While employed by Benjamin Graham, at Graham’s New York investment firm, Warren Buffett (Trades, Portfolio) got to know about the arbitrage side of the investment business — and the time he invested in learning about it paid off quite handsomely. He discovered that Graham’s firm had averaged 20% per year, on average, over the previous 30 years, and he was hooked.
In chapter 17 of “The New Buffettology,” authors Mary Buffett and David Clark highlight one of the guru’s successful arbitrage moves after he went out on his own, and they explained how arbitrage works.
Investing in corporate sellouts, reorganizations, mergers, spin-offs and hostile takeovers are some of the ways in which arbitrage opportunities emerge. Essentially it is a business of capturing the difference between prices today and prices at some point in the future.
Buffett called them “workouts” and looks at them when he sees few opportunities for long-term investments, as at the top of a bull market, for example. Rather than put his short-term cash into money-market funds, he looks for workouts that should last less than a year. It has been a successful strategy, and he has said his pre-tax return has averaged 25% per year.
He began investing in workouts when he ran the Buffett Partnership, his first investment firm (1957 to 1969). Indeed, the authors reported that workouts helped save the firm during bad years in the market, such as 1962. The Partnership actually lost money on its normal investments in that year, but managed to finish it with a gain of 13.9%, thanks to this alternative. At times he had up to 40% of his Buffett Partnership capital in workouts.
Benjamin Graham called these arbitrage trades “special situations” and described one particular type of them as “cash payments on sale or liquidation,” meaning a company decides to sell out or liquidate, shuts down its operations and distributes the cash to the holders of its securities. These are also the type Buffett likes best.
For example, the management of RJR Nabisco (NGH, Financial) announced in 1988 that they planned a management buyout. Once the offer emerged, other companies also decided to take a run at buying the firm from its shareholders. That prompted a bidding war, and Buffett, who invested more than a quarter-million dollars after the initial announcement, made even more than he expected going into the trade.
In conventional deals, the authors noted, Company X might announce it will sell all its stock to Company Y for $120 at a certain date in the future. An investor who can buy those shares for $100 — after the announcement and before the deal closes — stands to earn $20 per share with what appears to be minimal risk.
But, there is also the question of time, which is at the heart of these trades. If the deal closes in exactly one year, then the return will be 20%. If it closes in six months, the yield will be 40%. On the other hand, it might also drag on and close in two years, depressing the yield to 10%. As the authors described it:
“The arbitrage/workout situation is essentially an investment with a fixed profit and hopefully an established termination date. The amount that you are going to earn is fixed—in our example, $20 a share. The length of time that the security is held will determine the pretax annual rate of return. The shorter the length of time, the larger the pretax annual rate. The longer the length of time, the smaller the pretax annual rate. It goes without saying that an open-ended time can lead to disaster and should be avoided.”
If the deal fails all together, the share price may drop back to where it was trading before the announcement, or even lower. Many potential hazards can trip up the best-planned deals, including shareholder rejection, regulatory complications or the IRS issuing a tax ruling that squelches interest in the deal.
Often, investors buy themselves into trouble. One tactic that’s commonly observed is jumping in when a deal is only in the rumor stage; the authors wrote:
“What kind of fool would invest in a transaction that hasn’t been announced? Care to take a guess? You got it. Wall Street! Yes, the Wall Street wizards have worked their brains overtime and figured out that they can make a lot of money by investing in companies that are rumored to be takeover candidates.”
Buffett has taken part in hundreds of these arbitrage deals, and protects himself by investing only in announced deals; he does not bite during the rumor phase. He would rather take in a near-certain annual return of 25% than a 100% profit on a “big maybe.” Graham would describe that as being an investor, not a speculator.
Indeed, Buffett is said to believe that “arbitrage/workout investments would produce, year to year, the most steady and absolute profits for the partnership, and that in years of market decline they would give the partnership a big competitive edge.” This was particularly true for him during bear markets, when stock prices were going down and driving up his potential profits.
*A note for readers following this book on a chapter-by-chapter basis: Chapter 16 has not been included because too much of its content is dated (2002).
About
Mary Buffett and David Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor” (Mary Buffett is a former daughter-in-law of Warren).
This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.
Disclosure: I do not own shares in any company listed and do not expect to buy any in the next 72 hours.
