Workouts Work Out In Down Markets – Part 1

January 16, 2008 by Joe Ponzio

If you’ve read Mohnish Pabrai’s The Dhandho Investor, you”ll likely recall a chapter entitled “Use Arbitrage!” If you”ve been following F Wall Street for a while, you”ll remember (and possibly have made money on) Use Arbitrage! The Tribune Company Example. Why do we say you should use arbitrage? In fact, what is arbitrage and is it a strategy for the faint of heart?

Well, in a down market, it is one of the few strategies that can save your portfolio…and your nerves.

Of course, we are all big fans of Buffett; so, let”s turn to his January 18, 1965 letter to partners of Buffett Partnership, Ltd where he describes the four strategies he employs in managing the partnership”s assets:

“Workouts” – these are the securities with a timetable. They arise from corporate activity – sell-outs, mergers, reorganizations, spin-offs, etc. In this category we are not talking about rumors or “inside information” pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper.

Old Views On Arbitrage

When most people think of arbitrage, they envision institutional investors buying a future, currency, or security (e.g., the dollar) in London, selling it in New York, and pocketing an immediate premium. Back in the day (whatever day it was), this was entirely possible. Savvy investors could find a stock – U.S. Steel, for example – selling in Chicago at $125 and in New York at $126.

This opportunity presented a “risk-free” opportunity to make money. In essence, the investor would buy as much U.S. Steel in Chicago as humanly possible, while selling it short in New York at the same rate. Once the spread (in this case, a dollar) closed up, the investor would simply transfer his Chicago shares to his New York short, settle the trade, and make a quick dollar per share.

New Perspectives On An Old Strategy

The markets have become so popular, in-your-face, and, at times, scary that most people would benefit from a change in perspective – a topic best left for a full post. Still, I constantly preach it – these are businesses; we are silent partners; the price people are willing to pay is not always reflective of the value of the business; price follows value.

That said, you don”t have to – nor should you – ignore the short-term because that is precisely when opportunities arise. When the markets are on the rise, workouts are hard to find; when the prices of businesses are dropping, they become acquisition targets. And that”s when your workout portfolio can come to life.

The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialize. Such killjoys could include antitrust or other negative government action, stockholder disapproval, withholding of tax rulings, etc.

When looking for arbitrage opportunities, you are basically looking for “done deals” – acquisitions, mergers, etc. pending where the paperwork has been signed, the regulators have approved it, and there is little left for the companies to do, save the final integration planning (how the companies will handle the merge) and final payment.

The gross profits in many workouts appear quite small. It”s a little like looking for parking meters with some time left on them. However, the predictability coupled with a short holding period produces quite decent average annual rates of return after allowance for the occasional substantial loss.

In the Tribune example, we had the opportunity to make roughly 10% in three or four weeks on the upside and the risk of losing 15% to 20% on the downside. Though on the surface that sounds like a bad bet, it would only be foolish if the odds of the deal going through were 50/50. I didn”t believe that was the case – and that is the basis of workout arbitrage.

In years of market decline it should usually pile up a big edge for us; during bull markets it will probably be a drag on performance.

(Note: You can’t predict the direction of the markets, so you should be looking for workouts in all markets)

Keeping Your Eyes Open

When the markets are dropping, it is easy to become disheartened or lose focus. Still, that is precisely when you need to open your eyes and start scouring for deals – both in workouts and as a silent partner.

What, exactly, are you looking for? The steps of a merger or acquisition are, in broad and very general terms:

  1. Due diligence by both parties;
  2. Agree on a price, terms, and contingencies (financing, regulator approval);
  3. Get preliminary shareholder sentiment (or controlling shareholder approval);
  4. Secure financing arrangements (if needed);
  5. Obtain regulator (SEC, FCC, any and all) approval;
  6. Get final shareholder approval at a meeting called for that purpose;
  7. Complete the deal.

Once you”ve gotten past Step 5, there are a few minute details to be worked out and a little work on our part to analyze the deal – which we will dive in to in the next post. Basically, what will upset the applecart in Step 6 or Step 7?

More to come.

A Note From Joe Ponzio

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