertainty, risk-arbitrage-related securities may become unusually attractive. 



Example:

The December 1987 takeover of Becor Western Inc. by B-E Holdings, Inc., fit this description.

  • In June 1987 Becor sold its aerospace business for $109.3 million cash. This left the company with $185 million in cash (over $11 per share) and only $30 million in debt. The company also operated an unprofitable but asset-rich mining machinery business under the Bucyrus-Erie name. The offer by B-E Holdings to buy Becor Western was the last in a series of offers by several suitors. The terms of this proposed merger called for Becor holders to receive either $17 per share in cash or a package of the following: $3 principal amount of 12.5 percent one-year senior notes in B-EHoldings; $10 principal amount of 12.5 percent fifteen-year senior debentures in B-EHoldings; 0.2 shares preferred stock in B-E Holdings, liquidation preference $25; and 0.6 warrants to buy common stock in B-E Holdings at $.01 per share. A maximum of 57.5 percent of Becor shares were eligible to receive the cash consideration. Assuming that all stockholders elected to receive cash for as many shares as possible, each would receive per share of Becor owned: $9.775 cash $1.275 principal amount one-year notes $4.25 principal amount fifteen-year debentures .085 shares preferred stock .255 warrants The cash option was almost certain to be worth more than the package of securities. Thus the total value of the consideration to holders who elected cash was greater than for those who did not. Nevertheless, a small proportion of Becor holders failed to choose the cash alternative, increasing the value to be received by the vast majority of holders who did. 
What made Becor particularly attractive to investors was that in the aftermath of the 1987 stock market crash, the shares fell in price to below $10. 

  • Investors could thus purchase Becor stock for less than the underlying cash on the company's books, and for an amount approximately equal to the cash that would be distributed upon consummation of the merger, which was expected either in December 1987 or January 1988. 
  • The shares were a real bargain at $10, whether or not the merger occurred. The total value of the merger consideration was certainly greater than the $10 stock price-the cash component alone was nearly $10. Moreover, there was nearly enough cash on the books of B-E Holdings pro forma for the merger to retire the one-year notes. These appeared to be worth close to par value. Based on the market price of comparable securities, the fifteen-year debentures seemed likely to trade at a minimum of 50 percent of face value and perhaps significantly higher. The preferred stock was more difficult to evaluate, but 25 percent of its liquidation preference seemed conservative compared with other preferred issues. The warrants were virtually impossible to value. Even assuming they would trade at negligible prices, however, the total value of the merger consideration appeared to be at least $14 per share.
  • Better still, the downside risk to investors was minimal. The book value of Becor was $12 per share, nearly all of it in cash. There were several sizable holders of Becor stock, a fact that increased the likelihood that underlying value would be realized in some fashion. Even if the merger were rejected by shareholders, a corporate liquidation appeared likely to yield similar value. 
  • At prices of $12 or below, investors faced little downside risk and the prospect of an appreciable and prompt return. As it turned out, the merger consideration was worth about $14.25 at market prices. 
  • Becor shares had declined in the wake of a broad market rout to a level below underlying value, creating an opportunity for value investors.

Sunday 7 May 2017

Overview of the Different Classes of Arbitrage

Classic Arbitrage Category

1.  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 agreeing to be acquired by Berkshire for $100 a share.

This presents an arbitrage opportunity in that BNSF's stock price will trade slightly below Berkshire's offer price, right up until the day the deal closes.

These kinds of deals are plentiful.


2.  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.

This means that Company A is gong 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 real ugly, but it can offer lots of opportunity to make a fortune.


3.  Corporate 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.

You can arbitrage on these self-tenders.




Special Situations Category

4,  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 are less than what the liquidated payout will be.

An example of this would be when the real estate trust MGI Properties liquidated its portfolio of properties at a higher value than its shares were selling for.


5.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 to the shareholders.

It is possible to buy a great business at a bargain price by buying the conglomerate's shares before the spin-off, as when Dun & Bradstreet spun off Moody's Investors Service.

Spin-offs come under the category of special situations.



6.  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 you with many wonderful opportunities to profit from them.



7.  Reorganizations

This is a huge area of special situations that offer some very interesting arbitrage-like opportunities.

A 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.



Tendering Your Shares

The company doing the buying will make an announcement that it is asking shareholders to tender their shares between, say, June 1, 2010 and June 20, 2010.

This time period for tendering is usually twenty and sixty days.

Under certain circumstances, the time period may be extended.

If you don't tender your shares within that window of time, you may be stuck with the shares and have to try selling them directly in the market.

You may end up with another fixed price at which the company will buy them from you.

Either way, it may not be as good a deal as the tender offer.



Withdrawing shares from being tendered

During the time period to tender your shares, you also have the right to untender them.  

After you tender your shares,

  • you may decide not to wait until the tender to sell them or 
  • you may decide you want to hold the shares for the long term.


