Market Fluctuations as a Guide to Investment Decisions (2) - Timing or Pricing

Stock Brokers and the Investment Services

As a matter of business practice (or perhaps of thorough-going conviction), the stock brokers and the investment services seem wedded to the principle that both investors and speculators in common stocks should devote careful attention to market forecasts.

The investor can scarcely take seriously the innumerable predictions which appear almost daily and are his for the asking.

In many cases, he pays attention to them and even acts upon them.  Why?

Because he has been persuaded that it is important for him to form some opinion of the future course of the stock market and because he feels that the brokerage or service forecast is at least more dependable than his own.

This attitude will transform the typical investor into a market trader and will bring the typical investor nothing but regrets.



Timing in a Bull Market

During a sustained bull movement, when it is easy to make money by simply swimming with the speculative tide, he will gradually lose interest in the quality and the value of the securities he is buying and become more and more engrossed in the fascinating game of beating the market.

He begins by studying market movements as a "commonsense investment precaution" or a "desirable supplement to his study of security value"; he ends as a stock-market speculator, indistinguishable from all the rest.


Market Forecasting (or Timing)

A great deal of brain power goes into this field.

Undoubtedly some people can make money by being good stock-market analysts.

But it is absurd to think that the general public can ever make money out of market forecasts.

There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.


Timing and the Speculator

Timing is of great psychological importance to the speculator because he wants to make his profit in a hurry.

The idea of waiting a year before his stock moves up is repugnant to him.



Timing and the Investor

But a waiting period of such, is of no consequence to the investor.  

• What advantage is there to him in having his money uninvested until he receives some (presumably) trustworthy signal that the time has come to buy?
• He enjoys an advantage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income.

Timing is of little value to the investor unless it coincides with pricing, that is, unless it enables him to repurchase his shares at substantially under his previous selling price.

Market Fluctuations as a Guide to Investment Decisions (1) - Timing or Pricing

Common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices.

Should the intelligent investor be interested in the possibilities of profiting from these pendulum swings?

There are two possible ways he may try to do this:

• the way of timing and 
• the way of pricing.

Timing

By timing, the investor try to anticipate the action of the stock market - to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward.


Pricing

By pricing, the investor endeavours

• to buy stocks when they are quoted below the fair value and 
• to sell them when they rise above such value.

A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks.

This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels.


Pricing or Timing?

The intelligent investor can derive satisfactory results from pricing of either type.

If he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator's financial results.

A sound mental approach towards stock fluctuations (5): Market Declines and Unsuccessful Stock Investments

Market declines and unsuccessful stock investments

In the case of market declines and unsuccessful stock investments, there is a vital difference here between temporary and permanent influences.

The price decline is of no real importance:

• unless it is either very substantial - say, more than a third from cost - or 
• unless it reflects a known deterioration of consequence in the company's position.

In a well-defined bear market, many sound common stocks sell TEMPORARILY at extraordinarily low prices. 

It is possible that the investor may then have a paper loss of fully 50% on some of his holdings, without any convincing indication that the underlying values have been permanently affected.



The Price can be Extraordinary in a Recession or Bear Market

In the business recession and bear market in the past, there were times, an outstanding business was considered in the stock market to be worth less than its current assets alone - which means less as a going concern than if it were liquidated.  That price was extraordinary.

Why?  The reasons maybe many.  

• The reasons were justified in some.   
• Yet, in some, the reasons were exaggerated and eventually groundless fear; 
• while others were typical of temporary influences.

An example:  

An investor bought ABC in 1987 at say, 12 times its five-year average earnings or about 80.  The share price declined to 36 soon after. 

What was the implication of the share price to him?  

• We cannot assert that the decline to 36 was of no importance to the investor.  
• The investor would have been well advised to scrutinise the picture with some care, to see whether he had made any miscalculations.  

But if the results of his study were reassuring - as they should have been - he was 

• entitled to disregard the market decline as a temporary vagary of finance, and,
• unless he had the funds and the courage to take advantage of it by buying more on the bargain basis offered.

A sound mental approach towards stock fluctuations (4): Advancing, Bull or Rising Market

Advancing or Rising Market

The investor is neither a smart investor nor a richer one when he buys in an advancing market and the market continues to rise.

That is true, even when the investor cashes in a good profit, unless either:

• (a) he is definitely through with buying stocks - an unlikely story - or 
• (b) he is determined to reinvest only at considerably lower levels.

