Cogitator

Archive for the ‘Arbitrage’ Category

Do the Six Flags senior unsecured notes present good value?

In Arbitrage, Distressed Debt on August 13, 2009 at 2:55 am

The general commercial gloom has sent many companies into insolvency, reorganization or liquidation. Where the main issue is poor capital structure instead of operating weakness, there appear to be opportunities for the enterprising investor. One example of this type is furnished by Six Flags Inc., the affairs of which are now undergoing Chapter 11 reorganization.

Earning power. Financial performance over the past four years is presented below:

 

2008

2007

2006

2005
Revenue

1,021.3

970.83

942.18

956.76
Total Revenue

1,021.3

970.83

942.18

956.76

 

 

 

 

 
Cost of Revenue, Total

86.46

81.47

79.99

83.2
Gross Profit

934.84

889.35

862.19

873.56

 

 

 

 

 
Selling/General/Administrative Expenses, Total

214.55

245.37

239.36

192.84
Research & Development

0.0

0.0

0.0

0.0
Depreciation/Amortization

139.61

137.91

131.5

127.66
Unusual Expense (Income)

17.69

39.24

27.06

33.21
Other Operating Expenses, Total

419.04

428.69

413.29

390.8
Operating Income

143.95

38.14

50.99

129.06

Minority interests contribute an additional $40 million to GAAP net income each year. While these undistributed earnings do not count as cash flow, they tend to be fully as beneficial to Six Flags as if they had been distributed. Altogether, the business has earned an average of $130.5 million annually over the past four years.

Debt to equity exchange. Outstanding senior indebtness is set forth below:

Description

CUSIP

Outstanding Par Val.

Last Price
SIX.GJ 8.875% Senior Notes 2010

83001PAD1

$131.1 million

$11.00
SIX.GL 9.75% Senior Notes 2013

83001PAF6

$142.4 million

$10.50
SIX.GN 9.625% Senior Notes 2014

83001PAH2

$314.8 million

$10.00
SIX.GO 4.5% Senior Notes Convertible 2015

83001PAJ8

$280.0 million

$11.50
12.25% Senior Notes Convertible 2016

?

$400.0 million

?

The present Plan of Reorganization grants Avenue Capital 7 percent of the new equity of SFTP—a ridiculous arrangement trumped only by its former proposal of owning a majority of the new equity—and leaves all other senior unsecured noteholders with 1 percent.

Let us examine the investment prospects of the notes under these terms. Assuming that SFTP can maintain its present level of earnings while reducing capital expenditures by half, enterprise value is not much more than $4 billion. A 1 percent stake in this business ($40 million) is less than the aggregate market price of the 2010, 2013, 2014 and 2015 notes ($89.9 million). http://cxa.marketwatch.com/finra/BondCenter/AdvancedScreener.aspx

In the final analysis it must be remembered that Six Flag’s troubles are mainly financial. Its offerings have not lost their prestige, and the valuable goodwill built up by years of national advertising should be preserved unimpaired. However, instead of purchasing the senior unsecured notes I intend to wait for the issuance of new common stock.

skidmore, owings, merrill office

Miscellaneous considerations. Net loss carryforwards of $1.8 billion are a substantial benefit to holders of new equity in SFTP.

 The employee pension fund shows a deficit of approximately $50 million on December 31, 2008.

South Korea: ADR Pairs Trade

In Arbitrage on August 5, 2009 at 2:50 am

Hedging involves the simultaneous purchase of one security and sale of another, because the first is relatively cheaper than the second. Where the security bought sells lower than the one sold, there must be good reason for believing that the price of the two will come closer together,—and conversely for the opposite circumstance.

Oftentimes there are wide price differences between American Depository Receipts and their underlying stocks listed internationally. In fact, a simple relative value hedging method has produced returns of over 30% per annum:

http://www.bauer.uh.edu/rsusmel/Academic/ptadr.pdf

pkx arbitrage

shinhan arbitrage

Section 382 Rights Offerings

In Arbitrage on July 14, 2009 at 12:18 pm

Tax law provisions and the operating losses at several corporations have set forth a peculiar round of rights offering. According to Section 382 of the Internal Revenue Code, a company cannot realize the full amount of its deferred tax asset if there is a “change of control” of the business, defined as ownership of more than 4.95% of the common shares outstanding. (This is intended to prevent the seizure of tax credits by corporate raiders, and hence the rule does not apply to shareholders with greater than 4.95% ownership at present.) Several large corporations have issued contingent rights to shareholders that are only exercisable if a change of control occurs—similar to the “poison pills” used to dilute hostile bidders. There is a great deal of variation in the terms, but typically rightsholders can earn 100% by participating in the offering.

The most important stipulation in the deal terms is whether (1) rights are issued as new securities or (2) they are evidenced by ownership of the common stock prior to issuance. Obviously the former would hold more value to the speculator or arbitrageur; and the latter would give the common stockholder more reason to keep his shares. My strategy involves the purchase of common shares shortly before the record date (to receive rights) and the sale of a corresponding number of near term, deep-in-the-money call options. The objective is to pocket a free right, without any exposure to fluctuations of the stock and without any expense beyond brokerage fees.

There is an element of reflexivity which may prevent the rights from being worth anything—institutional investors may avoid purchasing large stakes of the common because they do not wish to be diluted. I think that in particular cases this risk is outweighed by the minimal expense and attractive terms of the rights.

Below is an excerpt from the rights offering document of Toll Brothers:

Continue Reading

Vigorish Forum Now Accessible

In Arbitrage on June 8, 2009 at 10:29 am

By October of last year it was apparent that the securities market had become dislocated. In addition to redemption-related selling by hedge funds and mutual funds, prime brokers had begun to liquidate client accounts that held insufficient margin. The EMH premise that market participants buy and sell assets solely on the basis of economic value seemed invalid for the moment.