Whatever the reason, once tendered, they can be untendered during the window for tendering.

If the tender offer is increased in price after you have tendered your shares, you automatically receive the increased price for your shares.



Arbitrage - where to look for these companies?

Where to discover what companies are -

  • planning on merging,
  • attempting a hostile takeover 
  • spinning off a business, 
  • doing a liquidation, 
  • planning a share buyback, or
  • reorganising into a trust or partnership?


Keep a vigilant eye on the financial press and any and all services that track such corporate events.

  • Wall Street Journal
  • Major regional newspapers for investment opportunities
  • Google:  search the words "tender offer" and "mergers"
  • Internet paid services e.g., mergerstat.com
  • Internet free services e.g., search engines at: 

Yahoo!  http://finance.yahoo.com/news/category-m-a and http://us.biz.yahoo.com/topic/m-a/. , MSN http://news.moneycentral.msn.com/category/topics.aspx.topic=TOPIC_MERGERS_ACQUISITIONS.

Leverage and Arbitrage

When is it safe to use leverage in your arbitrage?

The certainty of the deal presents an opportunity to safely use leverage - borrowed money - to increase the rate of return.

With arbitrage situations that is certain to reach fruition, be willing to leverage.

This is the exception to the usual advice against the evils of borrowing money to buy stocks.



What is the risk of using leverage?

The danger with any stock investment is that it will not perform, that the share price won't increase, that it will drop like a rock, taking our capital with it.

Borrowing money to invest in a risky investment is a sure way to eventually go broke.


How can you benefit from using leverage?

A high probability of the arbitrage deal being completed equates to a large amount of the risk being removed.

If you are certain that you are going to make your projected profit, it is safe to use borrowed money to increase your rate of return.

The use of leverage gives you the advantage of being able to pull additional earning power out of capital tied up in other investments.



When should you not use leverage?

There are two reasons:

(1)  If the deal or event that drives the profit is not certain, then borrowing capital to invest in it can be an invitation to folly, and,
(2)  If the time element is not certain, then determining the difference between the cost of borrowed capital and the rate of return becomes an impossible calculation.


The Time Danger of Using Leverage

In the game of using leverage, time is never on your side - quicker is always better

You can comfortably borrow $1 million at 5% to invest if we are 'certain" that the deal will be completed in the time period we projected.

If the investment, instead of its taking one year for our stock to move up, it takes four years; then the borrowed money is costing us $50,000 a year and if we hold it for four years, our interest costs will balloon to $200,000.

It is the certainty of both the time and the return that allows you to leverage up and use borrowed money to safely invest in arbitrage and other special situations.

Leverage, if used carefully, and only with deals where there is a high probability of performance, this strategy makes it possible to greatly enhance the performance of your arbitrage investments.




The Arbitrage Risk Equation Warren Learned from Benjamin Graham

An example of arbitrage.

Announcement of the $55 a share tender offer
Stock was trading at $44 a share before the announcement.
After the announcement, you are buying the stock at $50 a share.
Likelihood of Deal Happening 90%.


1,  Determine what is your potential return?

Tender offer $55 a share
You can buy the stock at $50 a share
Your arbitrage investment has a projected profit (PP) of $5 a share
This gives a 10% projected rate of return on your $50 investment.


2.  What is the likelihood that the event will occur as a percentage?

Does it have a 30% chance of being completed?  Or a 90% chance?

Likehood of Deal Happening = 90%



3.  Adjusted projected profit (APP)

APP
= Projected Profit x Likelihood of Deal Happening
= PP x LDH
= $5 x 90%
= $4.50


4. Adjusted Projected Rate of Return (APRR)

APRR
= Projected Profit / Your Investment
= PP / I
= $4.50 / $50
= 9%.


5.  What is the risk of the deal falling apart?

What is your risk of loss?

If the deal fails to be completed, the per share price of the stock will return to the trading price it had before the tender offer was announced.

If the stock was trading at $44 a share before the announcement of the $55 a share tender offer and after the announcement, we are buying the stock at $50 a share, we have a downside risk of $6 a share if the deal falls apart and the price of the company's stock returns to $44 a share ($50 - $44 = $6).

Thus, if the deal falls apart, you have a projected loss of $6 a share.

Projected Loss $6 a share
Likelihood of the deal falling apart (LDFA) 10%


6.  Adjusted Projected Loss

Adjusted projected loss (APL) of $0.60 a share ($6 x 0.1 = $0.60)


7.  Risk-adjusted projected profit (RAPP) 

RAPP
= Adjusted potential profit - Adjusted projected loss
= APP - APL
= $4.50 - $0.60
= $3.90


8.  Risk-adjusted Projected Rate of Return (RAPRR)

RAPRR
=Risk Adjusted Projected Profit / Investment
=RAPP/I
= $3.90 / $50
= 7.8%


Is a risk-adjusted projected rate of return of 7.8% an enticing enough return for us?