In a continuous program no market profit is fully realised until the later reinvestment has actually taken place, and the true measure of the trading profit is the difference between the previous selling level and the new buying level.

A sound mental approach towards stock fluctuations (3): Market Price Fluctuations

Market Price Fluctuations

When the general market declines or advances substantially, nearly all investors will have somewhat similar changes in their portfolio values.

The investor should not pay serious attention to such price developments unless they fit into a previously established program of buying at low levels and selling at high levels.

A sound mental approach towards stock fluctuations (2) Measuring Investment Results

Price Changes as Measuring Investment Results

The success of your investment program in common stocks must depend in great part on what happens ultimately to their prices.

• How far must you commit yourself to concern with the market's price fluctuation or conduct?
• By what market tests should you consider that you have been successful or not?

Yet, focusing on short-term or minor fluctuations will make you indistinguishable from the stock trader.

The experienced investors lean toward using a combination of dividend return and market-price change over a suitable period of time as the measure of investment success.  

• These calculations are made preferably between dates, several years apart, on which the general market level has not changed appreciably.
• The inclusion of the dividend income make this method a highly satisfactory one for testing investment results.
• It may be employed: 

1. (1) to measure the overall performance of an investor's portfolio, or 
2. (2) to compare one investment fund with another, or 
3. (3) to assess the merits of alternative principles of investment - for example, buying "growth stocks" versus buying undervalued securities.

Market Price Fluctuations

When the general market declines or advances substantially, nearly all investors will have somewhat similar changes in their portfolio values.

The investor should not pay serious attention to such price developments unless they fit into a previously established program of buying at low levels and selling at high levels.

A sound mental approach towards stock fluctuations (1)

Intelligent investment is more a matter of mental approach than it is of technique.

A sound mental approach towards stock fluctuations is the touchstone of all successful investment under present-day conditions.

Your portfolio should consist of:

(a)  Savings Bonds, which have no price fluctuations, and,

(b)  Common Stocks, which are likely to fluctuate widely in their market price.

Such changes in quoted prices may be significant to the investor in two possible directions:

(A)  As a measure of the success of your investment program.

(B)  As a guide to the selection of your securities and the timing of your transactions.

Berkshire Hathaway: A Safe, High-Quality, Growing Company

The Basics

• Stock price (5/4/17): $249,540
  • $166.34 for B shares
• Shares outstanding: 1.64 million
• Market cap: $409 billion
• Total assets (Q4 '16): $621 billion
• Total equity (Q4 '16): $286 billion
• Book value per share (Q4 '16): $172,108
• Repurchase maximum price (1.2x book): $206,530
• Downside to the Buffett repurchase put: 17%
• P/B: 1.45x
• Float (Q4 '16): $92 billion
• Revenue: $224 billion
• Berkshire Hathaway today is the 11th largest company in the world (and 4th largest in the U.S.) by revenues

History

• Berkshire Hathaway today does not resemble the company that Buffett bought into during the 1960s
• It was a leading New England-based textile company, with investment appeal as a classic Ben Graham-style "net-net"
• Buffett took control of Berkshire on May 10, 1965
• At that time, the company had a market value of about $18 million and shareholder's equity of about $22 million

• Buffett is doing a good job investing – the latest examples being Precision Castparts, Kraft and Duracell– but the cash is coming in so fast (a high-class problem)!
  • Berkshire will generate free cash flow equal to the $32.7 billion paid for PCP in ~2 years
• Markets have a way of presenting big opportunities on short notice
  • Junk bonds in 2002, chaos in 2008
  • Buffett has reduced the average maturity of Berkshire’s bond portfolio so he can act quickly

Valuing Berkshire

"Over the years we've…attempt[ed] to increase our marketable investments in wonderful businesses, while simultaneously trying to buy similar businesses in their entirety." – 1995 Annual Letter

"In our last two annual reports, we furnished you a table that Charlie and I believe is central to estimating Berkshire's intrinsic value. In the updated version of that table, which follows, we trace our two key components of value. The first column lists our per-share ownership of investments (including cash and equivalents) and the second column shows our per-share earnings from Berkshire's operating businesses before taxes and purchase-accounting adjustments, but after all interest and corporate expenses. The second column excludes all dividends, interest and capital gains that we realized from the investments presented in the first column." – 1997 Annual Letter

"In effect, the columns show what Berkshire would look like were it split into two parts, with one entity holding our investments and the other operating all of our businesses and bearing all corporate costs." – 1997 Annual Letter

