Friday, October 24, 2008

The New Buffettology: Chp 17: Stock Arbitrage

Warren learned about managing an arbitrage portfolio while working with Benjamin Graham. Arbitrage opportunities can arise from an "event" of corporate reorganizations, mergers, spin-offs, and hostile takeovers. Before the actual "event" takes place, a spread in the market can develop between the announced sale or liquidation price and the market price of the company's stock.

Warren estimates that his arbitrage activities have on average, annually contributed around 25% in pretax investment gains. Warren will typically invest in arbitrage plays when there are no suitable long-term investments to make. In the early Buffett Partnership days, Warren could have up to 40% of total funds invested in arbitrage plays.

To mitigate some of the risks associated with arbitrage investments, Warren only invests after the "event" is officially announced, as opposed to when an "event" is simply rumored to occur. In terms of arbitrage transactions, Warren is believed to most interested in type that Graham referred to as "cash payments on sale or liquidation". These are special situations where a company sells its business to another company or liquidates its operations and distributes the proceeds to its shareholders.

With much lower commission fees today than in the past and the availability of merger and acquisition information on the internet (such as, it is more feasible than before for smaller investors to explore arbitrage opportunities as investments. For those interested in arbitrage investments, the authors advise sticking with all cash merger and acquisition transactions due to their less complicated structure than transactions involving non-cash payments.

Warren believes that is only worth investing in arbitrage situations that you are certain will be completed. In order to guard against unforeseen risks, he prefers to invest in a large number of arbitrage plays. With this strategy, the many successful arbitrage plays will compensate for the odd loss.

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