If it is, we make our investment.



[If the RAPP is a negative number, walk away from the deal.]



Additional notes:

It is probably not necessary to do these calculations, though they serve as a means to help you think about the potential of the opportunity presented.

A successful arbitrage operation has more to do with the art of weighing the different variables than attempting to quantify them down to a hard scientific equation that tells you when to buy and when to sell.

These variables themselves can change and often they are simply unique to that situation.

They are tools that can be helpful if used properly.



-------------------------------------


Summary

Announcement of the $55 a share tender offer
Stock was trading at $44 a share before the announcement.
After the announcement, you are buying the stock at $50 a share.
Likelihood of Deal Happening 90%.


1,  Determine what your potential return is?

Your arbitrage investment has a projected profit (PP) of $5 a share
This gives a 10% projected rate of return on your $50 investment.


2.  What is the likelihood that the event will occur as a percentage?

Likehood of Deal Happening = 90%


3.  Adjusted projected profit (APP)

APP
= Projected Profit x Likelihood of Deal Happening
= PP x LDH
= $5 x 90%
= $4.50


4. Adjusted Projected Rate of Return (APRR)

APRR
= Projected Profit / Your Investment
= PP / I
= $4.50 / $50
= 9%.


5.  What is the risk of the deal falling apart?

Thus, if the deal falls apart, you have a projected loss of $6 a share.

Projected Loss $6 a share
Likelihood of the deal falling apart (LDFA) 10%


6.  Adjusted Projected Loss

Adjusted projected loss (APL) of $0.60 a share ($6 x 0.1 = $0.60)


7.  Risk-adjusted projected profit (RAPP) 

RAPP
= Adjusted potential profit - Adjusted projected loss
= APP - APL
= $4.50 - $0.60
= $3.90


8.  Risk-adjusted Projected Rate of Return (RAPRR)

RAPRR
=Risk Adjusted Projected Profit / Investment
=RAPP/I
= $3.90 / $50
= 7.8%


Is a risk-adjusted projected rate of return of 7.8% an enticing enough return for us?

If it is, we make our investment.



[If the RAPP is a negative number, walk away from the deal.]



Friday 5 May 2017

The 7 classes of arbitrage and special situations that Warren Buffett has invested into.

Warren Buffett has focused on seven classes of arbitrage and special situations.

Classic Arbitrage 
  1. Friendly Mergers
  2. Hostile Takeovers
  3. Corporate tender offers for a company's own stock

Special Situations
  1. Liquidations
  2. Spin-offs
  3. Stubs
  4. Reorganisation

Time Arbitrage

Example to illustrate "time arbitrage":

Company ABC's stock is trading at $8 a share.

Company XYZ offers to buy company ABC for $14 a share in four months.

In response to the offer, Company ABC's stock goes to $12 a share.


How can you arbitrage on this situation?

The simple arbitrage play here would be to buy Company ABC's stock today at $12 a share and then sell to Company XYZ in four months for $14 a share, which would give a $2 a share profit.

Unlike the normal everyday stock investment, this is a solid offer of $14 a share in four months.

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.

Once Company XYZ's offer is accepted by Company ABC, it becomes a binding contract between Company ABC and Company XYZ with certain contingencies.


What is the risk of this arbitrage?

The reason that the stock does not immediately jump from $8 a share to $14 a share is that there is a risk that the deal might fall apart  

In this case, we won't be able to sell the stock for $14 a share and Company ABC's share price will probably drop back into the neighbourhood of $8 a share.



Understanding Time Arbitrage

We are arbitraging two different prices for the company's shares that occur between two points in time, on two very specific dates.  This kind of arbitrage is thought of as "time arbitrage".

This kind of arbitrage is very difficult to model for computer trading. 

It favours the investors 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.


In Summary

1.  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.

2.  The positive price spread between the two develops because

  • of the risk of the deal falling apart and 
  • the time value of money.







The work of the arbitrageurs (Market arbitrage)

A particular commodity, e.g., gold,  trades virtually at virtually the same price in different markets in the world.

This is the work of the arbitrageurs.

The arbitrageurs will keep buying and selling until the spread in the prices in the two markets is eliminated.

The arbitrageurs will be pocketing the profits on the price spread between the two markets until the price spread finally disappears.

These transactions today are 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.

Arbitraging a price difference between two different markets, usually within minutes of the price discrepancy showing up is known as "market arbitrage".



Arbitrage is Warren's secret for producing great results

Professors Gerald Martin and John Puthenpurackal's studied the stock portfolio's performance from 1980 to 2003 of Berkshire Hathaway.