Buffett's Comments on Berkshire's Valuation Lead to an Implied Historical Multiplier of ~12x

• 1996 Annual Letter: "Today's price/value relationship is both much different from what it was a year ago and, as Charlie and I see it, more appropriate."
• 1997 Annual Letter: "Berkshire's intrinsic value grew at nearly the same pace as book value" (book +34.1%)
• 1998 Annual Letter: "Though Berkshire's intrinsic value grew very substantially in 1998, the gain fell well short of the 48.3% recorded for book value." (Assume a 15-20% increase in intrinsic value.)
• 1999 Annual Letter: "A repurchase of, say, 2% of a company's shares at a 25% discount from per-share intrinsic value...We will not repurchase shares unless we believe Berkshire stock is selling well below intrinsic value, conservatively calculated...Recently, when the A shares fell below $45,000, we considered making repurchases."

/2017/05/tilson-berkshire-hathaway-safe-high-quality-growing-company-30-upside/

Estimating Berkshire's Value: 2001 – 2016

1. Unlike Buffett, we included a conservative estimate of normalized earnings from Berkshire's insurance businesses: half of the $2 billion of average annual profit over the 12 years prior to 2014, equal to $600/share prior. Starting in the 2015 AR, Buffett began to include all insurance earnings, so this is reflected in 2014 and 2015 earnings. Both we and Buffett exclude investment income.
2. Historically we believe Buffett used a 12 multiple, but given compressed multiples during the downturn, we used an 8 in 2008-2010 and 10 since then.

Berkshire Is Trading 16% Below Its Intrinsic Value

* Investments per share plus 12x pre-tax earnings per share through 2007, then an 8x multiple from 2008-2010, and a 10x multiple thereafter.



12-Month Investment Return 

• Current intrinsic value: $296,000/share 
• Plus 6% annual growth of intrinsic value of the business 
• Plus ~$10,000/share cash build over next 12 months 
• Equals intrinsic value in one year of $324,000 
• 30% above today's price 


Catalysts 

• Continued earnings growth of operating businesses 
• Likelihood of meaningful acquisitions 
• New stock investments 
• Additional cash build 
• Share repurchases (if the stock drops to 1.2x book or below; it’s currently at 1.45x)


Conclusion: 

Berkshire Has Everything I Look for in a Stock: It's Safe, Cheap and Growing at a Healthy Rate 

• Extremely safe: Berkshire's huge hoard of liquid assets, the quality and diversity of its businesses, the fact that much of its earnings (primarily insurance and utilities) aren't tied to the economic cycle, and the conservative way in which it's managed all protect Berkshire's intrinsic value, while the share repurchase program provides downside protection to the stock 
• Upside: trading 16% below intrinsic value (without giving any credit to immense optionality), with 30% upside over the next year 
• Downside: Only 17% downside to 1.2x book value, which is where Buffett it will to buy the stock, thereby putting a floor on it. 
• Growing: Intrinsic value is growing at roughly 6-8% annually

Buffett: The stock market's casino-like characteristic can be agonizing for investors

Iconic investor Warren Buffett says Berkshire Hathaway (BRK.A) (BRK.B) thinks that investors will do reasonably well when speculators in the market get fearful.

During the Berkshire Hathaway’s annual shareholders’ meeting, a value investor from China asked Buffett and his right-hand man Charlie Munger for advice on how to spread the value investing philosophy in a market system where so many are speculating.

“There’s always some speculations, always some value investors in the market,” Buffett said.

The problem arises when people start to see others benefitting from playing the market.

“When speculation gets rampant and when you’re getting what I guess Charlie [Munger] would call ‘social proof’ that it’s worked recently, people can get very excited about speculating in markets. And, we will have it from time-to-time in the market,” Buffett said, adding, “There’s nothing more agonizing than to see your neighbor, who you think has an IQ 30 points below you, getting richer than you are by buying stocks, whether it’s internet stocks or whatever. And people succumb to it. They’ll succumb to it in this economy and elsewhere.”

Buffett noted that in developing markets, there’s probably a tendency to be more speculative than already established markets.

“Markets have a casino characteristic that has a lot of appeal to people, particularly when they see people getting rich around them,” Buffett said. “And those who haven’t been through cycles before are probably a little more prone to speculate than people who have experienced the outcome of wild speculations.”

Munger added that China will probably have more trouble.

“They’re very bright people. They have a lot of action. Sure, they are going to be more speculative, but it’s a dumb idea. And to the extent that you’re working on it, why you’re on the side of angels. Lots of luck.”