One of the most peculiar opportunities I discovered was a classical arbitrage in the shares and warrants of Foster Wheeler. On days that FWLT advanced considerably, FWLTW would sometimes have an ask price 5% lower than its intrinsic value, which was immediately realizable from the warrant conversion terms. This was my first discovery of a true market inefficiency—substantial in that the return was both riskless and immediate.

Soon I conceived the idea of creating a private forum to discuss similar arbitrage opportunities. I appreciate the input of everyone who has participated.

vigorish.wordpress.com

George Soros: Method of Operation

In Arbitrage, George Soros on May 17, 2009 at 7:54 pm

baby5mos1503-800x534

Source: Michael T. Kaufman

“Technically his position was that of an arbitragist, albeit junior grade. In those days, arbitrage meant buying in one market and selling in another, seeking to take advantage of generally small variations in price. As Soros explains it, the idea was to spot a trend and position yourself. “Let’s say you noticed that Brussels was accumulating one particular gold stock in South Africa, so you would try to buy it in South Africa and then sell it in Brussels later in the day, that sort of thing.” It was a highly technical and professional activity involving a good deal of risk and the need to make speedy decisions.

“Through the late spring and summer, Soros hit a hot streak at Singer & Friedlander. The Ford Motor Company had gone public through an international distribution of shares. George realized that the demand for the shares in America would be higher than in Europe. At his urging the firm bought up Ford shares in London and sold them in New York, scoring a significant success.

“F. M. Mayer was not a member of the New York Stock Exchange. It functioned as an over-the-counter trader, and Soros’s job was to handle arbitrage in foreign securities, basically trading the same gold shares and oil shares in England. It was not a big part of the firm’s business. But barely a month after his arrival, Soros again found luck when the Suez crisis erupted in violence. Earlier that summer, Egypt’s president Gamal Abdel Nasser had nationalized the canal, seizing control from the internationally owned private stock company that ran it. In August Nasser expelled British oil officials from Egypt. Then in late October, Israeli forces launched a lightning attack and seized the Gaza Strip and almost all of the Sinai. Taking advantage of Egypt’s losses, Britain and France attacked Egyptian positions by air and established their own control over the canal zone until pressure from the United States forced their withdrawal and led to the creation of a U.N. peacekeeping force.

Continue Reading

Meadow Valley Corporation (MVCO): Arbitrage Opportunity

In Arbitrage, Security Analysis on December 14, 2008 at 10:06 pm

U P D A T E

On February 2, 2009, Meadow Valley completed its going private transaction at $11.25 per share. The approximate return to arbitrageurs is 65%, or 520% per annum.

http://finance.yahoo.com/news/Meadow-Valley-Completes-bw-14229823.html

T H E S I S

Meadow Valley’s construction services segment builds bridges, overpasses, channels, roadways and airport runways; the construction materials segment manufactures ready-mix concrete, sand and gravel products. In a 10-Q filed November 14, Meadow Valley comments on the status of its operations:

“As with each quarter this year, the third quarter was significantly buoyed up by the performance of our construction services segment. Entering fiscal 2008 with approximately $172.4 million in backlog provided a good deal of momentum for the construction services segment. Contract backlog as of the end of the third quarter was approximately $145.1 million, 63.4% more than a year ago, and should continue to provide near-term opportunity for solid performance from the construction services segment. The construction services segment is primarily engaged in public infrastructure construction and, so far, the public works sector of the construction industry has been less affected by the turmoil in our nation’s economy. As a result, we have had ample bidding opportunities, but what is apparent from the bidding is that competition is intensifying both in terms of the number of bidders as well as tightening profit margins. Our current bonding limits of approximately $250 million total bonding program and a single project limit of approximately $100 million allow us to bid on larger projects which typically see fewer bidders because of such high bonding requirements. Nonetheless, in today’s competitive environment we see an increased number of bidders on jobs of all sizes.

“The sharp decline of the housing sector has been the primary cause of the recent poor performance of our construction materials segment. Since demand for our product, ready-mix concrete, depends entirely on the amount and location of construction activity and because most of our facilities are located to best serve the residential or residential-related commercial construction projects, we have been dramatically affected by this downturn. A few quarters ago, what seemed to start as a slowdown in housing has now erupted into a full-blown global financial crisis. It appears highly likely that we will experience a much more pronounced and longer downturn than previously believed. Furthermore, commercial construction typically lags residential construction and we have only begun to see the slowdown in commercial construction activity. Accordingly, we have taken specific actions to reduce costs and preserve cash for our construction materials segment. These actions include, but are not limited to: (i) not filling the vacancy created by the promotion of our Vice President to President of RMI upon our President’s retirement, (ii) reducing construction materials segment administrative personnel, (iii) implementing a fuel surcharge, and (iv) reducing operational overtime for the construction materials segment. Subsequent to the third quarter ended September 30, 2008 we also imposed a 5% reduction in pay for all construction materials segment salaried employees. We will continue to analyze our operations for other opportunities to further reduce costs and preserve cash.”

Since service contracts account for the great majority of Meadow Valley’s revenue, the company should maintain a moderate level of earning power through the current recession. Indeed, third quarter performance has been satisfactory even after the exclusion of a particular non-recurring benefit. There are, however, two important risk factors for the construction services segment:

“Because much of the funding of transportation infrastructure comes from local sales and fuel taxes, any event that may impact the overall economy that would decrease consumer spending or diminish fuel consumption would result in lower receipts of tax dollars that, in turn, would diminish the availability of funding for transportation infrastructure.

