Download Making Money with Special Situation Arbitrage

CONTROLS:
Investments in
which we control
the cash-flow.
Starting your own
part-time business is
the most intelligent
investment you can
make!
WORKOUTS:
Special
short-term
situations
involving a
corporate
event.
GENERALS: Long-term,
fractional ownership in
superb businesses with
strong economic moats.
You expect to earn a
decent return but little
cash-flow.
“…we often have more cash than good ideas. At such times, arbitrage
sometimes promises much greater returns than Treasury Bills and,
equally important, cools any temptation we may have to relax our
standards for long-term investments.” – Warren Buffet
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A workout situation occurs when an announced
corporate activity produces a spread between a stock’s
current price and what the proposed closing price will be
at the conclusion of that activity. “…in other words, they
are securities with a timetable where we can predict within
reasonable error limits, when we will get how much and
what might upset the applecart.”
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Because work-outs are non-traditional opportunities not
generally correlated with the stock market, they are used
by investors to produce a positive return in hard times.
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Work-outs also serve the purpose of keeping investors
occupied so they don’t do something really stupid like
buying a poor long-term investment or speculating in
stocks instead of waiting patiently.
Standard arbitrages based on reorganizations, going private,
recapitalization or merger plan.
Cash payouts in recapitalizations, mergers, or going private
transactions.
Cash payouts on sale or liquidation.
Litigated matters.
Public Utility Breakups.
Miscellaneous Special Situations such as spin-offs and distressed
(i.e. bankruptcy) investing.
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Some detective work is required.
Special Websites such as
› http://www.arbitrageview.com/riskarb.htm
› http://www.mergerinvesting.com/pendingmergers
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The newspaper or news media (remember, we
are only looking for announced deals, inside
information is should not be necessary for a
successful work-out)
SEC filings (3 forms of interest: 13E , 14A/14C,
S4/maybe S1 for spinoffs)
› http://www.sec.gov/cgi-bin/browse-
edgar?company=&CIK=&type=SC+13E3&owner=incl
ude&action=getcurrent
› SEC aggregator sites that search filings for specific
keywords, ‘e.g. merger, liquidation, spinoff, etc..’
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Work-outs should be announced in
the general media (we are not
speculating on unknown deals).
Friendly deals – it is more likely to go
through if the proposal is desired by
both parties.
Small companies and small deals
have less coverage. You have a
bigger advantage than in a megadeal, as well as wider spreads.
Two philosophies depending on skill
level:
›
›
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Most investors should look at
investing in a diversified work-out
portfolio. You are aiming for an
aggregate annualized profit even if a
few deals blow-up. (Ben Graham
actually proposed this even for the
pros)
More experienced investors should
think about doing 1-4 high certainty
deals per year.
Cash deals are preferred.
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“I believe in using borrowed money
to offset a portion of our work-out
portfolio since there is a high degree
of safety in this category in terms of
both eventual results and
intermediate market behaviour…my
self imposed limit is 25% of
partnership net worth…when we do
borrow is it only as an offset against
work-outs” – Buffet Partnership
Letters
CAUTION: Watch a few deals
before jumping in. Some deals have
regulatory approval and financing
issues which may delay or even kill
the deal.
The faster the deal closes and the
lower your cost basis, the higher
your return. Delays erode rate of
return and tie up your capital.
Realizing your profit : You must
decide whether to receive your
profit via the deal terms or by selling
in the open market prior to deal
closing.
Annual Return = [GC – L (100%-C)]/YP
Where,
G: Expected gain in points if successful
L: Expected loss in points if unsuccessful
C: Expected chance of success (%)
Y: Expected time of the holding in years
P: Current price of the security
 Expected return is the average return over
many workouts, not the actual return since
a successful deal should be weighted 100%.
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Company announced going
private offer from founder May 13,
2008.
Founder & control group own 68%
of company stock (seek to buy
the remaining 32%) at $26/share
via a public tender offer.
Financing by Able Finance, a
division of Cerberus Capital
Management.
Tender offer expires June 27th,
expected to close June 30th, 2008.
When looking at a work-out,
enumerate all the possible
outcomes, their probabilities, and
the risk/return profile of each
option. In Usana’s case, the 5
main options are deal at $26, deal
above or below $26, no deal, or
delayed deal.
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Between May 23rd and June 9th,
you could have bought the stock
for as low as $24.50 or a spread of
$1.50 for 27 days prior to closing.
A 6% spread in less than 30 days is
about a 72% annualized return if
the deal closes.
Expected Return = [($1.5 * 80%) –
($3 * 20%)] / .08 * $24.50 = $1.2 $0.60 / (1.96) = .306 * 100 = 30.6%
Last 2 weeks of June price ranged
from $26-$28.50/share.
I did invest in this workout, but
made the mistake of selling too
soon given my comfort level with
the deal…still, the annualized
return was 46% but a common
mistake is leaving money on the
table even when your level of
confidence is very high.
Adding work-outs to your portfolio can provide a
solid return in bear markets while waiting for your
general long term investments to appreciate.
 Work-outs require hard work and knowledge. For
most people, making fast, easy money is a myth.
Only 1/5th of 1% of the world’s population has over
$1 million liquid assets (10 million out of 5.7 billion
people!!), and only 100,000 people have over $30
million.
 Books: ‘You can be a Stock Market Genius’ – Joel
Greenblatt, Security Analysis, Ben Graham
 Workout Excel Spreadsheet:
http://focusinvestor.com/RiskArbModel.xls

“One of the best rules anybody can learn about investing is to
do nothing, absolutely nothing, unless there is something
to do.” – George Soros
GOOD LUCK!
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A low-cost index fund (such as Vanguard) is the best alternative
for most investors who cannot or do not want to invest
considerable time in education and improvement.
There is a mathematical proof showing that actively managed
portfolios (such as hedge funds) must underperform passively
managed portfolios (such as buying the S&P500 index) in the
aggregate.
If you are not a professional and do not bring anything to the
table, why should you expect an above average return?
Remember the ‘sleep’ test. If owning a position makes you sleep
poorly at night, sell some immediately. A good night’s sleep is
the best way to make money.
Excellent Book: “Juggling Dynamite” by Danielle Park. Investors
are too active and not fully aware of the risks involved in
investing.
“Paradoxically, when "dumb" money acknowledges its limitations, it
ceases to be dumb” – Warren Buffett