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Arbitrage Rundown

January 18, 2009
I first came across the term while reading Dhando Investor. A really really basic definition is the idea of taking advantage of the price difference between an investment. e.g. if gold is selling for US$980 on the Australian market and being sold for $1010 in the US market, an arbitrageur would purchase gold from the Australian market and sell it immediately on the US market with close to zero risk. We will look at how it relates to stocks.

Some Definitions

A detailed explanation is provided on Wikipedia about the different types of arbitrage. A nice little summary from the page is…

Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. - Wikipedia

Why Arbitrage?

In the current down market, we all hate to see our money shrink. According to behavioural finance, losing money hurts twice as much as gaining the same amount of money. So it is a way to save your portfolio is bad times.

A well analysed arbitrage will save your portfolio. It can also provide a short term gain with very low risk. I only tend to engage in a play when the deal between two merging companies is close to finalised. This lets me invest my money for a short period of time (usually 3-5 weeks).

How to Arbitrage

I tend to get my information from reading books, magazines, listening to finance stations on the radio and blogs but the best description and rundown of how to get started, what to watch for, when to start considering putting money down etc came from FWallStreet. I highly recommend you take a look.

There are 4 posts that make up the arbitrage/workout series.

Part 1

Part 2

Part 3

Part 4

I personally only engage in merger arbitrage where it has been confirmed ( in newspapers, press release etc) a company will be buying out another company. My investing nature is completely against “speculative buyouts”.

Homework BEFORE Jumping In

Arbitrage is not easy. It is time consuming (at first) and not risk free (although it can be very low risk).

These are some general steps of how a merger usually plays out and what you must look for (taken from FWallStreet).

1. Due diligence by both parties;

2. Agree on a price, terms, and contingencies (financing, regulator approval);

3. Get preliminary shareholder sentiment (or controlling shareholder approval);

4. Secure financing arrangements (if needed);

5. Obtain regulator (SEC, FCC, any and all) approval;

6. Get final shareholder approval at a meeting called for that purpose;

7. Complete the deal.

The above 7 steps can all be found from news, SEC filings (remember the SEC RSS to make it quick and easy to check), proxy statements.

In most mergers, once the deal gets past number 5 or 6, the deal is very close to completion and close to risk free at this point. However, by this time, the price difference or spread has usually closed and the profit will probably be a very small %. BUT, there are many many mergers that Wall Street forgets abouts. It is these that provide quite a substantial annualised gain.

Merger Investing provides a status of all current pending mergers. You can see the closing dates and potential annualised gain as well.

The Risk

A deal could fall out just as suddenly as it was announced. Last minute financing could be the problem, they may not meet the deadline and the deal gets cancelled or approvals could not be obtained.

That is why, to reduce as must risk as possible, doing your homework on the 7 steps above as well as keeping up to date with current situations is vital for a successful workout.

Risk also comes from being involved in too many at the same time.

Most practitioners buy into a great many deals perhaps 50 or more per year. With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks. - Warren Buffett

The key is to look for the ones where the odds are in your favour. Not something like the Microsoft Yahoo merger where there are many antitrust issues, shareholder disapprovals and pricing disagreements.

By Jae Jun, www.oldschoolvalue.com

About the author:

Jae Jun
Jae Jun is the author of Old School Value, a value investing blog dedicated to the Old School methodologies and teachings of the investment greats such as Graham, Buffett and Fisher. The blog deals with finding intrinsic value, fundamental stock analysis and special situations including spinoffs and merger arbitrage.

Visit Jae Jun's Website


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