“As public works constitute the majority of our CSS volume, and governmental entities are the primary source of funding for infrastructure work, it is, therefore, important that public funding be maintained. The national transportation legislation, SAFETEA-LU, was signed by President Bush on August 10, 2005 and should provide relatively stable funding for transportation infrastructure at least until its expiration in the fall of 2009.”

Government construction expenditures should increase under the Obama administration.

In July 2008, Insight Equity proposed to acquire Meadow Valley for $11.25 per share. Given the significant premium to current prices, I believe that stockholder approval is assured. However, Insight Equity now claims Meadow Valley may have experienced a material adverse effect, viz., fair market value has declined by more than $6 million. Fair market value is not clearly defined in the merger agreement, but the main issue appears to be poor operating results at Meadow Valley’s Ready-Mix subsidiary. According to management, Ready-Mix has not violated deal covenants.

There are three obvious outcomes to the Meadow Valley situation: first, stockholders can receive $11.25 per share; second, they may receive some reduced price; and third the merger may be terminated. I believe that each outcome is equally probable, and that even a termination will not be too onerous for stockholders. The mathematical expectation is positive.

Vigorish.wordpress.com

In Arbitrage, Benjamin Graham, Bill Ackman, Security Analysis, Warren Buffett on November 25, 2008 at 2:20 am

Vigorish.wordpress.com is a private forum detailing arbitrage and hedging opportunities in equities, bonds, derivatives and convertible securities. I am not certain of how to proceed with the blog; however due both to technical matters and my desire to keep opportunities “close to the vest,” I do want to limit the audience to 35 individuals. Candidates will be selected based on the quality of their ideas (submitted to me via email).

oswaldshot

Wild Card: Well forget about EMH, would you agree a lot more riskless opportunities exist now than say…back in 2006?
How highly efficient can this market really be right now?

Deep Throat: Riskless is very relative. The tricky part of a market like the one we have is figuring out which deals are fairly priced. Ok, that’s the tricky part of every market. But my point is that you might be more easily become overly excited in a market like this than in a much calmer market, when perhaps people with the tiny amount of capital that we have are more likely to blow their wad on stuff that’s not worth it.

In other words, look at those people on google finance who invested in Freddie and Fannie, thinking it was a riskless opportunities. Obviously, we’re not that dumb… but it’s all relative.

Cogitator: No, [REDACTED]. As I understand the English language, riskless means “without risk.” And the [REDACTED] arbitrage truly is without risk; you short sell 3.3682 shares per [REDACTED], and exercising the [REDACTED] gives you 3.3682 shares back. It’s like selling 10 apples at $1 each and getting those identical apples back for a price of only $0.93. It yielded a riskless 7% return today.

How could an investment in Fannie Mac riskless? Any directional bet is by its terms riskier than an arbitrage. Granted, the Volkswagen/Porsche incident demonstrates the risk of this technique, but that is a peculiar case. If you buy and short sell economically equivalent securities (of the same issuer) at a substantial spread (say, 30% or more), the risks should be nil.

The market is efficient most of the time for virtually all participants. However, Ackman makes a very good point: not everyone has permanent capital (capital not subject to redemption). A great deal of Buffett’s success is due to having steady access to capital at times when the rest of the world does not.

Continue Reading

Greif Inc. (GEF / GEF.B): Relative Value Arbitrage Opportunity

In Arbitrage on October 6, 2008 at 11:15 am

U P D A T E

On December 23, 2008, GEF.B closed at a slight premium to GEF.

T H E S I S

This morning I noted the following quotes for GEF and GEF.B, respectively: $52.90 and $40.90. The correct arbitrage procedure is to sell one “A” Share for every 1.3 “B” Shares purchased so that the dollar value of each position is equal.

http://finance.yahoo.com/echarts?s=GEF#chart2:symbol=gef;range=1y;compare=gef-b;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

Relative Value Arbitrage: An Academic Paper

In Arbitrage, Security Analysis, Seth Klarman on October 2, 2008 at 1:26 pm

The relative value arbitrage technique detailed in this paper has yielded 11% per annum. It requires no capital, since the cost of one security is offset by proceeds from short selling a related security. I believe it to be a sound technique, so long as the public does not act on it en masse. In fact the expected return of relative value arbitrage increases as its popularity diminishes.

“Many investors make the mistake of thinking about returns to asset classes as if they were permanent. Returns are not inherent to an asset class; they result from fundamentals of the underlying businesses and the price paid by investors for the related securities. Capital flowing into an asset class can, reflexively, impair the ability of those investing in that asset class to continue to generate the anticipated, historically attractive returns.”
-Seth Klarman
Security Analysis Sixth Edition 

Mueller Water (MWA / MWA.B): Relative Value Arbitrage Opportunity

In Arbitrage, Long-Term Capital Management, Warren Buffett on September 30, 2008 at 10:23 am

U P D A T E  2

http://biz.yahoo.com/prnews/081030/clth041.html?.v=101

U P D A T E 1

Since Monday morning the “A” Share / “B” Share spread has fallen from $2.40 to $1.54. This decline is indeed significant, but anything lesser would also have yielded an infinite return on capital.

The author of a recent TheStreet.com column suggests purchasing one “B” Share for every “A” Share sold short. This would generate a large loss if Mueller Water were to advance, regardless of whether the spread narrows. (Consider what would happen if MWA and MWA.B were to double from their current quotes.) The correct procedure is to purchase and short sell an equivalent dollar amount of both classes.