Their findings:

  • Portfolio's 261 investments had an average annualised rate of return of 39.3%.
  • 59 of those 261 investments were identified as arbitrage deals.
  • Those 59 arbitrage deals produced an average annualised rate of return of 81.28%!
Their study brought to light the powerful influence that Warren's arbitrage operations had on Berkshire's stock portfolio's entire performance.

If those Warren's 59 arbitrage investments for that period were cut out from the portfolio, the average annualised return for Berkshire's stock portfolio drops from 39.38% to 26.96%.

In 1987, the S&P 500 delivered a 5% return, while Warren's arbitrage activities earned an amazing 90% that year.

Arbitrage is Warren's secret for producing great results when the rest of the stock market is having a down year.

Certainty of the deal being completed is everything.  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.




Terms: Arbitrage,  Leverage, Compounding

Arbitrage and Special Situations

In the past, these have been the domain of professional investors, who have access to lower brokerage rates.

In the world of arbitrage and special situations, the high retail brokerage rates formed an almost impassable barrier of entry for lay investors.

Simply their brokerage costs often exceeded any potential profit in the trade.

With the advance of the Internet and with the lower rates now available, the world of stock arbitrage and other special situations are opened up to the masses.

Aggressive investors can learn how to identify the bet with the least risk, which can enable the investor to take very large positions and produce results that can be spectacular.


Monday 11 April 2016

Arbitrage is the simultaneous purchase and sale of securities or foreign exchange in two different markets; a process of identifying market inefficiencies.

In 1954, a temporary shortage of cocoa in US caused its price to increase from 5 cents to 60 cents per pound, a whopping 12 times.

As a result, Rockwood & Co., a brooklyn based chocolate products company, found itself in a sweet spot. They were sitting on 13 million pounds of excess inventory of cocoa which instantaneously became a huge asset because of cocoa price increase.

So selling the inventory to make a handsome profit was a no-brainer except that there was just one catch to it. Rockwood & Co. followed LIFO (last in first out) inventory valuation which would have created a 50% tax liability on profits from sale of inventory.

Young Warren Buffett

Buffett in his early 20s
So to avoid this tax, they came up with an ingenious way to exploit the temporary opportunity. They extended a share buyback offer which allowed the shareholder to tender a share in exchange for 80 pounds of cocoa. This maneuver, according to 1954 tax code, was perfectly legal and didn’t invite heavy tax liability.

This caught the attention of a 24 year old investment analyst who was working in New York for Graham Newman Corp. It was obvious to him that one could buy Rockwood shares for $34, sell them back to the company for 80 pounds of cocoa beans (worth $36), and then sell the cocoa beans making an instant profit of $2. Considering the transaction could be done in less than a week, it worked out to a sky-high annualized return.

“For several weeks I busily bought share, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.”, recounts Warren Buffett, the protagonist in the story above, “The profits were good and my only expense was subway tickets.”

What Buffett did is called an Arbitrage. It’s a process of identifying market inefficiencies. The classic idea is that of buying an item in one place and selling it in another. In the very early days the word applied only to the simultaneous purchase and sale of securities or foreign exchange in two different markets.

Mohnish Pabrai, in his wonderful book The Dhandho Investor, explains –
Arbitrage is classically defined as an attempt to profit by exploiting price differences in identical or similar financial instruments. For example, if gold is trading in London at $550 per ounce and in New york at $560 per ounce, assuming low frictional costs, an arbitrageur can buy gold in London and immediately sell it in New York, pocketing the difference.

Read more here:
http://www.safalniveshak.com/latticework-of-mental-models-arbitrage/

Sunday 29 March 2015

INVESTMENT MADNESS

INVESTMENT MADNESS























Here’s a question for you: what kind of business becomes more attractive as an investment proposition the more expensive it becomes?

The answer – apparently – is just about any business that has a strategy of acquiring other businesses.
Here’s how the logic works. Suppose you are the CEO of a company whose shares trade at a price/earnings of say 20x. That’s a robust multiple and demands a certain amount of growth. If your business doesn’t have the necessary organic growth, you will need to deliver the expected growth via acquisition. The good news is that you can buy companies in the same line of business from private sellers, and the multiples paid in the private market are much lower than 20x; perhaps even in the single digits.
This difference in multiple means that you can issue your own shares to acquire the privately held businesses, and achieve an automatic Earnings Per Share (EPS) uplift. The earnings attached to the shares you issue (at 20x) are much lower than the earnings you acquire in return, and so by the magic of arbitrage, your shareholders have achieved earnings (and presumably value) uplift.
Some acquisitions create value through synergy benefits, but for this strategy it is probably better to avoid that sort of thing. Integrating the acquired businesses and extracting the synergy benefits is troublesome, and likely to distract you from the main game. You are probably better off focusing on acquisitions that don’t require much integrating. That way you can do more acquisitions in a given space of time, and ….. achieve more EPS uplift!
This is advantageous for your strategy, as faster EPS uplift will justify a higher multiple being ascribed to your shares, and this in turn will increase the ratings differential between your shares and the businesses you are acquiring. A higher rating means a more magical arbitrage value.
In this way, you should be able to see that the more expensive your company’s shares become, the more effective your growth strategy becomes, and the whole thing becomes a kind of virtuous cycle.
…except that the logic is a tiny bit circular.
If for some reason your ratings were to fall, or private acquisition targets at low multiples were to become scarce, the whole charade might just start to unravel in the same way that it came about. A declining share price could wipe out the value creation potential of your strategy and justify an ever decreasing share price.
Here’s my tip: if you see a broker finding virtue in an elevated price/earnings multiple by pointing out that it facilitates EPS accretive acquisitions, it may be wise to count the seats between you and the exit row.
Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. 


