Warren use to call this special situation of investing as ‘Workouts’ and has invested in multiple of situations in his early days of partnership to juice up his returns. Warren also leveraged up while investing in some of these arbitrage situations.
Arbitrage situation occurs when one can buy a stock or an asset below the price someone else is offering to acquire the same asset. Mergers and acquisitions is the area of arbitrage where Warren
invested most to park his money and earn decent returns when not many value opportunities were available in the market.
Arbitrage is all about assessing the “certainty” of the deal being completed. High certainty of deal being
completed meant low risk and sure profits. Following are some of the key factors to evaluate while assessing the certainty of the deal:
1. Nature of the merger / acquisition – Strategic or Financial. Strategic buyers lend more credibility to the deal and increase the certainty quotient. If buyer is big and has lot of cash even better. No matter the state of the economy a strategic buyer who is big with deep pockets will ensure the deal is done. Financial buyer may back out if the economy is bad and his source of finances dry up or credit markets freeze.
2. Source of financing – Self financed deals are better vs. those done on borrowed money, specifically if the economic environment is bad.
3. Terms of the deal – all cash or stock purchase. Stock for stock deal has a higher probability of going through if the economic environment is not conducive
4. Intentions of the management of company being acquired – If management of the company being acquired was actively shopping in the market, the seller is motivated and it is very highly likely that the deal will be closed. Even if the buyer backs out there is high probability that some other buyer will come knocking as management has been actively shopping to sell the company
5. Board approval – if it is a friendly acquisition and the boards of both companies are onboard the certainty of the deal closing increases
6. Shareholder approval – who already owns the stock? If any of the big shareholders is against the deal it is better to stay away from this opportunity, but if insider own large block of the stock and is behind the deal there is a high probability of getting the shareholder approval thus increasing the certainty of the deal. If management owns very little stock and lot of the stock is owned by mutual funds or individual investors, and the price offered is fair there is a high probability of deal getting approved (both mutual funds and individual investors have short time view and they all love to make fast buck)
7. Government agency approval – approval from DOJ and FTC is required for lot of the deals and if there is any notification from DOJ or FTC that they are going to look into the deal from antitrust violation perspective, stay on the sidelines till the review is complete. It can take years before companies gets approval from government agencies and no one wants to tie their money for so long
8. Competing buyer – Is there a competing buyer. This situation is like icing on the cake and provides higher probability of deal getting approved as competitive bidding ensures top price for the company being acquired.
Merger and acquisition activity is hot and there are some real opportunities out there to make some money. There are some excellent books available to learn about special situation investing. Check out the following books to learn and juice up your returns
Warren Buffet and the art of stock arbitrage – Mary Buffett and David Clark (basic read without much detail)
You can be a stock market genius – Joel Greenblatt (a level higher)
Distress Investing : Principles and Technique – Martin Whitman (for experienced investors)
Also check out:
- Warren Buffett Undervalued Stocks
- Warren Buffett Top Growth Companies
- Warren Buffett High Yield stocks, and
- Stocks that Warren Buffett keeps buying