T H E S I S

Mueller Water “B” Shares are roughly 30% cheaper than the comparable “A” Shares. This spread—almost historically high—may have resulted from forced selling by arbitrageurs. Of course the impersonality of the securities market makes it difficult to identify causation in such a case.

http://finance.yahoo.com/echarts?s=MWA#chart2:symbol=mwa;range=5d;compare=mwa-b;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

“In your investing life you will have one or two opportunities that can’t go wrong. For example, in 1998 the New York Fed offered a 30-year Treasury bond yielding less than the 29-½ year Treasury bonds by 30 basis points. LTCM put a trade on at 10 basis points and it was a crowded trade; they were 100% certain to make money but they could not afford any hiccups. I know more about human nature; these were MIT grads, really smart guys, and they almost toppled the system with their highly leveraged trading. This was definitely a good time to act.”
-Warren Buffett

Constellation Energy Group (CEG / LLJAE): Covered Call Opportunity

In Arbitrage, Berkshire Hathaway, Warren Buffett on September 29, 2008 at 2:34 pm

At $19 per share, CEG is trading 40% below the offer price stipulated in its merger agreement with MidAmerican Energy. It appears intelligent to buy CEG in round lots and to sell a corresponding number of $25 call options. One-fourth of the premium received constitutes “free money,” and the investor’s cost basis can be reduced to $17 per share.

Blockbuster (BBI / BBI.B): Relative Value Arbitrage Opportunity

In Arbitrage, Carl Icahn, Long-Term Capital Management on September 23, 2008 at 8:43 pm

U P D A T E

Since September 23 the “A” Share / “B” Share spread has fallen from $0.89 to $0.75. The arbitrage return is technically infinity.

T H E S I S

3:03 AM Cogitator: also blockbuster is attractive
Client-9: who’s buying and how is it being financed?
3:05 AM Cogitator: nobody
it’s just share class arbitrage
buy the b shares and short the a shares
3:09 AM Client-9: my computer is being slow right now… what’s the spread
Cogitator: 60%
3:11 AM Client-9: wow. what’s the difference between the two securities?
3:12 AM Cogitator: b shares have two votes; a shares only have one
Client-9: how are the company’s financials?
3:13 AM Cogitator: it’s blockbuster…
pretty crappy
but if you buy the b and short the a, you will make money
3:14 AM most brokers don’t let people short sell bbi
which explains the large spread
3:15 AM Client-9: how do they historically trade?
3:16 AM Cogitator: http://finance.yahoo.com/echarts?s=BBI#chart2:symbol=bbi;range=3m;compare=bbi-b;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

Constellation Energy Group (CEG): Arbitrage Opportunity

In Arbitrage, Berkshire Hathaway, Warren Buffett on September 19, 2008 at 10:35 am

U P D A T E

It appears prudent to sell now as CEG’s last quote is a dollar above the stipulated offer price.

T H E S I S

The public utility subsidiary of Berkshire Hathaway will acquire Constellation Energy Group for $26.50 in cash—18% higher than the last quote. A synopsis of the company’s operations can be found here: http://cosmos.bcst.yahoo.com/up/player/popup/?rn=289004&cl=9803508&src=finance&ch=4535474

Compañía de Telecomunicaciones de Chile S.A. (CTC): Arbitrage Opportunity

In Arbitrage on September 19, 2008 at 10:12 am

U P D A T E

On October 30, CTC shareholders accepted IT’s revised tender offer of 4,400 Chilean pesos ($7.00) per share. This is quite a satisfactory outcome, considering both the substantial decline in global stock markets and the appreciation of the U.S. dollar.

T H E S I S

Inversiones Telefónica (IT) is conducting a tender offer for the American depository receipts of Compañía de Telecomunicaciones de Chile (CTC). Shareholders will receive the dollar equivalent of 4,000 Chilean pesos per share—about US$7.54 at current exchange rates. This is 8% above CTC’s last trade price; the annualized return should approximate 50%.

IT has conditioned the deal on the following terms:  (1) there being validly tendered and not withdrawn prior to the expiration date of the Offers a number of Shares (including Shares represented by ADSs) that, together with the Shares already owned by TICSA, would represent at least 75% of the total number of the outstanding Shares (including Shares represented by ADSs) and (2) the shareholders of the Company (the “Shareholders”) approving bylaw amendments that would, among other things, eliminate the restriction currently contained in the Company’s bylaws that limits to 45% the percentage of Shares that may be owned or voted by one Shareholder, directly or through related persons (the “Bylaw Amendments”), by the affirmative vote of holders of at least 75% of the Shares with voting rights, including Shares represented by ADSs, at a special meeting of the Shareholders requested by TICSA (as a Shareholder of the Company) for such purpose (the “Shareholder Meeting”).

Highlights From Security Analysis Sixth Edition: Seth Klarman & David Abrams

In Arbitrage, Benjamin Graham, Carl Icahn, Guy Wyser-Pratte, Net Current Asset Value, Security Analysis, Seth Klarman, Warren Buffett on September 18, 2008 at 10:19 pm

The sixth edition of Security Analysis is a strange amalgamation of Graham’s original work (styled in British English) and new commentary from prominent value-oriented investors (in American English). I find it impossible to read fluidly. Nonetheless the contributors make a strong independent showing, especially Seth Klarman and his protégé, David Abrams. They argue—as I have done in numerous essays—that market inefficiencies are smaller in magnitude and frequency than before.

I am especially pleased that both men acknowledge the hedging opportunities present in derivative securities. This has become my favorite area of study and action—and one that appears unlikely to be outmoded soon. (Elsewhere, I have found much of the “value investing” philosophy to be comparatively inadequate.)

Continue Reading

Put Option Premiums & Closed-End Fund Discounts Historically High

In Arbitrage on September 18, 2008 at 7:55 pm

Put option premiums and closed-end fund discounts appear to have reached a level not seen in my lifetime.

AIG Options: Conversion Arbitrage Opportunity

In Arbitrage, Guy Wyser-Pratte on September 15, 2008 at 12:26 pm

Throughout the day, there have been multiple opportunities to create cheap synthetic positions in AIG options. The premium received in selling calls and puts is substantial, and in effect guarantees a satisfactory result regardless of whether the common stock advances, declines, or stands still.

