In my previous post on the Allied-Ares merger arbitrage opportunity, I introduced a topic which I realized I’ve never quite talked about here. As I intend this blog for both beginning investors and seasoned investors alike, here’s a run down on the concept of merger arbitrage.

What is arbitrage?
Rigorously speaking, arbitrage is the practice of taking advantage of a price differential between two markets which allows the arbitrageur, or person taking advantage of the arbitrage, to obtain a risk-less profit.

In my prior post, “Allied Capital Goes from Value Trap to Deep Value,” I made the point that the Ares/Allied acquisition created a potentially interesting merger arbitrage opportunity. As astutely pointed out by commenter BeauZeau at Seeking Alpha, the merger arbitrage opportunity is not quite as large as I portrayed.

In a classic merger arbitrage, the investor ought to short the acquirer Ares Capital (ARCC) and buy the target Allied Capital (ALD). That is because, assuming that the deal closes, the target and acquirer shares are now representative of the same asset. Consequently, any price discrepancy between the two stocks represents a fundamental disconnect with underlying value*. In the case of ARCC and ALD, I posited that the proposed exchange rate of .325 ARCC shares for each ALD share creates an opportunity based on current closing prices.

I’ve written extensively about Apple this past year. And, not without reason. Investing in the stock has been a very fun ride ($89 – $200 in a little over 6 months). The Company, whether it be delighting users with new products or frustrating users with its mismanagement of the iPhone app approval process, has managed to stay in the headlines and, as a result, remains a plentiful mine for content. Because Apple (AAPL) has a contentious group of zealous fanboys, let me start with my Apple Investor Disclaimer and then get on with the post. This is specifically for mac fanboys, so those who have an open mind and understand how one can have a differing views of a Company and the Company’s stock valuation, just skip the blockquote below.

I, the author of The Curious Investor, am currently long Apple stock. In fact, it makes up nearly 10% of my personal portfolio. In my apartment are multiple Apple products including several iPhones, several iterations of the iPod, a MacBook, and an Airport Express. I believe Apple is more than just a trendy consumer products maker and that the iPhone truly represents a new growth engine as the world embraces mobile computing. As an investor, however, I understand that stocks do not only move in one direction. Valuations will overshoot and undershoot true value in the short term and a prudent investor must be aware of this and make decisions with this phenomenon in mind. It is possible for a great company to possess a not very great stock valuation (see: CSCO circa 1999-2000). So, please, leave your hate mail unsent.

For those that follow this blog, I once wrote about an asset class known as business development companies, particularly middle-market lending BDCs. These businesses typically concentrate on investing through the financing of middle-market private equity transactions. Over the last year, some have come under pressure as a result of government regulations over BDCs which require them to maintain certain asset coverage levels. As a result of the disjunction in the markets, mark-to-market mark downs on BDC portfolios resulted in some BDCs (most recognizably Allied Capital (ALD) and American Capital (ACAS)) falling out of line with asset coverage regulations, tripping debt covenants, and discontinuing dividends.

On Monday, a major shakeup was announced within the BDC industry. Ares Capital (ARCC), one of a few BDCs which has managed through the recession while maintaining a substantial dividend, announced that it was acquiring a former giant of the industry, Allied Capital (ALD). The acquisition is expected to be an all-stock deal where ALD shareholders will receive 0.325 shares of ARCC for each share of ALD they own.

Been meaning to write this post for a while, but it seems that my patience has paid off as I have even more chart evidence to work with. And, that is the main point of this post. Technical analysis is not a means for predicting the future. That may seem paradoxical to those who have seen me use technical analysis to attempt to determine buy and sell points. If technical analysis isn’t for predicting the future, then how can it be useful?

What I mean by technical analysis isn’t meant for predicting is that rigorous technical analysis isn’t a means for front running what you “think” may happen to a stock. It’s a means for gleaning information from an existing chart about an existing trend and helping the practitioner to make investments with underlying market supply and demand behind them.

I wrote a little while back about the rumored Apple Tablet. At the time I talked about my desire for a product which would truly legitimize the netbook/UMPC category. Apple has done a terrific job differentiating its computing offerings. The majority of computer users start with a laptop for general everyday use and occasional mobility. Power users might buy a desktop for more horse power. And, everyone needs an iPhone for highly mobile media and light productivity. To me, the natural follow on to these three product categories is a full on mobile productivity device.

The Mobile Productivity Device
In my post on the Apple Tablet, I talked about my image of the perfect mobile device being shaped by the viral Microsoft Origami Project videos circa 2006. Well, leave it to Microsoft to drop yet another follow on which I think once again targets my mobile productivity desires – the Microsoft Courier.