http://www.montinvest.com/

Friday 5 April 2013

A 5% return may end up being a better deal than a 20% return.

If one is able to get a 5% return in a month, we could argue that it is a better investment than one that earns us a 20% return over a two-year period.

The reason for this is that a 5% rate of return in a month is arguably the equivalent of getting a yearly rate of return of 60% (5% x 12 = 60%). 

Likewise, a 20% return at the end of two years is arguably the same as only getting a 10% yearly rate of return.  (20% / 2 years = 10%).

Of course, this argument is premised on being able to reallocate the capital that we had out at 5% for a month, at attractive rates in the preceding months. 

But in theory, if you could reallocate your capital 5 times over a two-year period and each time earn 5% a month, it would still produce better results than getting a 20% return at the end of a two-year period.  

The certainty of the deal is important.  This allows for a quick and certain return

Friday 21 December 2012

Warren Buffett on Arbitrage


Arbitrage


     Berkshire’s arbitrage activities differ from those of many arbitrageurs.  First, we participate in only a few, and usually very large, transactions each year.  Most practitioners buy into a great many deals perhaps 50 or more per year.  With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks.  This is not how Charlie nor I wish to spend our lives.  Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation.  So far, Berkshire has not had a really bad experience.  But we will - and when it happens, we’ll report the gory details to you.

     The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced.  We do not trade on rumors or try to guess takeover candidates.  We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities.

     Some offbeat opportunities occasionally arise in the arbitrage field.  I participated in one of these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 50 cents per pound.  In 1954, a temporary shortage of cocoa caused the price to soar to over 60 cents.  Consequently Rockwood wished to unload its valuable inventory - quickly, before the price dropped.  But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

     The 1954 Tax Code came to the rescue.  It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business.  Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity.  Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share.

     For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.  The profits were good and my only expense was subway tokens.

     The architect of Rockwood’s restructuring was an unknown brilliant Chicagoan, Jay Pritzker, then 32.  If you’re familiar with Jay’s subsequent record, you won’t be surprised to hear the action worked out rather well for Rockwood’s continuing shareholders also.  From shortly before the tender until shortly after it, Rockwood stock appreciated from 15 to 100, even though the company was experiencing large operating losses.  In recent years, most arbitrage operations have involved takeovers, friendly and unfriendly.  With acquisition fever rampant and anti-trust challenges almost non-existent, and with bids often ratcheting upward, arbitrageurs have prospered mightily.  In Wall Street the old proverb has been reworded: “Give a man a fish and you feed him for a day.  Teach him how to arbitrage and you feed him forever.”

     To evaluate arbitrage situations you must answer four questions: 
(1) How likely is it that the promised event will indeed occur?  
(2) How long will your money be tied up?  
(3) What chance is there that something still better will transpire - a competing takeover bid, for example?  and 
(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

     Arcata Corp., one of our more serendipitous arbitrage experiences, illustrates the twists and turns of the business.  On September 28, 1981 the directors of Arcata agreed in principle to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), then and now a major leveraged-buy out firm.  Arcata was in the printing and forest products businesses and had one other thing going for it: In 1978 the U.S. Government had taken title to 10,700 acres of Arcata timber, primarily old-growth redwood, to expand Redwood National Park.  The government had paid $97.9 million, in several installments, for this acreage, a sum Arcata was contesting as grossly inadequate.  The parties also disputed the interest rate that should apply to the period between the taking of the property and final payment for it.  The enabling legislation stipulated 6% simple interest; Arcata argued for a much higher and compounded rate.  Buying a company with a highly-speculative, large-sized claim in litigation creates a negotiating problem.  To solve this problem, KKR offered $37.00 per Arcata share plus two-thirds of any additional amounts paid by the government for the redwood lands.

     Appraising this arbitrage opportunity, we had to ask ourselves whether KKR would consummate the transaction since, among other things, its offer was contingent upon its obtaining “satisfactory financing.”  A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage.  However, we were not particularly worried about this possibility because KKR’s past record for closing had been good.  We also had to ask ourselves what would happen if the KKR deal did fall through, and here we also felt reasonably comfortable: Arcata’s management were clearly determined to sell.  If KKR went away, Arcata would likely find another buyer, though the price might be lower.