Lehman Brothers Common (LEH), $5 Calls (LYHDA) & $2.50 Puts (LYHPZ): Conversion Arbitrage Opportunity

In Arbitrage, Guy Wyser-Pratte on September 10, 2008 at 11:33 pm

Yesterday I noted these quotes for LEH, LYHDA and LYHPZ, respectively: $8.00, $6.10 (bid) and $0.69 (ask). For about 10 minutes it was possible to create a cheap synthetic position by buying the common in round lots and then selling calls and buying puts in corresponding amounts.

A decline in LEH to $1.90 will be fully offset by premium received from the short calls; any further decline will be offset by the puts. In a worst case scenario the investor will lose $9 per round lot, but his maximum gain is vastly disproportionate—$241. The mathematical expectation appears to be positive.

This type of conversion arbitrage is commonly practiced by market makers. It is not necessarily a violation of EMH since transaction costs tend to hinder everyone else.

The “Missing” Berkshire Hathaway Letters (1969-1976)

In Arbitrage, Benjamin Graham, Berkshire Hathaway, Buffett Partnership, Charlie Munger, Net Current Asset Value, Security Analysis, Victor Niederhoffer, Warren Buffett on August 25, 2008 at 5:33 pm

warren-buffett-young

There is a conspicuous gap between the last Buffett Partnership letter, written in 1969, and the first Berkshire Hathaway letter posted on the company’s website, written in 1978. Recently I discovered several of the “missing” documents.

A consistent theme in Buffett’s early management of Berkshire is that capital from the textile operation was best redeployed in either marketable securities or business acquisitions. From 1969 to 1977 the textile operation averaged a return on capital of less than 3%, while the insurance and banking subsidiaries averaged well above 10%. Buffett’s refusal to shut down the Berkshire mills resulted in an immense opportunity cost compounded over nearly 20 years.

The moral seems to be that basing investment solely upon asset value (quite significant in Berkshire’s case) is not intelligent. This was a rewarding activity when security analysis was in its infancy, but a great deal has changed since then. One of the best criticisms of the “Graham approach”—which involves net working capital bargains, classic arbitrage, etc.—can be found in Victor Niederhoffer’s The Education of a Speculator:

“On the rare occasion when a true guru shares secrets of a recurring, well-defined systematic nature, the cycles are about to change. Better to go against. What looks good today is encapsulated in the market tomorrow and will change the expected profits, the probabilities, and the paths of least resistance in subsequent periods. A good bet is that all systems will stop working when you use them.”

This criticism extends to merger arbitrage, convertible arbitrage and liquidations, as well as to other approaches that are less systematic. Recent experience suggests that even value-oriented investors are unsafe.

1969

1971

1972

1973

1974

1975

1976

Relative Value Strategies & Market Efficiency

In Arbitrage, Benjamin Graham, Buffett Partnership, Long-Term Capital Management, Security Analysis, Seth Klarman, Warren Buffett on August 18, 2008 at 6:46 pm

Recently I studied the prospectus for Royal Dutch’s 2005 exchange offer. On page 47 it reads:

“The historical trading relationship between Royal Dutch ordinary shares (RDA) and Shell Transport ordinary shares (SHEL) has broadly matched the 60/40 interests set forth in 1907. When this relationship has deviated from parity, it appears to have done so for reasons external to the Royal Dutch/Shell Group, such as index inclusion, relative index performance and taxation changes.”

From 1986 to 2005, the market capitalization of RDA as a percentage of the Royal Dutch/Shell Group averaged 61.72.

This mispricing per se does not prove that security prices are inefficient. The short sale of RDA and simultaneous purchase of SHEL had been consistently profitable, with one exception: in 1998 it cost Long-Term Capital Management several hundred million dollars. In the case of closed-end fund arbitrage, which involves the purchase of fund shares below NAV and the short sale of underlying portfolio securities, the magnitude of mispricing is correlated with the difficulty of finding shares to short sell. These two cases vindicate efficient market hypothesis as I understand it. While mispricings exist, they are either too risky, too costly or too difficult to exploit.

Relative value strategies, however, do not need to be narrowly defined as the type practiced by LTCM, West End Capital (a Buffett investee) or Salomon Brothers. Early this year I effected a relative value hedge by purchasing Genesco and Finish Line simultaneously. My initial success has given me a strong interest in specialized operations of this kind—among other things, I have concluded that money can be made both conservatively and plentifully by buying two common stocks which analysis shows to be inconsistently discounting the chance of one major event. This is an unpopular strategy but one that seems to be entirely logical.

In the mid-1960s, Warren Buffett practiced a more common variant of relative value hedging:

“‘Generals – Relatively Undervalued’ – this category consists of securities selling at prices relatively cheap compared to securities of the same general quality. We demand substantial discrepancies from current valuation standards, but (usually because of large size) do not feel value to a private owner to be a meaningful concept. It is important in this category, of course, that apples be compared to apples – and not to oranges, and we work hard at achieving that end. In the great majority of cases we simply do not know enough about the industry or company to come to sensible judgments – in that situation we pass.

“As mentioned earlier, this new category has been growing and has produced very satisfactory results. We have recently begun to implement a technique which gives promise of very substantially reducing the risk from an overall change in valuation standards; e.g., we buy something at 12 times earnings when comparable or poorer quality companies sell at 20 times earnings, but then a major revaluation takes place so the latter only sell at 10 times. This risk has always bothered us enormously because of the helpless position in which we could be left compared to the “Generals – Private Owner” or “Workouts” types. With this risk diminished, we think this category has a promising future.”

