This book “Warren Buffet and The Art of Stock Arbitrage: Proven Strategies for Arbitrage and Other Special Investment Situations” is written by the Mary Buffett & David Clark combination.
Their Buffettology book was not bad, though it did not reach the popularity of Rule #1 by Phil Town (which came later and was similar to Buffettology) for some reason. While Buffettology is on value investing in great businesses, this book goes through special situations investing, and gives examples of Buffett’s arbitrage transactions from the 1980s.
Compared to Joel Greenblatt’s “You can be a stock market genius” book which covered special situations investing very well, I would say that this book goes through at a high-level and is not as detailed as Greenblatt’s book. Greenblatt’s points about the dangers of participating in risk arbitrage, and also his view that a spin-off loaded with debt can be an attractive investment, are also good points to consider in this area.
- Berkshire Hathaway’s stock portfolio from 1980 to 2003, the portfolio’s 261 investments had an average annualized rate of return of 39.38%. Out of those 261, 59 (~22%) are arbitrage deals. The arbitrage deals produced an average annualized rate of return of 81.28%. If you take out the 59 deals, Berkshire’s performance drops from 39.38% to 26.96%.
- Return from the deal = [Probability Deal Goes Through * Projected Profit + (1 – Probability Deal Goes Through) * Projected Loss] / Investment
- Annualized Return = (Return / No. of months it takes) * 12
- With leverage, the “Investment” in the equation is the interest cost over the time period for the money borrowed to buy the stock.
- Buffett wrote in his 1963 annual letter to partners, “I believe in using borrowed money to offset a portion of our arbitrage portfolio, since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior… My self-imposed standard limit regarding borrowing is 25% of partnership net worth, although something extraordinary could result in modifying this for a limited period of time.”
- Shares-for-Shares: For each share of the target bought, short the specified number of the acquirer’s share that will be received per target share.
- Stock and cash deal: Same as Shares-for-Shares.
- Pure cash deal: Just buy the target’s shares.
- Shares-for-Shares with Guaranteed Value for Shares: Same as pure cash deal.
Factors Affecting the Probability of the Deal Going Through
- Nature of acquirer
- Strategic buyer – almost certain to go through regardless of the economic climate, the larger the strategic buyer w.r.t. the target, the better.
- Financial buyer – PE and LBO firms, usually safe in stable economic times. Track record of the financial buyer is important.
- Financing and economic environment
- Self-financing with available cash is the best.
- Stock-for-stock deals have high probability of going through, but depend on stability of the buyer’s and seller’s shares.
- If the buyer is relying on borrowing money or selling assets, there is added risk. If credit markets are calm and banks are lending, it is much safer.
- Management of the target
- If management was actively out shopping the company, it is good because likely the majority of the board of directors are motivated to sell the company, and will actively find another buyer if the deal falls through.
- Board approval
- Board approval is obtained.
- Shareholder approval
- Delaware corporation law requires shareholders to approve dissolution, merger, or the sale of substantially all of the company’s assets.
- If management or the founding family owns large blocks, it will all depend on them.
- If mutual funds and/or individual owns the majority, then it will happen if the offer is fair.
- Proxy statement
- Retail shareholders are short-sighted and will do the deal for a 10% gain.
- If there is no dissenting shareholder that is a majority stockholder, the deal will more than likely get done.
- Department of Justice and Federal Trade Commission approval
- Review of a buyout or merger by the DOJ can take a year or longer.
- Safer to sit out until the DOJ/FTC have made their ruling.
- Competing Buyer
- More than one buyer will greatly increase the likelihood of the deal going through.
Hostile takeovers make up ~4% of all takeovers.
Conditions Beneficial for Risk Arbitrage
- A single controlling shareholder that is “for” the buyout ensures that the deal will be agreed to.
- Most institutional and individual shareholders have a very short-term perspective, so they are easily enticed to sell out by a 20% premium over the current market price.
- A target business with predictable products that are producing a steady stream of earnings, will likely attract other bidders for a bidding war.
- A management buyout is certain to go through because management would never put out a bid that it throught the board of directors would refuse.
