Risk arbitrage is a favorite of top money managers as you'll see by the guru ownership in each of these below. To do it like the Warren Buffetts (Trades, Portfolio) of the world, you need to be comfortable leveraging longer-term cash positions to buy and sell stocks for short-term gains with borrowed money. For example, if you’ve built a $2.84 million portfolio on 10 shares of Berkshire Hathaway (BRK.A)(BRK.B), you would keep that position intact and buy short-term “workout” positions on margin, understanding that if the position went the wrong direction, you may have to liquidate one of your shares -- or pony up the cash for a margin call. That’s why you should follow some simple rules.
Rules:
1. All-cash buyouts only.
2. Annual yields above 15%.
3. Limited downside risk.
8.5% Profit Potential
Bayer is buying Monsanto for $63.5 billion in cash with an expected close in March. The buyout price is $128 and Monsanto’s price is $118 right now. That $10 spread represents roughly 8.5% gain, but when you run the number on margin, it would be a lot higher. For one, Interactive Brokers charges 2.32% to borrow cash -- 0.19% a month.
If the deal does close by the end of March for the expected price, you would have spent 0.77% to earn 8.5%. In other words, a $100,000 investment would produce $8,500 minus $770 before taxes. With a deal like Monsanto/Bayer, you have less downside risk since the stock hasn’t risen that much from the original acquisition date. Other M&A transactions carry a lot more volatility if they aren’t completed.
Warren Buffett (Trades, Portfolio) owns over 2% of the stock with 8,873,469 total shares, followed by Jeremy Grantham (Trades, Portfolio) and Jim Simons (Trades, Portfolio) with over 2 million shares in MON.
27% Profit Potential
Ant Financial Services began with a low ball bid at $13.25, which was subsequently upped to $18 in April and approved by the MoneyGram stockholders. The big hurdle for Ant Financial (operator of the world’s leading mobile and online payment platform, Alipay), is it’s a Chinese company, which means the deal could have a problem clearing the Committee on Foreign Investment in the United States (CFIUS). It has re-filed, which indicates increased government scrutiny ,and more deals have been resubmitted to CFIUS since the inauguration of Donald Trump.
MoneyGram has a short interest of 16.55%, but don’t expect the deal to close in 2017. If it doesn’t, MoneyGram stock could slide back to the $11 to $12 level, down from $14. If completed by the first quarter of 2018, the margin trade would yield 35 times your money.
Jim Simons (Trades, Portfolio) owns over 2.3% of MGI with 1,259,491 shares.
55% Profit
Genworth Financial (GNW, Financial) is another company that has been under scrutiny because of a Chinese buyer. However, China Oceanwide Holdings has been approved by the South Carolina Department of Insurance, which could pave the way for others to do the same. Of course, the deal was expected to close by the end of December, which I don’t think is likely.
That being said, if the profit margin stays the same, as long as the the deal closes in the next year, it will be well worth the position. In fact, with Zacks ranking the stock a strong sell, and the price down from pre-announcement levels, I think it could be the best trade of this article. To be safe, buying it without margin may be best, despite the extremely high return potential.
Richard Pzena (Trades, Portfolio) owns 3,966,700 shares (0.79%) followed by Jim Simons (Trades, Portfolio) (again) with 2,356,100, and Arnold Schneider (Trades, Portfolio) with 1,445,819 shares.
Scripps Networks (SNI, Financial)
11% Profit
Discovery Communications announced it would acquire Scripps in July. The $14.6 billion deal has special conditions including a 70-30 combination of cash and stock. Under the original terms, Scripps shareholders would receive $63.00 in cash and $27.00 in Discovery Class C shares.
While it’s not an all-cash deal, it’s worth it because the union would actually create very strong long-term potential. If you decided to sell once the deal closes, you’d see 14 times on the margin loan. And, if Discovery (DISCK) shares remain at their current level, you could buy into it at a major discount. Together, these companies will generate over $2.5 billion in free cash annually.
Mason Hawkins (Trades, Portfolio), Mario Gabelli (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio), and Jim Simons (Trades, Portfolio) all have over 100,000 shares of the company.
Conclusion
As you can tell, guru investors like arbitrage. With each of these positions, the downside risk is limited because of the companies being bought. However, when using borrowed money, the losses are also exaggerated. Don’t be afraid to sell out at a profit if the stock moves up before the anticipated close date. I’ll revisit these in a month.
Disclosure: I am not long/short any stocks mentioned in this article, but may purchase shares in SNI in the next 72 hours.