This technique was well suited to the “Nifty Fifty” era, when for instance GM sold at a large premium to Ford, despite nearly identical operating metrics. A great deal has changed since then. First, it is almost impossible to find two corporations similar enough in their operations to be comparable (even Coca-Cola and Pepsi are quite different); and second, the speculative component that caused divergent valuations in the 1960s is no longer present.

Nonetheless I believe that low-risk relative value opportunities will arise from time to time—perhaps once a year.

Landry’s Restaurants (LNY) & Landry’s Restaurants Options (LNYHC): Covered Call Opportunity

In Arbitrage on July 19, 2008 at 3:15 am

U P D A T E

Landry’s has satisfied EBITDA requirements stipulated in the debt commitment letter. If LNYHC remains in the money by expiration on August 16, covered call writers will have earned 10% in one month—or 120% per annum.

Continue Reading

United Rentals (URI): Arbitrage Opportunity

In Arbitrage, Security Analysis on July 8, 2008 at 9:38 am

U P D A T E

URI should cash out odd-lot holders by the end of July—resulting in a 160%+ annualized profit for arbitrageurs.

Continue Reading

Benjamin Graham: Method of Operation

In Arbitrage, Benjamin Graham, Net Current Asset Value, Security Analysis, Warren Buffett on July 7, 2008 at 2:13 am

Judging by the track records of analysts, money managers, OPMIs, bloggers, etc., the endeavor to select issues with above average expectancy is not on the whole a satisfactory activity. It is successful at times and it is unsuccessful at other times, but on balance it does not pay. The work of many intelligent minds engaged in this field becomes self-neutralizing and self-defeating given equal access to information.

Ben Graham’s superior performance is due at bottom to his preference for obscure situations and techniques. I have excerpted relevant sections of his memoir:

Continue Reading

IndyMac Bancorp (IMB) & IndyMac Bancorp LEAPS (KIJAZ.X): Arbitrage Opportunity

In Arbitrage, Security Analysis on July 5, 2008 at 8:07 pm

The buyer of one KIJAZ.X contract is paying $200 for the right to buy 100 shares of IMB at $2.50. Since it costs only $67 for 100 shares, the option buyer is effectively giving $133 to charity. We can infer that he is either (1) unintelligent or (2) acting surreptitiously on inside information.

Whatever the cause for this discrepancy, it would be intelligent to purchase shares of IMB and to write a corresponding number of call option contracts against them—thereby ensuring a riskless 200%+ arbitrage profit.

PT Indosat Tbk (IIT): Arbitrage Opportunity

In Arbitrage, Security Analysis on July 3, 2008 at 9:19 am

U P D A T E

Under newly revised Indonesian law, a company must purchase all outstanding shares of another company once its ownership exceeds 50%. It is unclear whether this threshold will apply to Qatar Telecom’s offer, since the law was revised during tender offer considerations.

Continue Reading

Mathematical Expectation of Securities

In Arbitrage, Benjamin Graham, Bill Ackman, Charlie Munger, Joel Greenblatt, Martin Whitman, Net Current Asset Value, Security Analysis, Seth Klarman, Warren Buffett on June 22, 2008 at 3:44 am

My observation has been that analysts, money managers, OPMIs, bloggers, etc., cannot consistently select issues with above-market returns. I believe this is due to a feature inherent to all parimutuel systems, viz., calculations of expectancy should vary only slightly from one person to another—with any major difference resulting from some unknowable factor. The selection of securities is often akin to a shell game.

We should not conclude from this that securities markets are strong-form efficient. On the contrary, investors with access to material non-public information have earned high returns without bearing commensurately high risk. In 1925 Ben Graham learned that Northern Pipeline—selling at only $65 per share—had “$95 in cash assets for each share, nearly all of which it could distribute to stockholders without the slightest inconvenience to its operations.” Major brokerage firms were never aware of this information; Graham found it at the Interstate Commerce Commission in Washington, D.C. A more recent example is Bill Ackman’s MBIA short position, which is predicated on special knowledge of reserve adequacy, unusual insurance transactions, etc. (Ackman supposedly went through 140,000 pages of internal documents.)

Allied to the foregoing are situations involving neglect of public information. This has been especially persistent in the field of distressed debt, where vulture investors profit from claimholders unwilling to interpret bankruptcy documents. (Seth Klarman, Michael Price and Marty Whitman owe a great portion of their returns to this activity—and not to common stock investments exclusively.) Many of the opportunities mentioned on stableboyselections.com tend to be neglected because they fall outside the scope of traditional equity investment.

I do not believe that passive “value investors” as a class will yield above-average returns by focusing on large U.S.-based companies. The investment community has wised up to the extent that apparent bargains now involve greater risk. This is a natural consequence of the increasing popularity of “value investing,” which seems to have reached an historical peak over the past few years. (Most worrisome is the crowding in such stocks as USG, SHLD, FMD and Mortgage Originator X, Y, Z.) You can take it as an axiom that strategies become less effective as they become more popular.

The really spectacular returns will come from investors who discover unpublicized or underpublicized inefficiencies. At present, auction-rate securities, distressed debt, arbitrage and certain Chinese stocks seem to offer the most favorable mathematical expectation.

“If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered that there are, indeed, such serious-minded individuals. But we must also add that… investment based on genuine long-term expectation is so difficult today as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes.”
- J. M. Keynes

Sunstone Hotel Investors (SHO): Arbitrage Opportunity

In Arbitrage, Security Analysis on June 10, 2008 at 1:05 pm

U P D A T E

Two weeks prior to the tender offer expiration date, Sunstone Hotel Investors lowered its offer price range. Arbitrageurs should withdraw from the tender and sell at a slight loss. While not as lopsided as the FBSI bet, SHO was attractive ex-ante because of zero downside risk and quick turnaround. It is highly unusual for a company to change price ranges of a tender offer so close to expiration; this causes inconvenience for shareholders who have already tendered.