Conditions Harmful for Risk Arbitrage (Takeover Defenses)
- Staggered Board of Directors: A study of 93 hostile takeovers found that a target company with a staggered board was half as likely to be taken over than if the board was elected en masse.
- Crown Jewel: Target spins off or sells its best assets to become less attractive.
- Poison Pill / Flip-In: Current shareholders can buy more of the target at a discount if the buyer hits a certain ownership threshold.
- Flip-Over: Current shareholders can buy more of the target at a discount if the target got acquired.
- Lobster Trap: No one with more than 10% of the firm’s convertible securities can convert them.
- White/Gray Knight: Target company finds someone else to buy it.
- Nancy Reagan: Refuse the buyer, but may be sued by shareholders.
- Pac-Man: Target company turns around and makes a hostile offer for the buyer (e.g. Bendix Corp and Martin Marietta Corp).
Types of Tender Offers
- Fixed price tender offers are absolutely certain to go through. There is a risk that if the offer is oversubscribed, you will be left with some shares, however they are probably worth more after the buyback.
- Dutch auction tender offers will pay the lowest price between a low and high price, in which the company can buy back all the shares it wants. If the premium of the high price(compared to current price) is not that high, it is likely that the high price will be paid.
- The time period for tendering is usually between 20 and 60 days.
- Read the SEC filings Schedule 14D-9, Schedule TO (Tender Offer), and the Offer to Purchase, for the details.
- You will have to call your broker and give instructions to tender your shares.
- Before the close of the tendering period, you can choose to un-tender them.
- For businesses that have little or no long-term need for internal capital accumulation (e.g. no long-term capital needs), they can pay out 100% of their net after-tax earnings.
- Such companies can reorganize themselves into either royalty trusts or master limited partnerships, which don’t have to pay any taxes on their net earnings if they pay them all out to their owners.
- The reorganized companies will be valued in relationship to bond yields.
- After the company announces that it is going to convert into either a royalty trust or a master limited partnership, the stock market doesn’t recognize the dividend increase until the conversion is completed and the dividend is actually increased and paid out.
- Buy after the shareholders approve of the conversion.
- The inefficiency exists because they are usually small caps that are not well followed.
Master Limited Partnership
- Any dividends paid out to its shareholders could be used to decrease the shareholders’ tax cost basis in their shares.
- Shareholders wouldn’t have to pay any taxes on the distributions they recevied up to the amount they paid for their stock.
- In exchange for the deferred taxes, there is a larger capital gain when the shares are sold.
Opportunity in Real Estate Investment Trust (REIT) Liquidations
- Liquidation value of a REIT’s properties is greater than the price of its units.
- After announcement of liquidation, the stock market lags in adjusting the price upwards to reflect the liquidation value because REITs tend to be small caps ignored by Wall Street and the liquidation value is uncertain.
- If there is a big gap between the estimated liquidation price and the trust units’ price, shareholders will certainly approve the liquidation.
- Wait for the shareholders approval before buying in.
- While waiting for the liquidation, dividends from rent can be collected.
- Parent spins off a subsidiary that has better economics than the parent. This is what Buffett is interested in.
- Parent loads a mediocre-performing subsidiary with debt and spins it off. Buffett is not interested in this.
How to play this
- Buy shares in the conglomerate before the spin-off.
- After the spin-off, sell shares in the conglomerate and keep the shares in the spin-off.
- Always look at where the management goes to, whether they stay in the parent or goes to the spni-off. Manaegment always goes with the star and leaves the dog.
- Buffett bought Dun & Bradstreet in 1999 when it spun off Moody’s, kept Moody’s and made 27% CAGR on the investemnt by 2010.
- Stubs issued as a claim on unpaid cumulative preferred dividends that have been accrued but haven’t been paid. These usually trade at a deep discount.
- Stubs issued as a claim on assets on a company where the selling price of the assets exceed the cost of the stubs.
- Stubs issued on a tax/legal claim in a liquidation, typically with a floor (e.g. the government compensation that was deemed too low).
- Stubs representing the minority interest of a company bought out by PE/LBO firms. These are not attractive to Buffett as an arbitrage situation because there is no set date for the pay off.
WHERE TO FIND ARBITRAGE OPPORTUNITIES
- Search for “tender offer” or “mergers” in Google News