Buffett noted that there will be “more opportunities” for investors if they can “keep their wits about them.”

“Fear spreads like you cannot believe until you’ve seen a few examples of it,” Buffett said, pointing to the panic in U.S. money market funds in 2008 as an example.

“The way the public can react is really extreme in markets and that actually offers opportunities for investors,” he added. “People like action and they like to gamble.”

The lesson here: the market rewards patience.

https://finance.yahoo.com/news/buffett-stock-markets-casino-like-characteristic-can-agonizing-investors-184338850.html

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.]

Using Annual Rate of Return to Determine the Investment's Attractiveness

The time it takes to achieve the projected profit ultimately determines a great deal of the investment's attractiveness.

Therefore, the time it takes to get to fruition ultimately determines our annual rate of return.

Time ultimately determines the attractiveness of the deal.

By viewing investment returns from a yearly perspective, it is possible to put these returns into perspective compared to what other investments are paying.

Two reasons why investors lose money in the stock market

1.  They buy poor quality stocks.

2.  They pay too high  prices.  

Buying Cheaply Works

When we talk about value investing there is a lot of evidence that value investors have been on the right side of the trade. The statistical studies that run against or contradict market efficiency almost all of them show that cheap portfolios—low market-to-book, low price-to-book—outperform the markets by significant amounts in all periods in all countries—that is a statistical, historical basis for believing that this is one of the approaches where people are predominantly on the right side of the trade. And, of course, someone else has to be on the wrong side of the trade.

Those studies were first done in the early 1930s; they were done again in the early 1950s. And the ones done in the 1990s got all the attention because the academics caught on. There is statistical evidence that the value approaches—buy cheap securities—have historically outperformed the market. Buying Cheap works.


http://csinvesting.org/wp-content/uploads/2012/06/greenwald_2005_inv_process_pres_gabelli-in-london.pdf

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.

Investing has a whole new set of rules.

If we are to be successful, we need to play by these new rules.

Why the average equity fund investor underperforms the market?

From 1993 to 2012, the S&P Index 500 averaged a gain of 8.21% per year.

However, during that same 20 year period, the average equity fund investor had an average annual gain of only 4.25%.  

Had the average equity fund investor just bought a low-cost S&P 500 Index fund and held it, he/she would have almost doubled their rate of return.

The underperformance was due to investor behaviour such as market timing and chasing hot funds.

Had these investors been long-term, buy-and-hold investors, they would have earned close to the market's returns.

When the average investor underperforms the index by such a significant amount, it is clear that most are playing with a bad set of guidelines or none at all.

A one-time investment of $10,000 invested at 8% compounds to $46,610 in 20 years.

The same $10,000 invested over the same period at 4.25% compounds to only $22,989.

Short-run performance of the stock market is random, unpredictable and very volatile

The short-run performance of the stock market is random, unpredictable and for most people, nerve-racking.

The next time you hear someone saying that he/she knows how the stock market or any given stock is going to perform in the next few weeks, months, or years, you can be sure they are either lying or self-delusional.

The long-term trend of the stock market is up and its performance consistent

There is more than 200 years of U.S. stock market history and the long-term trend is up.  

Over the long term, stock market performance has been rather consistent.

During any 50-year period, it provided an average after-inflation return of between 5 and 7 percent per year.

If you invested in a well-diversified basket of stocks and left them alone, the purchasing power of your investment would have doubled roughly every 12 years.

Stocks over the long-run offer the greatest potentials return of any investment

Although long-term returns are fairly consistent, short-term returns are much volatile.  

Stocks over the long-run offer the greatest potential return of any investment, but the short-run roller-coaster rides can be a nightmare for those who don't understand the market and lack a sound investment plan to cope with it.  

The 1990s were stellar years for stocks but the 1930s were a disaster.

Applying these principles to investing is destined to leave you poorer!

• Don't settle for average.  Strive to be the best.
• Listen to your gut.  What you feel in your heart is usually right.
• If you don;t know how to do something, ask.  Talk to an expert or hire one and let the expert handle it.  that will save you a lot of time and frustration.
• You get what you pay for.  Good help isn't cheap and cheap help isn't good.
• If there's a crisis, take action!Do something to fix it.
• History repeats itself.  The best predictor of future performance is past performance.

Explanations:

As an investor, you can be well above average by settling for slightly less than the index returns.

Listening to your gut is the worst thing you can do.