Continue Reading

First Bancshares (FBSI): Arbitrage Opportunity

In Arbitrage on May 29, 2008 at 2:40 pm

U P D A T E

Although shareholders rejected FBSI’s going private transaction, arbitrageurs managed to make a slight profit. This demonstrates the importance of fundamental value in buttressing stock prices. Potential downside was 5%, while upside was 60%—a manifestly lopsided bet.

Continue Reading

Track Record Since Inception

In Arbitrage, Milton Friedman, Security Analysis on May 21, 2008 at 1:17 pm

The results of many years of decision-making in securities will demonstrate how well an investor can calculate mathematical expectation (probability of loss multiplied by size of loss plus probability of gain multiplied by size of gain). Anyone who does not buy an index fund believes, in effect, that he can select individual issues with higher expectancy than the general market. This is impossible for investors as a whole, for it would mean the average investor could beat himself—a logical contradiction. However, I believe that a small number of people can find opportunities with high expectancy, as my track record suggests:

*Listed in order of mention
*Annualized returns approximated

FBEI (Arbitrage)
+13%
Annualized
+80%

SCRJY (Arbitrage & Hedge)
+12%
Annualized
+50%

SCRJY (Unhedged)
+31%
Annualized
+120%

CPTH (Arbitrage)
+21%
Annualized
+210%

CKXE (Arbitrage)
+3%
Annualized
+10%

GCO & FINL (Relative Value Arbitrage)
+205%
Annualized
+820%

ALGI (Generally Undervalued)
-6%
Annualized
-11%

MGST (Arbitrage)
+24%
Annualized
+100%

PSBG (Generally Undervalued)
-35%
Annualized
-80%

CRMH (Generally Undervalued)
-47%
Annualized
-85%

When I wrote about PSBG and CRMH, I knew about their respective operating problems, viz., increasing loan losses and under-reserved self insured groups. I thought that a low price relative to book value and earnings would compensate for these risks. This is ass-backward reasoning; it is wiser to determine the value of a business before looking at the price (which always carries some degree of influence). Since stock prices are very efficient, statistical “bargains” usually have poor underlying businesses. I now believe that low-risk, high return opportunities in generally undervalued securities may come less often than once a year.

My track record for arbitrages and hedges is far better. All selections have been profitable, with annualized returns averaging more than 200% and with disproportionately low risk incurred. I will not change my approach until the stigma against arbitrage fades. Of course this is a very small sample, so large deviations from average might indicate luck rather than skill. To find out for sure, I will increase the sample size over the next few years.

Milton Friedman, a hero of mine, once said something about government efficiency that applies to many other areas—including the investment process. It is good advice to live by:

“One of the great mistakes is to judge policies and programs by their intentions rather than [by] their results. We all know a famous road that is paved with good intentions.”

Integrity & Investment Performance

In Arbitrage, Benjamin Graham, Berkshire Hathaway, Charlie Munger, Security Analysis, Seth Klarman, Warren Buffett on May 11, 2008 at 11:13 pm

“Index funds are imperfect, but they provide the best outcome for most know-nothings, in order to avoid being misled by fools and liars.”

Charlie Munger

Investing is the process of putting money away now to be sure of getting more money back in the future. A good definition of success is the ability to earn a higher rate on one’s principal than commonly available. Ideally this would be achieved over at least a 10-year period, where the terminal level of the S&P 500 is the same as the starting point. An examination of investors’ track records shows that success, as so defined, is scarcely practicable; more than 90% of portfolio managers fail to earn excess returns consistently.

Continue Reading

First Bancorp of Indiana (FBEI): Arbitrage Opportunity

In Arbitrage, Security Analysis on March 4, 2008 at 9:42 pm

First Bancorp of Indiana will soon conduct a going private transaction. Buying 299 or fewer shares at the current quote will yield a 13%+ return (around 50% annualized, depending on the expediency of management, transfer agents, et cetera). Risk of deal failure is nil because the transaction is not subject to shareholder approval. You must request stock certificates from your broker in order to be cashed out, as only shareholders of record can partake.

Clarkston Financial (CKSB): Arbitrage Opportunity???

In Arbitrage, Security Analysis on February 21, 2008 at 2:51 pm

Clarkston Financial Corporation plans to pay $10 for each share owned by holders of fewer than 111 shares. There is a 25% arbitrage spread at the current quote.

Probability of deal failure seems moderate. 22.8% of the shares are certain to be voted in favor of the transaction and a 10% owner plans to abstain. Thus at least 40% of the remaining shares must be voted affirmatively.

Statistical Bargains: Historical Perspective

In Arbitrage, Benjamin Graham, Buffett Partnership, Charlie Munger, Net Current Asset Value, Security Analysis, Warren Buffett on February 12, 2008 at 3:54 am

In 1952, Warren Buffett made a concentrated bet on Western Insurance Securities. At two times earnings and half of book value, the stock had tremendous upside and no downside. An enterprising investor could easily find opportunities with similar mathematical expectation ((probability of loss x size of loss) + (probability of gain x size of gain)).

By 1967 Buffett realized that the situation had changed:

“Statistical bargains have tended to disappear over the years. This may be due to the constant combing and re-combing of investments that has occurred during the past twenty years, without an economic convulsion such as that of the ’30s to create a negative bias toward equities and spawn hundreds of new bargain securities. It may be due to the new growing social acceptance and usage of takeover bids which have a natural tendency to focus on bargain issues. It may be due to the exploding ranks of security analysts bringing forth an intensified scrutiny of issues far beyond what existed some years ago. Whatever the cause, the result has been the virtual disappearance of the bargain issue as determined quantitatively – and thereby of our bread and butter.”