     Finally, we had to ask ourselves what the redwood claim might be worth.  Your Chairman, who can’t tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.  We started buying Arcata stock, then around $33.50, on September 30 and in eight weeks purchased about 400,000 shares, or 5% of the company.  The initial announcement said that the $37.00 would be paid in January, 1982.  Therefore, if everything had gone perfectly, we would have achieved an annual rate of return of about 40% - not counting the redwood claim, which would have been frosting.

     All did not go perfectly.  In December it was announced that the closing would be delayed a bit.  Nevertheless, a definitive agreement was signed on January 4.  Encouraged, we raised our stake, buying at around $38.00 per share and increasing our holdings to 655,000 shares, or over 7% of the company.  Our willingness to pay up - even though the closing had been postponed - reflected our leaning toward “a whole lot” rather than “zero” for the redwoods.

     Then, on February 25 the lenders said they were taking a “second look” at financing terms “ in view of the severely depressed housing industry and its impact on Arcata’s outlook.”  The stockholders’ meeting was postponed again, to April.  An Arcata spokesman said he “did not think the fate of the acquisition itself was imperiled.”  When arbitrageurs hear such reassurances, their minds flash to the old saying: “He lied like a finance minister on the eve of devaluation.”

     On March 12 KKR said its earlier deal wouldn’t work, first cutting its offer to $33.50, then two days later raising it to $35.00.  On March 15, however, the directors turned this bid down and accepted another group’s offer of $37.50 plus one-half of any redwood recovery.  The shareholders okayed the deal, and the $37.50 was paid on June 4.  We received $24.6 million versus our cost of $22.9 million; our average holding period was close to six months.  Considering the trouble this transaction encountered, our 15% annual rate of return excluding any value for the redwood claim - was more than satisfactory.  But the best was yet to come.  The trial judge appointed two commissions, one to look at the timber’s value, the other to consider the interest rate questions.  In January 1987, the first commission said the redwoods were worth $275.7 million and the second commission recommended a compounded, blended rate of return working out to about 14%.

     In August 1987 the judge upheld these conclusions, which meant a net amount of about $600 million would be due Arcata.  The government then appealed.  In 1988, though, before this appeal was heard, the claim was settled for $519 million.  Consequently, we received an additional $29.48 per share, or about $19.3 million, and another $800,000 in 1989.   

      At year end 1988, our only major arbitrage position was 3,342,000 shares of RJR Nabisco with a cost of $281.8 million and a market value of $304.5 million.  In January we increased our holdings to roughly four million shares and in February we eliminated our position.  About three million shares were accepted when we tendered our holdings to KKR, which acquired RJR, and the returned shares were promptly sold in the market.  Our pre-tax profit was a better-than-expected $64 million.

     Earlier, another familiar face turned up in the RJR bidding contest: Jay Pritzker, who was part of a First Boston group that made a tax-oriented offer.  To quote Yogi Berra; “It was deja vu all over again.” During most of the time when we normally would have been purchasers of RJR, our activities in the stock were restricted because of Salomon’s participation in a bidding group.  Customarily, Charlie and I, though we are directors of Salomon, are walled off from information about its merger and acquisition work.  We have asked that it be that way: The information would do us no good and could, in fact, occasionally inhibit Berkshire’s arbitrage operations.

     However, the unusually large commitment that Salomon proposed to make in the RJR deal required that all directors be fully informed and involved.  Therefore, Berkshire’s purchases of RJR were made at only two times: first, in the few days immediately following management’s announcement of buyout plans, before Salomon became involved; and considerably later, after the RJR board made its decision in favor of KKR.  Because we could not buy at other times, our directorships cost Berkshire significant money.

     Considering Berkshire’s good results in 1988, you might expect us to pile into arbitrage during 1989.  Instead, we expect to be on the sidelines.

     We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them.  We know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.  We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders. 

Friday 17 February 2012

Ways to Limit Opportunity Cost - Most Important is holding Part of your Portfolio in Cash

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash.  
  • Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. 
Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others.  Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration.  Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value.
  • Equity investments in ongoing businesses typically throw off only minimal cash through payment of dividends.  
  • The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase.  
  • Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months.
An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one's initial investment returned to cash, one's profits are as well.

Another way to limit opportunity cost is through hedging. 
  • A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline. 
  • If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities .

Friday 14 October 2011

Rule No. 1: Do Not Lose Money. How Warren Buffett avoids yearly losses in his entire portfolio?

Avoiding losses is probably the most important tool for long-term success in investing. No investor, even Buffett, can avoid periodic losses on individual stocks. Even, if you resigned yourself to buying only at incredibly cheap prices, occasional mistakes will still occur. What differentiates Buffett from nearly all other investors is his ability to avoid yearly losses in his entire portfolio.






