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Jonathan Poland
Jonathan Poland
Articles (225)  | Author's Website |

Warren Buffett's Financial Engineering

For decades Buffett used borrowed money and this strategy to crush the market

November 15, 2016 | About:

Investors often overlook the financial engineering that Warren Buffett (Trades, Portfolio) has employed throughout the years that helped build his personal fortune and the book value of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B).

One such technique was to take a variety of positions in stock arbitrage trades using leverage to do so – in other words, borrowing money against his cash positions to trade for short-term gains.

Give a man a fish, and you will feed him for a day.

Teach a man to arbitrage, and you will feed him forever.

Warren Buffett (Trades, Portfolio)

Buffett did this well throughout his partnership and for decades at Berkshire, and in turn it bolstered his stock returns substantially. This is exactly why he reads so much. Back in the “old days” you could find money in the newspaper. Arbitrage is the byproduct of a range of corporate activity that will only get larger with the economy. In fact, here in Washington, the largest law firms in the world generate billions of fees on practice areas revolving around this activity.

His son Peter’s ex-wife Mary Buffett (didn’t want to give up that name) has co-authored many books on Buffett, including one on “The Art of Stock Arbitrage.” It’s a short book that should be on any investor's reading list, but for the purpose of this article, I want to focus on strategy and system.

First, arbitrage has many names from friendly mergers, hostile takeovers, tender offers, liquidations and spinoffs to stubs and reorganizations. These actions are how most activist investors generate billions. At least, they were until Bill Ackman (Trades, Portfolio) started marketing his shorts to the public, but I digress.

Second, there is a long list of possible stock arbitrage trades available right now in the market  maybe over 100 from which to choose. Thus, investors have plenty of options. Arbitrage arises when there is a current price differential on the future sale of an asset.

More specifically as it pertains to a stock in today’s market, if Bayer AG (BAYRY) successfully completes its purchase of Monsanto (NYSE:MON) for $66 billion, Monsanto shareholders will receive $128. per share. The stock is trading at less than $100, creating a “middle” of would-be profit if the deal closes in late 2017. This difference is good for a 30% total gain, which in any market would leave investors smiling. What’s better is that this deal is all cash, which is something that Buffett almost demands from these types of trades.

Third, there are risks. With big deals like Bayer and Monsanto, the year-long dog-and-pony show needed to convince regulators to approve the merger generates a massive expense (hence big law) and if the deal falls through, the acquiree’s stock is likely to fall to preannouncement levels. This may not be the case in this particular deal because Monsanto is already a mega-corp, and its stock didn’t jump on the news of Bayer’s acquisition.

To quantify the risk, mathematicians have put together a neat little equation for investors (see below). While I am a fan of calculating long-term prospects in the earnings per share, book value and market price departments, I think of arbitrage as a rather simple calculation. If successful, I make (x)%. If unsuccessful, I lose (x)%. Then my job is to find deals that have (1) have the highest likelihood of closing and (2) provide the highest net ROI and (3) buy as many as possible.

Arbitrage ROI Equation:
ROI = (GC – L(100%-C))/YP

G: Potential gain ($) in the event of success
L: Potential loss ($) in the event of failure
C: Estimated probability of success (%)
Y: Holding period (in Years)
P: Stock buy price

Finally, for the majority of investing borrowed money is a sin and should be frowned upon. However, for successful arbitragers, borrowed money creates massive gains that would be otherwise unattainable. For example, let’s say you have $100,000 in the market and all of it is tied up in BRK.B, and you want to buy into the Bayer-Monsanto deal, but since Berkshire doesn’t pay a dividend, you need to either pony up more out of pocket or borrow against the money you have already invested.

If you do have this level of assets, I sincerely hope you are with a broker like Interactive Brokers so you can get the margins rate down under 2%. It still baffles me how many investors trade at big names like E-trade and Fidelity and pay 5x more than they would at Interactive.

Since the deal is likely to take a year to close, if you borrow 10% of your current portfolio ($10,000) at a 2% interest rate ($200), and the deal goes through, your profit would be $2,800 before taxes. If you had 10 deals like this, you could effectively generate an extra 28% on top of how BRK.B trades short term.

Thankfully, Google has made it really easy to find any piece of information you want, if you can put in the work. And the punch line is Buffett can't compete with you on most of these deals.

Disclosure: I do not have a position in any of the stocks mentioned in this article.

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About the author:

Jonathan Poland
Thanks for reading! I'm a former money manager and financial publisher that has helped investors produce market beating results since 2001. Today, I turn 40,000 hours of work analyzing and forecasting the world's leading investments into models for better business development.

Visit Jonathan Poland's Website


Rating: 5.0/5 (3 votes)

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Comments

batbeer2
Batbeer2 premium member - 1 year ago

>> Back in the “old days” you could find money in the newspaper.

Take it from me, you still can.

Jonathan Poland
Jonathan Poland - 1 year ago    Report SPAM

You just don't need to read the paper anymore Batbeer2

zyl41
Zyl41 premium member - 1 year ago

Very interesting, we don't really hear much about this aspect of Buffett's investing strategy. Any other recommended readings on details of this technique?

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