When I came across this short book Warren buffett and the art of stock arbitrage earlier this year by Mary Buffett, the former daughter in law of the Oracle of Omaha, I already knew that Warren Buffett was a devoted Graham practitioner. But when the market didn’t offer any bargains what did he do? I assumed that he waited patiently and did nothing. I was wrong. I learned here that he did a lot of stock arbitrage. I had not realized until reading this book, that it represented such an important portion of the returns of the partnership in the early years.
Indeed corporate activities, such as M&As, spin-offs, and liquidations can be a treasure of ideas. To illustrate why here is one example of a takeover situation. Imagine that company A declares that it will buy company B in cash at a price of X per share. Assume that you know for sure that it will happen as stated. Then, anyone selling their shares of company B at a price below X is offering you a bargain. The discount might not be huge, but if you leverage like Warren did, it could turn out profitable.
If it’s so simple why isn’t everyone successful at it? Well, there is a trick. How certain are you that the takeover will indeed happen? The key is to have certainty.
There are many situations where companies make public statements of intent for takeovers, mergers, privatizations, spinoffs, etc. But how likely are they to be all concluded? The upside on these trades are usually small in percentage terms, and the downside could be significant, especially since anyone betting on these deals uses leverage. Therefore the key is not to take any chances. Be selective. Focus on takeovers that are friendly, strategic, paid in cash, and sure to happen. Avoid situations where the buyer is an LBO firm.
It doesn’t seem like much, but for me, it resonated with one of the teachings of Graham: don’t speculate. It takes an enormous amount of discipline to find these opportunities and a vast amount of research to reach 100% confidence. A guaranteed $1 gain is better than a speculative $10. Not everyone thinks like that.
My purpose in life is wisdom, independence and achieving my maximum potential. Like Charlie Munger, I believe in the discipline of mastering the best that other people have ever figured out. With this blog I hope to keep track of my learning about value investing, business, and self development and inspire others to do the same. Join my Journey. John.