I highlighted Isis Pharmaceuticals (ISIS) a few weeks ago believing that a sell-off causing a price decline from $19 to $16/share was a prime opportunity to buy a potential high-growth business. It seems, however, that my proclamation may not have been entirely correct. And, post last week’s trading, I’ve liquidated my position in ISIS. Do I still think ISIS could present a tremendous opportunity to invest in next-generation biotechnology? I do. But, with markets seemingly reaching a top and real cash flow in ISIS years away, it’s probably better to be safe than sorry. Moreover, lacking the ability to perform accurate fundamental analysis due to ISIS’s place on its growth curve, an investor is left only with technical analysis to guide the investment process and, as I will show, ISIS’s charts no longer paint the profoundly bullish picture they once did. Before I begin, I recommend those unfamiliar to read my post on long term technical analysis.

Near-term Daily Chart

By now we’ve all heard of Amazon’s near-billion dollar acquisition of Zappos which provided a tremendous return to Zappos’ original investors – Sequoia Capital and Venture Frogs. In fact, they only invested $60 million in the company over seven rounds. And, now, they’re sitting on a billion dollar return. How’s that for IRR?

Obviously, this is the magic of venture capital and outside of investing in a publicly traded venture BDC like Harris and Harris (Ticker: TINY), there’s not much we at home investors can do to get in on the ground floor. But, with up and coming retailers, we can still win! Heck, everyone remembers when Zappos was a low-price retailer instead of just a “customer service focused” retailer. Those were good days weren’t they?

Almost all of us investors have felt the way Bob Chapman or Dan Loeb at one point in our lives. I can’t count the number of times that I’ve wanted to grab a member of management and give him what for. Well, there are times when just sitting back and searching for 13D letters just isn’t enough.

Truth is, you don’t need to be a 5% shareholder or even a shareholder at all, to write a letter to a company you deal with. Just look around for the “comments and suggestions” addresses on the packaging of the products you use. Or, simply go online and look for some customer service e-mail addresses. In my experience, these little customer service entreats are often a great way to test how well a company responds to the demands of their customers and whether or not they’re nimble and persuasive or stubborn and uncooperative. I don’t think I have to say, investing in nimble businesses which can convince customers of their value proposition is usually a winning bet.

Below is a 5-year weekly chart for McDonald’s (MCD). (Click to enlarge)

As described by David Gordon of The Deipnosophist, MCD seems to have entered a hesitation after a strong, multi-year bull run. Over the last year, however, a symmetrical triangle seems to have formed which is a type of intermediate term base which is expected to end in a breakout or breakdown, though usually symmetrical triangles signal a brief pause before the continuation of the primary trend. But, I’ll leave the discussion of technical analysis for another post. If you’re interested in an extensive analysis of MCD’s chart patterns do follow the above link to David’s post.

Though it’s been happening for the last six months, the dollar’s weakening seems to have hit a head over last six months. Moreover, it seems that gold has directly offset the weakening dollar. Could this mean that, contrary to popular belief, investors are actually fleeing to the quality of gold as opposed to increasing their appetite for risk?

Click to enlarge:

The title, Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, pretty much sums up the book’s thesis. This is actually Kevin Phillips’ third book on the subject matter, the first two being - American Theocracy and Wealth and Democracy. I haven’t read the first two of his books, but he freely admits in the introduction to Bad Money that the book is somewhat of a rehash of his first two books. In fact, he discusses almost not writing a third book until he realized that those topics he warned us of in his previous books were finally coming to fruition and that the 2008 election cycle might truly be a pivotal moment in American and world history.

Kevin Phillips has been warning of the dangers of the “financialization” of our economy, ineffectual politics, and over reliance on foreign debt and oil for years. In Bad Money, the reader is finally offered a glimpse of the consequences of “American Capitalism.” As a former historian and former Republican strategist, Kevin Phillips provides a unique perspective on the economic and political motivations of many of America’s foreign and domestic policies over the last century and demonstrates for the reader how it has shaped the society we live in today. From the beginnings of “financial mercantilism” and “dollar diplomacy” to our recent binge on debt and dangerous dependence on foreign oil, Phillips draws parallels between our “period of American triumphalism” and the rise of the British and Dutch empires which preceded ours. The observations are not inspiring. In Phillips’ eyes, wayward politics guided by a lack of foresight particularly with respect to energy policy and a reliance on excessive debt coupled with our societal deification of finance have left our nation vulnerable and on the precipice of fading relevance as the world’s economy matures around us and realigns away from us.

1. People who think that I’m an Apple expert.
2. Mac fanboys upset that I haven’t given a 100% Buy! Buy! Buy! comment on Apple.

For those in group 1, I’m sorry to disappoint you, but this isn’t an Apple blog. I don’t purport to have any particular insight on Apple and its products other than through my interest as an Apple (AAPL) investor. But, I have written a few articles on my view of Apple’s stock and business strategy (follow the link to find the full collection).