How Warren Buffett avoids yearly losses in his entire portfolio?


Warren Buffett would rather not place his faith in the hands of investors and traders. The methods he uses to lock in yearly gains take the market out of the equation.

He reckons that if he can guarantee himself returns, even in poor markets, he will ultimately be way ahead of the game. 
To learn more, we should focus on how Buffett best avoids losses.

These include:

Timing the market. He is not concerned about the day-to-day fluctuations in the stock market. However, Buffett - whether by accident or calculation - must be recognized as one of the most astute market timers in history.


Convertibles. Some of Buffett's most lucrative investments in the late 1980s and early 1990s involved convertibles, which are hybrid securities that possess features of a stock and an income-producing security such as a bond or preferred stock.

Options. On a number of occsions, Buffett has expressed his disdain for derivative securities such as futures and options contracts. Because these securities are bets on shorter-term price movements within a market, they fall under the definition of "gambling" rather than of "investing." If Warren Buffett does dabble in options, and few doubt he could dabble successfully, he does so quietly. He once acknowledged writing put options on Coca-Cola's stock; at the time he was thinking of adding to his stake in the soft-drink company.

#Arbitrage. Not only did Buffett continue to beat the major market averages, but he suffered few single-year declines along the wayThat second accomplishment is, by far, the more remarkable. Buffett's scorecard shows that he has increased the book value of Berkshire Hathaway's stock 35 consecutive years. In only 4 years, did the S&P 500 Index beat the growth of Berkshire's equity. Right from the start of his investment management career, Buffett resorted extensively to takeover arbitrage (the trading of securities involved in mergers) to keep his portfolio results positive. In poor market years, arbitrage activities have greatly enhanced Buffett's performance and keep returns positive. In strong markets, Buffett has exploited the profit opportunities of mergers to exceed the returns of the indexes.Benjamin Graham, Buffett's mentor, had made arbitrage one of the keystones of his teachings and money management activities at Graham-Newman between 1926 and 1956. Graham's clients were informed that some of their money would be deployed in shorter term situations to exploit irrational price discrepancies. These situations included reorganizations, liquidations, hedges involving convertible bonds and preferred stocks, and takeovers.


----

There are only 3 ways an investor can attain a long-term, loss-free track record:


1. Buy short-term Treasury bills and bonds and hold them to maturity, thereby locking in 4 to 6 percent average annual gains.

2. Concentrate on private-market investments by buying properties that consistently generate higher profits and that can sell for greater prices each year.

3. Own publicly traded securities and minimise your exposure to price fluctuations by devoting some of the portfolio to unconventional "sure things (arbitrages).# "





Also read:

Focus on how Buffett best avoids losses


http://myinvestingnotes.blogspot.com/2009/09/list-your-top-5-rules-for-success-in.html

Thursday 31 March 2011

Welcome to the World of Stock Arbitrage and Special Investment Situations

Give a man a fish and you will feed him for a day.  Teach a man to arbitrage and you will feed him forever.
- Warren Buffett

One of the great secrets of Warren Buffett's investment success has been his arbitrage and special situations investment.

With the advance of the Internet, brokerages started offering online trading at deep discounts from their full-service retail rates.  With the lower rates the world of stock arbitrage and other special situations are 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 can only be described as spectacular.

It was Warren's arbitrage investments that took a great investor and turned him into a worldwide phenomenon.  Professors Gerald Martin and John Puthenpurackal's study of Berkshire Hathaway's stock portfolio's performance from 1980 to 2003, they discovered that the portfolio's 261 investments had an average annualized rate of return of 39.3%.  Even more amazing was that out of those 261 investments, 59 of them (22.7%) were identified as arbitrage deals.  And those 59 arbitrage deals produced an average annualised rate of return of 81.28%.

In 1987, Forbes magazine noted that Warren's arbitrage activities earned an amazing 90% that year, while the S&P 500 delivered a miserable 5%.  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, it was high time that you took a serious look at the arbitrage and special situation investment strategies and techniques that produce Warren's mind-numbing results.

You must explore how he find the deals, evaluates them, and makes sure that they are winners. You will dwell into the mathematical equations and intellectual formulas that he uses to determine the probability of the deal being a success.   In Warren's world, certainty of the deal being completed is everything.  It is how the high probability of the event happening that creates the rare situation in which Warren is willing to use leverage to help boost his performance in these investments to unheard-of-numbers.  

Sunday 13 September 2009

Focus on how Buffett best avoids losses

List Your Top 5 Rules for Success in Investing

If I polled 1,000 investors and asked them to list their top 5 rules for success, their answers would differ from Buffett's. Here is what they would probably say:

Rule 1: Take a long term perspective.