Although it sometimes pays to hire an expert, you may get less than you pay for.

Trying to fix a perceived investment crisis by taking action is usually a recipe for poor returns.

Using yesterday's results to pick tomorrow's high-performing investments or investment pros is another losing strategy.

Porter's Five Forces Framework - the implications of the industrial environment on corporate strategy

Porter's Five Forces Framework

1. Threat of substitute product
2. Bargaining power of customers
3. Bargaining power of suppliers
4. Threat of new entrants
5. Intensity of rivalry.

Market Share Stability determines the competitive environment in an industry

Stable market shares indicate less competitive industries.

Unstable market shares often indicate highly competitive industries with little pricing power.

Market shares are affected by the following factors:

• Barriers to entry
• New products
• Product differentiation.

Industry Capacity determines the competitive environment in an industry.

Limited capacity gives companies more pricing power as demand exceeds supply.

Excess capacity results in weak pricing power as excess supply chases demand.

In evaluating the future competitive environment in an industry, we should examine current capacity levels as well as how capacity levels are expected to change in the future.

It is important to keep in mind that:

• If new capacity is physical (e.g., manufacturing facilities) it will take longer for the new capacity to come online so tight supply conditions may linger on for an extended period.  Usually however, once physical capacity is added, supply may overshoot, outstrip demand, and result in weak pricing power for an extended period.
• If new capacity requires financial and human capital, companies can respond to tight supply conditions fairly quickly.

Industry Concentration determines the competitive environment in an industry

If an industry is relatively concentrated i.e., a few large firms dominate the industry, there is relatively less price competition.  This is because:

• It is relatively easy for a few firms to coordinate their activities.
• Larger firms have more to lose from destructive price behaviour.
• The fortunes of large firms are more tied to those of the industry as a whole so they are more likely to be wary of the long run impact of a price war on industry economics.

If an industry is relatively fragmented i.e., there is a large number of small firms in the industry, there is relatively high price competition.  this is because of the following reasons:

• Firms are unable to monitor their competitors' actions, which make coordination difficult.
• Each firm only has a small share of the market, so a small market share gain (through aggressive pricing) can make a large difference to each firm.
• Each firm is small relative to the overall market so it tends to think of itself individualistically, rather than as a member of a larger group.

There are important exceptions to the rules defined above.

• For example, Boeing and Airbus dominate the aircraft manufacturing industry, but competition between the two remains fierce.

Barrier to Entry - A form of Durable competitive advantage

Low barriers to entry mean that new competitors can easily enter the industry, which makes the industry highly competitive.  Companies in relatively competitive industries typically have little pricing power.

High barriers to entry mean that existing companies are able to enjoy economic profits for a long period of time.  These companies have greater pricing power.

However, the above mentioned characteristics of high and low barrier industries are not always observed.

Further it is important to note that:

• Barriers to entry should not be confused with barriers to success.
• Barriers to entry can change over time.

Relationship between Price and Maturity of Bonds

If the yield remains constant:

• A premium bond's value decreases towards par as it nears maturity.
• A discount bond's value increases towards par as it nears maturity.
• A par bond's value remain unchanged as it nears maturity.

Costs of trading, illiquid markets and costs associated with gathering and analyzing information affect security prices.

Two securities that should trade for the exact same price in an efficient market may trade at different prices for various reasons:

1. If the costs of trading on the mispricing (to make a profit) for the lower cost traders are greater than the potential profit.
2. In such cases, these prices are still "efficient" within the bounds of arbitrage.  The bounds of arbitrage are relatively narrow in highly liquid markets (e.g., U.S. T-bills), but wider in relatively illiquid markets.
3. There are always costs associated with gathering and analyzing information.  Net of information acquisition costs, the return offered on a security should be commensurate with the security's level of risk.  If superior returns can be earned after deducting information-acquisition costs, the market is relatively inefficient.

Factors Contributing to and Impeding a Market's Efficiency

Market participants:   

The greater the number of active market participants (investors and financial analysis) that analyze an asset or security, the greater the degree of efficiency in the market.

Information availability and financial disclosure:

The availability of accurate and timely information regarding trading activities and traded companies contributes to market efficiency.

Limits to trading:

The activities of arbitrageurs, who seek opportunities to trade on mispricings in the market to earn arbitrage (riskless) profits, contribute to market efficiency.

Transactions costs and information acquisition costs:

Investors should consider transaction costs and information-acquisition costs in evaluating the efficiency of a market.