For group 2, let me address my viewpoint on the rumored Apple tablet as quoted by Jim Rogers in his recent article, “Investors Keen to Taste Apple’s Tablet.” (Seems that Jim Rogers is becoming a regular collaborator with The Curious Investor.) The quote Jim used from me described my disappointment with recent leaks on the Apple Tablet. From what I can tell, rumors have focused on a 10 inch screen, a $600-$800 price range, and arguments over whether or not the tablet will run iPhone on steroids or run OSX.

As some members may know, The Curious Investor is a member of the Forbes.com blog network. This week, they’ve organized the bloggers to answer the prompt:

What is your economic forecast for 2010? Are there specific economic markers that you find particularly useful and upon which you rely on in making your prediction?

Apple’s (AAPL) stock is fast approaching its 52-week high of $177.50, set almost exactly 1 year ago, and seems within striking distance of its all-time high valuation near $200. I wrote at the beginning of the year about Apple’s intrinsic value and recommended buying the stock when it hit $89/share amid rumors of Steve Jobs’ declining health and Apple’s inability to continue to make hit products. The stock has appreciated almost 90% since and it would seem a good time to revisit the Company’s valuation.

My method of determining whether or not a stock is trading at a “value” is to determine the market’s implied valuation. Rather than attempt to model and predict a company’s operating performance, I use the current market value to back into implied growth rates. Then, I try to make a decision as far as how realistic the market implied growth rate actually is. In the end, we retail investors - lacking the ability to control the companies we invest in - are merely trying to determine reasonable prices at which to “buy growth.”

The S&P has rallied nearly 50% from its lows and is up over 10% year to date. For those that sat out the rally, afraid to get in, the market is starting to look (at the very least) fairly valued. It’s hard to say where things will go from here. But, a closer look at the leaders of the recent rally sheds some light on some stocks which just might have been overlooked. Not having benefited from the powerful rally we’ve just experienced, it would stand to reason they will have less to correct should the market turn and offer more of an opportunity for appreciation as investors continue to look for uninflated assets.

Click to enlarge:

I recently highlighted a small biotech firm, ISIS Pharmaceuticals, as a potential “value” growth play. ISIS (ISIS) took a tumble after earnings despite being just a penny off of estimates. Despite slightly lower than expected earnings, the Company showed a strong cash position, moderate cash burn, and a likelihood that it would be able to at least make it through full trials for its most promising drug. I know that for some even this doesn’t count as value. Afterall, the Company is not free cash positive and any value ascribed to the Company is derived from future expectations of its drug pipeline of which there are none currently in distribution.

For those looking for more proven business models but still looking to take advantage of the coming shift towards genetic pharmaceuticals as opposed to small molecule pharmaceuticals, a look at ISIS’s partners may clue you into some interesting finds.

Private equity funds are much maligned for being inaccessible and merely being a vehicle for the rich to get richer. Well, if you can’t beat them, join them! A little known asset class made a few headlines in recent days when two participants – Ares Capital Corp. and Apollo Investment Corp. – filed public offerings to raise capital. These two companies are a subset of a little known asset class which was created to provide small investors access to private equity investments while also providing more capital to help small and middle market companies grow.

These companies are known as Business Development Companies (BDC) and, when publicly listed, are roughly akin to closed end funds. Ares and Apollo represent the most typical style of BDC – those which provide financing through debt and equity instruments to middle-market companies. Typically speaking, the deals that these types of BDCs invest in are leveraged buyout transactions sponsored by a who's who of middle market private equity firms – GTCR, Audax, Apax, etc.

Since bottoming near the end of 2008, ISIS Pharmaceuticals (ISIS) has been one of the hottest stocks in the first half of 2009.

The market (and internet) is buzzing with talk of the Yahoo!-Microsoft search deal. The deals are pretty simple and somewhat more beneficial than the deal which AOL signed with Google (GOOG) a few years back. Basically, Microsoft (MSFT) will power Yahoo’s (YHOO) search and Yahoo will become the ad platform across both search properties. Yahoo is granting Microsoft a 10-year license on its search technologies and transferring much of their search development team to Microsoft. What becomes of Microsoft AdCenter seems hazy, but without access to a legitimate search destination, it will likely be phased out as advertisers prefer to deal with ad networks that have broader reach.

Implications for Yahoo!
Yahoo is finally embracing the fact that it is not a true tech firm or development shop. The company started as a web directory when the internet was in its nascence. It’s only innovation was that prior to Yahoo, no one had created a comprehensive listing of interesting sites online. Dave Filo was just skilled enough to develop a file server which could scale the website as it became popular and then what? It expanded into various content verticals – finance, games, e-mail. But, name for me a real innovation that it provided. It’s search was the “best” simply by virtue of having a human-vetted directory to pull from. Once crawlers and search algorithms gained popularity, it fell behind the curve and, in fact, was powered by Inktomi (which Yahoo later acquired and ostensibly turned into its search group) and Google.