Rule 2: Keep adding money to the market and let the magic of compounding work for you.

Rule 3: Don't try to time the market.

Rule 4: Stick to companies you understand.

Rule 5: Diversify.


Few investors would think to mention Buffett's cardinal "don't lose money" rule.

Why?


  • Some investors, sadly, refuse to believe that losses can occur, so accustomed are they to the unprecedented rally in the major indexes since 1987.
  • Surveys done by mutual fund companies during the past few years indicate that a high percentage of individual investors still don't believe that mutual funds can lose money or that the market is capable of dropping more than 10% anymore.
  • Other investors see losses as temporary setbacks or as opportunities to add to their positions.
  • Still others, acting out a psychological defense mechanism, try to avoid losses by violating their own rules. They let the ticker tape infect decision making and trade in and out of winners and losers to avoid the psychological trauma of having to report a loss.
Let's examine these issues.

1. Avoiding losses is probably the most important tool for long-term success in investing. No investor, even Buffett, can avoid periodic losses on individual stocks. Even, if you resigned yourself to buying only at incredibly cheap prices, occasional mistakes will still occur. What differentiates Buffett from nearly all other investors is his ability to avoid yearly losses in his entire portfolio.

2. Diversification alone can't prevent losses. All diversification can do is minimise the chances that a few stocks implode (non-market risk or stock specific risk) and drag the performance of the portfolio with them. Even if you hold 100 stocks, you are forever vulnerable to "market risk," the risk that a declining market causes nearly all stocks to drop together.

3. Most investors use the market as their mechanism for avoiding losses. What does this mean? They simply sell when a stock falls below its break-even point, no matter the fundamentals. One highly touted strategy of the 1990s, espoused by Investor's Business Daily, implores investors to sell any issue that falls more than 8% below its purchase price, irrespective of events. Market timers rely on similar strategies. They make short-term bets on the direction of individual stocks and are prepared to exit quickly if the market turns against them.

4. These strategies ultimately degrade into a form of gambling, where the odds of success shrink because the investors' holding period is too short. Other investos avoid losses by continuing to hold poor-performing stocks, sometimes for years, until they rally back above their original cost. To profit from this strategy, you must pin your hopes on the market's ultimately validating your decision.


How Warren Buffett avoids yearly losses in his entire portfolio?

Warren Buffett would rather not place his faith in the hands of investors and traders. The methods he uses to lock in yearly gains take the market out of the equation.

He reckons that if he can guarantee himself returns, even in poor markets, he will ultimately be way ahead of the game.

To learn more, we should focus on how Buffett best avoids losses.

These include:

Timing the market. He is not concerned about the day-to-day fluctuations in the stock market. However, Buffett - whether by accident or calculation - must be recognized as one of the most astute market timers in history.

Convertibles. Some of Buffett's most lucrative investments in the late 1980s and early 1990s involved convertibles, which are hybrid securities that possess features of a stock and an income-producing security such as a bond or preferred stock.

Options. On a number of occsions, Buffett has expressed his disdain for derivative securities such as futures and options contracts. Because these securities are bets on shorter-term price movements within a market, they fall under the definition of "gambling" rather than of "investing." If Warren Buffett does dabble in options, and few doubt he could dabble successfully, he does so quietly. He once acknowledged writing put options on Coca-Cola's stock; at the time he was thinking of adding to his stake in the soft-drink company.

#Arbitrage. Not only did Buffett continue to beat the major market averages, but he suffered few single-year declines along the way. That second accomplishment is, by far, the more remarkable. Buffett's scorecard shows that he has increased the book value of Berkshire Hathaway's stock 35 consecutive years. In only 4 years, did the S&P 500 Index beat the growth of Berkshire's equity. Right from the start of his investment management career, Buffett resorted extensively to takeover arbitrage (the trading of securities involved in mergers) to keep his portfolio results positive. In poor market years, arbitrage activities have greatly enhanced Buffett's performance and keep returns positive. In strong markets, Buffett has exploited the profit opportunities of mergers to exceed the returns of the indexes. Benjamin Graham, Buffett's mentor, had made arbitrage one of the keystones of his teachings and money management activities at Graham-Newman between 1926 and 1956. Graham's clients were informed that some of their money would be deployed in shorter term situations to exploit irrational price discrepancies. These situations included reorganizations, liquidations, hedges involving convertible bonds and preferred stocks, and takeovers.


----

There are only 3 ways an investor can attain a long-term, loss-free track record:

1. Buy short-term Treasury bills and bonds and hold them to maturity, thereby locking in 4 to 6 percent average annual gains.

2. Concentrate on private-market investments by buying properties that consistently generate higher profits and that can sell for greater prices each year.

3. Own publicly traded securities and minimise your exposure to price fluctuations by devoiting some of the portfolio to unconventional "sure things.# "