Continue Reading

SCOR Holdings Switzerland ADS (SCRJY): Arbitrage Opportunity

In Arbitrage, Insurance, Security Analysis on February 9, 2008 at 5:35 pm

On January 7, 2008 SCOR delisted its American depository shares from the NYSE. Shareholders will receive a cash payment equal to 2.75 Swiss Francs, 0.20 Euros and 25% a SCOR SE share. At current exchange rates, the workout value is $7.87, or 12.4% above SCRJY’s last trade price. In order to achieve this return risk-free, investors should establish currency hedges and a SCOR SE short position.

logo-scor.jpg

Nuclear Solutions (NSOL): Arbitrage Opportunity???

In Arbitrage, Security Analysis on February 9, 2008 at 4:44 pm

Last December, Inter-Americas offered to purchase each of Nuclear Solutions’ outstanding shares for $1.50. At the current quote, there is a 200%+ arbitrage spread.

Inter-Americas allegedly employs well-regarded scientists and holds equity interests in several high-technology businesses. Yet I can’t find information on the company outside of its website. This “deal” appears to be a poorly conducted boiler room operation.

Critical Path (CPTH): Arbitrage Opportunity

In Arbitrage, Security Analysis on February 7, 2008 at 7:33 pm

Critical Path plans to conduct a going private transaction early this year. At the current quote there is a 20%+ arbitrage opportunity (around 80% annualized, depending on the expediency of management, transfer agents, et cetera). Risk of deal failure is nil because majority shareholders have already signed voting agreements.

CKX (CKXE): Arbitrage Opportunity

In Arbitrage, Security Analysis on January 30, 2008 at 8:36 pm

U P D A T E

CKX’s intrinsic value seems to be far lower than its current market capitalization of $926 million. The company earned only $20 million and $10 million (after-tax; before extraordinary items) in the past two years, with deficits in all years prior to 2006. Earnings will have to improve substantially to justify the current price. Furthermore, CKX lost a large part of its asset value after spinning off FX Real Estate. If the management buyout does not take place, CKXE could fall considerably—it is not cheap.

Continue Reading

Genesco (GCO) & Finish Line (FINL): Relative Value Arbitrage Opportunity

In Arbitrage, Net Current Asset Value, Security Analysis on January 28, 2008 at 6:56 am

My reasoning for this position starts at Cogitator (2:34:52 AM).
A quick summary:

GCO

FINL

Deal completed

+80%

-50%

Deal terminated

-30%

+60%

Deal price reduced

+0%

+0%

Continue Reading

Zunicom (ZNCM): Relative Value Arbitrage Opportunity???

In Arbitrage, Benjamin Graham, Net Current Asset Value, Security Analysis on January 15, 2008 at 9:55 pm

Zunicom conducts all of its operations through AlphaNet Hospitality Systems, a provider of computer access to hotel guests. This business is in serious decline as contracts expire and marketing efforts cease. According to Zunicom’s most recent 10-Q, AlphaNet lost nearly $600,000 in the first nine months of 2007.

Continue Reading

Buffett Partnership Letters: Lessons for Professional Investors

In Arbitrage, Benjamin Graham, Buffett Partnership, Security Analysis, Warren Buffett on January 15, 2008 at 3:09 am

À la Lawrence Cunningham, I have rearranged the Buffett Partnership letters by topic. Pay particular attention to the final section—The Dearth of Bargains.

warren-buffett-young.jpg

Continue Reading

Relative Value Arbitrage

In Arbitrage, Long-Term Capital Management, Security Analysis on January 14, 2008 at 2:37 am

In 1907 Royal Dutch Petroleum and Shell Transport agreed to merge their interests while remaining distinct entities. 60% of the cash flows of the combined enterprise were attributable to Royal Dutch shareholders in the Netherlands; the remaining 40% were attributable to Shell shareholders in Britain. Because of this fixed arrangement, one would expect the market cap of Royal Dutch to be precisely 1.5 times greater than Shell’s.

Long-Term Capital Management discovered that this price relationship did not usually hold. If it went up to 1.53 times, LTCM would short Royal Dutch and buy Shell. This resulted in a profit once prices returned to parity.

According to Donald MacKenzie, author of An Engine, Not a Camera, several arbitrageurs had mimicked LTCM’s portfolio of relative value trades as well as convergence trades (for instance, buying “off-the-run” Treasuries and shorting “on-the-run” Treasuries). When Russia defaulted on its bonds, panicked investors bought large amounts of on-the-run Treasuries, thereby creating large losses on convergence trades. LTCM copycats liquidated portfolio assets to reduce risk exposure; they even sold out of relative value arbitrages that were unaffected by the recent “flight to quality.” Selling Shell and covering Royal Dutch short positions drove prices further away from parity (Scruggs 34).

If MacKenzie is right, relative value arbitrage is profitable except under very unlikely contingencies. I have identified one current opportunity; however, it is not suitable for passive minority investors.

MagStar Technologies (MGST): Arbitrage Opportunity

In Arbitrage, Security Analysis on January 8, 2008 at 11:02 pm

MagStar Technologies will conduct a going private transaction on February 5. Buying 1,999 or fewer shares at the current quote will yield a 20%+ return (around 80% annualized, depending on the expediency of management, transfer agents, et cetera). Risk of deal failure is nil because the transaction is not subject to shareholder approval. Furthermore, beneficial owners can partake.

PSB Group (PSBG): Deep Value/Arbitrage Opportunity

In Arbitrage, Security Analysis on December 18, 2007 at 9:19 pm

U P D A T E

I found this article in Crain’s Detroit Business. It supports my argument that PSBG is sufficiently capitalized and that management will again try to go private.

Continue Reading