Pre-Regulatory Workouts

February 26, 2008 by Joe Ponzio

I don’t want to focus this blog solely on workout situations; still, I think a majority of visitors never even dreamed of finding workouts until we walked through the various steps, the timeline, and the potential profits and risks. So, let’s add another chapter to the workouts/arbitrage discussion. Question: Should you consider buying workouts before regulatory approval goes through – when the potential profits are greater?

Let’s look at a specific example: The SIRIUS and XM merger, first announced on February 19, 2007. This merger has flown well under my radar simply because it is still in the pre-regulatory approval stage, even though shareholder approval has been obtained. It was brought to my attention last night while watching Jim Cramer’s Mad Money (I’ll tell you why I was watching at the end.)

More than a year after the announcement, the deal has not yet gone through. Cramer says it is because of some boneheads in Congress holding it up. I’ll take that at face value because I’m not interested in the deal and that doesn’t affect our discussion here.

The dangers of investing long before Step 7; Risking more than money

If you recall from Workouts Work Out In Down Markets – Part I, there are generally 7 steps to any merger, acquisition, or going private transactions (“workout”). Steps 5 and 6 (regulatory approval and shareholder approval, respectively) can happen in either order. In RTSX, shareholder approval came after regulatory approval; in Tribune and the above merger, shareholder approval came first.

At each Step along the way, the chances of the deal going through become greater, the risk is reduced, and the potential reward is (usually) lessened (on an actual basis, not necessarily on an annualized return basis).

When investing early, there are also potentially huge risks, not just of loss of principal but of loss of opportunity as well. In the RTSX deal (discussed here), we had a defined timeline because the deal was pending shareholder approval and was expected to close shortly thereafter. In addition, this Step 6 workout was practically in Step 7 because shareholder approval was all but locked up. The only thing supporting RTSX’s $28+ stock price was the deal. If it fell through, we stood to lose a considerable amount in just a few minutes. All the more reason to find virtually “done deals.”

In the SIRIUS/XM deal, early investors have had their money locked up while Congress (or whomever) is playing games. Those investors have missed plenty of “no-brainer” workouts and other opportunities in the hopes of making a big killing six or nine months down the road. If this deal falls apart or is blocked by regulators, early investors that have already lost opportunity would then stand to lose money as well.

If you don’t know jewelry, know the jeweler

The above quote by Warren Buffett can be applied to workout situations: If you don’t know the rules and regulations, know the regulators. Okay, a bit of a stretch. Still, if you don’t know the ins-and-outs of the regulatory hurdles and laws, why not wait until those hurdles are overcome?

Odds are good that, for every one deal offering the potential for 20+% gains in nine months, you’ll find four or five offering 5+% in a matter of weeks with considerably less risk. In both strategies, you can potentially lose 10%, 20% or more. If you are going to put your money in workouts, why not invest in those little slam dunks that are all but “done deals” where you know exactly what to expect?

Don’t be an all-in player; Stay grounded

In Texas Hold’em, pocket Aces against one opponent is a dream-come-true and smart strategy says that, if given the opportunity, put all of your money in the pot before the flop. And yet, from time to time, you’ll lose the pot…and your bankroll.

The difference between Vegas and the stock markets is that, in the markets, you’ll never be blinded out while waiting for pocket Aces. Patience is the name of both games, but just-before-Step-7 workouts generally have better odds.

In a down market, when we’ve had our butts kicked in the past, or when we are young and optimistic, we look for those glimmers of hope and salient returns that turn dreamers into millionaires. Keep your head out of the clouds and get back down in the dirt (SEC filings) where real money and opportunities lie.

Why I was watching Jim Cramer

A few weeks back, a friend e-mailed me a YouTube clip (now removed) in which Cramer, late in 2007, was telling people to buy overpriced stocks, knowing that they are overpriced but that they’ll keep going up. During that same speech, he admitted that it sounded irresponsible, but that this was how the real money was made in the markets.

I was floored. I never really watched Cramer before, but know a lot of people that did/do. I decided to watch a few episodes of Mad Money to see what he was saying, and then became intrigued by his transformation from “crazy stock picker” to “protector of Average Joe’s money.”

If you are going to be a business-oriented investor, you have to read every book, study every philosophy and strategy, and know what “Average Joes” are watching and hearing. The best way to become rock-solid and immutable in your strategy and approach is to fully understand why you aren’t doing it another way.

Jim Cramer is a brilliant guy and his strategies worked well for his private, not-looking-for-TV-ratings, trading-more-than-one-hour-a-day hedge fund, but not so well for the Average Joe. Find the strategy that fits your psychology and time constraints, and then execute.

Want to see me on TV? The F Wall Street Show would be the most boring half hour on television. Reading annual report. “That company stinks.” More reading. Goes to get coffee. Reads more. “Interesting. Let me take a look at that.” Reads more. “Ah, forget that.” Goes for more coffee.

“Well folks, that’s our show. Join us next week for another exciting episode. And now, a word from our sponsors – the great folks at Folgers.”

A Note From Joe Ponzio

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