While spin-offs can lead to success (as discussed in the previous chapter), risk arbitrage is a loser's game, argues Greenblatt. Whereas investors used to be able to make money by buying stocks of companies with announced takeovers, that is no longer the case. Competition has reduced the spreads between current prices and the take-out prices, resulting in a lot more risk (as a result of financing falling through, buyers who change their minds, macro events etc.) than the rewards warrant. Greenblatt has had a few "sure-thing" lookalikes fall apart, and strongly advises against risk arbitrage.
However, that doesn't mean Greenblatt thinks one can't make money from mergers; it just has to be done in a different way. Greenblatt advises readers to scrutinize special merger securities. These are securities that are often thrown into merger deals as "sweeteners" to top a bid or convince shareholders to sell, without actually requiring further financing. For example, a buyer may offer cash plus stock plus some combination of warrants, preferred stock or convertible debt to shareholders of the target. It is the warrants and other non-cash, non-stock securities that Greenblatt says often get overlooked.
The idea behind this market inefficiency closely resembles that of the spin-off: shareholders receiving such merger securities often sell them, pushing their prices down in relation to their values. Like a spun-off company, merger securities are often not desired by receiving shareholders; for example, they often fall outside the mandates of the funds that receive them. As such, investors can purchase these (after having done the research on them, of course) after the merger has taken place, thereby avoiding the major risk: that the merger won't close.
Greenblatt takes the reader through a few examples where he has been able to purchase discarded warrants and preferred shares for a discount, as they were sold by shareholders who received them as part of a merger transaction.
By Saj Karsan, Sunday, March 6, 2011, 6:59 AM | Joel Greenblatt, You Can Be A Stock Market Genius | 1 comments »