Market Value versus Intrinsic Value

Market Value

The market value or market price of the asset is the price at which the asset can currently be bought or sold.  

It is determined by the interaction of demand and supply for the security in the market.


Intrinsic Value

Intrinsic value or fundamental value is the value of the asset that reflects all its investment characteristics accurately.

Intrinsic values are estimated in light of all the available information regarding the asset; they are not known for certain



Efficient Market

In an efficient market, investors widely believe that the market price reflects a security's intrinsic value.


Inefficient Market

On the other hand, in an inefficient market, investors may try to develop their own estimates of intrinsic value in order to profit from any mispricing (difference between the market price and intrinsic value).

Efficient Market versus Inefficient Market

An information efficient market (an efficient market) is one where security prices adjust rapidly to reflect any new information.

It is a market where asset prices reflect all past and present information.

Investment managers and analysts are interested in market efficiency because it dictates how many profitable trading opportunities may abound in the market.



Efficient market

In an efficient market, it is difficult to find inaccurately priced securities.  

Therefore, superior risk-adjusted returns cannot be attained in an efficient market.

It would be wise to pursue a passive investment strategy which entails lower costs.

In an efficient market, the time frame required for security prices to reflect any new information is very short.   

Further, prices only adjust to new or unexpected information (surprises).



Inefficient market

In an inefficient market, securities may be mispriced.

Trading in these securities can offer positive risk-adjusted returns. 

In such a market, an active investment strategy may outperform a passive strategy on a risk-adjusted basis.

Overview of a Fixed-Income Security (Bonds)

Who are the issuers of fixed-income security or bonds?

• Supranational organizations
• Sovereign (national) governments
• Non-sovereign (local) governments
• Quasi-government entities

Credit worthiness of Bonds

Bond issuers can also be classified based on their credit worthiness as judged by credit rating agencies.

Bonds can broadly be categorized as

• investment-grade bonds or
• non-investment grade (or high yield or speculative) bonds.

Maturity of Bonds

Fixed-income securities which, at the time of issuance, are expected to mature in one year or less are known as money market securities.

Fixed-income securities which, at the time of issuance, are expected to mature in more than one year are referred to as capital market securities.

Fixed-income securities which have no stated maturity are known as perpetual bonds.

Par Value

The par value (also known as face value, nominal value, redemption value and maturity value ) of a bond refers to the principal amount that the issuer promises to repay bondholders on the maturity date.

Bond prices are usually quoted as a percentage of the par value.

• When a bond's price is above 100% of par, it is said to be trading at a premium
• When a bond's price is at 100% of par, it is said to be trading at par.
• When a bond's price is below 100% of par, it is said to be trading at a discount.

Coupon Rate and Frequency

The coupon rate (also known as the nominal rate) of a bond refers to the annual interest rate that the issuer promises to pay bondholders until the bond matures.

The amount of interest paid each year by the issuer is known as the coupon, and is calculated by multiplying the coupon rate by the bond's par value.

Zero-coupon (or pure discount) bonds are issued at a discount to par value and redeemed at par (the issuer pays the entire par amount to investors at the maturity date).  The difference between the (discounted) purchase price and the par value is effectively the interest on the loan.

Currency Denomination

Dual currency bonds make coupon payments in one currency and the principal payment at maturity in another currency.

Currency option bonds give bondholders a choice regarding which of the two currencies they would like to receive interest and principal payments in.

Yield Measures

The current yield or running yield equals the bond's annual coupon amount divided by its current price (not par value), expressed as a percentage.

The yield to maturity (YTM) is also known as the yield to redemption or the redemption yield.  It is calculated as the discount rate that equates the present value of a bond's expected future cash flows until maturity to its current price.

Given a set of expected future cash flows, the lower  the YTM or discount rate, the higher the bond's current price.

Given a set of expected future cash flows, the higher the YTM or discount rate, the lower the bond's current price.

Important Relationships of Fixed Income Securities (Bonds)

Defining the Elements of a Bond

Coupon rates and bond prices

The higher the coupon rate on a bond, the higher its price.

The lower the coupon rate on a bond, the lower its price.


Interest rates and bond prices

An increase in interest rates or the required yield on a bond, will lead to a decrease in price.

A decrease in interest rates or the required yield on a bond will lead to an increase in price.

That is, bond prices and yields are inversely related.


Bonds risks and bond yields 

The more risky the bond, the higher the yield required by investors to purchase the bond, and the lower the bond's price.