Wisdom From the Master
Occasionally I'll peruse my dog-eared copy of the collected letters of Berkshire Hathaway to mine the words of Warren Buffett for some wisdom. As I have progressed in my own personal career of investing, I have wanted to try new things. Unfortunately in this business, doing new things can often be dangerous. Thankfully I made it through my day-trading phase, my options phase and my short selling phase relatively unscathed (and a little ahead actually ... if you don't count the amount of hair and mileage on my heart that I probably lost during a few harrowing episodes).
Even though Buffett is known for buying and holding wonderful businesses and leading one of the best insurance and reinsurance operations in the world, there is one facet of his career that I only recently began to explore: Merger Arbitrage. When you invest, usually things that excite you are preludes to losing a lot of money - so I was very careful to contain myself and, in the style of Charlie Munger, cultivate low expectations when approaching this technique.
What is Arbitrage?
In a nutshell - arbitrage is when one party exploits a price difference between a buyer and seller. If I know I can purchase something for $1 from Person A with the knowledge that Person B will purchase it for $1.10 and I do so, I have successfully conducted arbitrage if the cost of the transaction (the buying and selling, plus any other expenses I have incurred) is less than the total profit I have made. In a more practical context, if you can purchase stock in a company at a price that is less than the stated amount offered by an acquirer for the shares, you are looking at an arbitrage opportunity - and are now tasked with determining if your efforts merit the endeavor.
Buffett's personal style of Merger Arbitrage was influenced by his teacher, Ben Graham, the progenitor of Value Investing. Ben Graham was incredibly risk averse, operating a highly diversified portfolio owning fractional interests in businesses that could be liquidated for significantly more than the price he paid. He did it very well and for a very long time. One facet of investing that especially appealed to Graham was the potential for profit without significant risk - something that properly executed arbitrage promises. Usually there is not a large profit to be had. However there is potential for "free money" situations to occur if the arbitrage is well executed.
Warren Buffett's Arbitrage Methodology
Warren Buffett would only conduct arbitrage on situations that were publicly announced, a key difference from many who would speculate that a company would be acquired by a larger entity on a rumor at some undetermined point in the future ... a method that is to say the least difficult to consistently execute.
Buffett's approach would produce deals that would not create spectacular profits, however they would produce an attractive annualized return and provided a place to utilize excess cash or a portion of ones own portfolio earmarked for cash and cash equivalents because, since the terms were known, risk could be carefully contained. Once the terms of the deal were known, Buffett would calculate the likelihood of the deal going through and both the possibility and magnitude of loss if it failed.
American Greetings (AM)
American Greetings operates within the publishing sector as a greeting card manufacturer. It also has an online business, e-cards, and has significant intellectual property holdings. Currently the stock is priced at $16.31 per share, and pays a dividend of 3.69% annually at current prices. The company is also losing money, and has been caught in the midst of a changing industry (from print to digital). The company is trading under book plus cash, with $20.33 of book value and $2.00 cash per share. The stock has been volatile over the past 52 week period, reaching a low of $12.53 and a high of $17.49. I had been very interested in American Greetings when it was trading around $13 per share in the latter half of 2012, however I decided that I didn't understand its online business well enough to make a commitment. A significant error of omission on my part, because the Weiss family, majority holders of American Greetings, announced an offer to take the company private, first at $17.18 per share in late 2012 and later at $17.50 per share in early 2013.
The Possibility of Arbitrage - Risks and Rewards
A major reason the company declined in price in the months following the public offer was because of the shareholder lawsuits brought against the company and uncertainty. The offer to take the company private was significantly below the company's book value plus cash per share, something which many shareholders, particularly those who have held American Greetings over the long term, were understandably upset about.
Any time litigation is involved surrounding a merger or acquisition, there are considerable delays that consume a large amount of time and money on behalf of the acquirers. In situations such as this, brevity is the soul of profit for the arbitrageur because of the time value of money. As time drags on, the acquiring party's financing could dry up, or they could abandon their efforts in the face of costly and lengthy litigation. This is not good, as protracted litigation can turn an attractive return into a mediocre or even terrible one as time progresses relative to other opportunities.
However, depending on the price at which shares in the company were purchased and the length of time it will take to close the deal, there is the potential for significant upside, so I decided to run an experiment with a portion of my own portfolio typically reserved for cash and cash equivalent holdings.
What I Did and Why
Purchasing shares of American Greetings at $15.90 and receiving $0.15 in dividends quarterly, my return is capped at 13.8% assuming the shares are purchased at the price of $17.50 - a 10.06% difference in price combined with a 3.77% annual dividend yield. If the deal does not go through after one year or falls through and the stock declines to $14.78 (the last quoted price before the buyout offer was announced) - I will sell - with my loss amounting to 7.5% not factoring in any dividend payments received. If, hypothetically after one year of dividend payments are made and the deal falls through, I am looking at a loss of 3.73% (7.5% subtracting the dividends received of 3.77%). I do not feel like this is a bad place to commit a portion of ones cash and funds earmarked for cash equivalent holdings (as if successful, there is currently a higher yield compared to short term treasury securities of the same duration, especially so if one considers inflation and the possibility of tax loss harvesting).
What Could Happen
Since I believe I have a reasonable estimate of my downside and have planned accordingly, I will now explore two scenarios on the upside. Despite the fact that this is an attractive outlet for ones excess cash over the period of one year when applying the currently announced terms of the deal - a number of situations could unfold that provide significantly higher returns on an annualized basis, making this situation a possible candidate for an attractive "mispriced gamble."
1. Plan for the Long Haul but Pray for a Short Run
Lets say that the deal closes in six months instead of twelve, I will still make 10.06% plus two quarters of dividend payments (1.885%+10.06%), giving me a return of 11.945% or, 23.89% annualized. If the deal closes within 9 months, I will make an 18.86% annualized return. Time is of the essence in these situations, and the shorter the horizon - the better, however from these back of the envelope calculations I hope that the inherent attractiveness of this type opportunity is apparent.
2. Sometimes Litigation Works In Your Favor...
Lets say that litigation is successful against the Weiss family, and they must pay a higher price or deal is shopped around to other prospective buyers (possibly the private greeting card titan: Hallmark) at a level higher than the current offer of $17.50 per share. Lets say that this takes one year to resolve and a higher buyout price is obtained at $18 per share (I am pulling this number out of a hat), my annualized return factoring in dividends would be 15.47% - again not bad at all, especially for money that was lying fallow as cash or in low yielding short term treasury bonds or CDs.
I believe that American Greetings provides an excellent opportunity for an investor to attempt arbitrage only after carefully evaluating the possible outcomes and preparing for exigencies, as arbitrage operations often tie up a meaningful amount of capital despite being relatively low risk. Entry points in situations such as this are also extremely important, and I must strongly caution investors to pay very close attention to their cost basis relative to the final price realized through an acquiring bid. I would also encourage examining the possibility of using options to obtain even more protection provided they are correctly priced.
I'll end with one of my favorite Warren Buffett quotes: "Give a man a fish and you will feed him for a day. Teach a man to arbitrage and you will feed him forever."