Warren Buffett and the Art of Stock Arbitrage

SKU:
$0.00
Unavailable
per item


If you subtract warren Buffett’s arbitrage trades from his annualized rate of return, it would drop from 39% to 26%.


Arbitrage is the reason currency exchange rates and assets like gold have price parity throughout the world. 


Time arbitrage is the process of buying an asset at present under the notion its expected value at a later date is to be higher given a buyout or some other near-guaranteed event.


Time arbitrage opportunities are created by the price spread between the current market price and the fixed future value. As time draws closer to the event that will solidify the increased value, the spread tightness due to less perceived risk.


There are a number of ways time arbitrage opportunities can arise:


  1. Friendly mergers (two companies mutually agreeing to a buyout) as the stock price will trade slightly below the merger price leading up to the actual event.
  2. Hostile takeovers (when a company/buyer buys a controlling interest in another company) as there is usually a spread between the current price and the hostile takeover bid price.
  3. Corporate self-tender offers (an alternative to buybacks where a company makes a tender offer directly to shareholders to buy them out) when price trades below the tender offer.
  4. Liquidations (when a company liquidates assets to pay out to shareholders) if the share price is less than what the liquidated payout will be.
  5. Spin-offs (when companies/conglomerates spin off one or more companies under their umbrella to shareholders). This is a good way to get a great company at a discounted price.
  6. Stubs (a financial instrument that represents some asset of a company) when the stub value is lower than the asset value it represents.
  7. Reorganizations (when companies transition from corporations to trusts, corporations to a master limited partnerships, etc.).


Warren only engages in time arbitrage when he is absolutely certain the announced deal will end up happening. He also doesn’t buy until after the deal has been announced.


Generally speaking, Warren only uses leverage on arbitrage trades that are a sure thing.


When it comes to mergers and acquisitions, you want to buy the company being swallowed. If company A is doing the buying/swallowing, you would buy 1 share of company B and short the number of shares company A is offering for that share. Then on the closing day of the merger, you would exchange your company B share for the shares company A is offering and use those shares to cover your short, thereby locking in the spread difference.


Arbitrage deals are only wise when economic conditions, including credit markets, are stable.


Shareholders are short-sighted and generally prefer a quick profit via a buyout meaning deals of that nature usually come to fruition unless a primary shareholder disputes it.


A competing buyer adds to the certainty a buyout deal will happen and often ensures the highest price will be paid.


There are three avenues for a hostile takeover to take place:


  1. Get the target company’s board to approve the deal.
  2. Get the support of a majority of shareholders to vote and replace the board.
  3. Go into the market and buy the necessary shares to replace the board on their own.


The poison pill defense against hostile takeovers gives the current shareholders an opportunity to buy additional shares at a discount. This dilutes the per-share value of the company, which increases the cost to the hostile buyer.