Thursday, 7 June 2012

Book Review - Warren Buffett and the Art of Stock Arbitrage, by Mary Buffett and David Clark

Warren Buffett is widely known for investing in high-quality businesses with a sustainable competitive advantage, a high return on capital, run by able and honest managers, and selling at a bargain price.  When he's able to find such gems, he likes to hold them long-term, ideally "forever."  His success in arbitrage and special situations investments, however, is not widely understood.  In fact, these investments are in some ways the very opposite of his usual focus, as they offer only a one-time, short-term opportunity.  A study of Buffett's investments from 1980 to 2003 found that the average investment returned 39% per year, but the average arbitrage deal returned an incredible 81%.  Without such investments, his overall performance would have fallen significantly, from 39% to 27%.  In Warren Buffett and the Art of Stock Arbitrage, Mary Buffett and David Clark set out Buffett's criteria for making such investments.
Buffett has focused on three forms of arbitrage - friendly mergers, hostile takeovers, and corporations making tender offers for their own shares - and four kinds of special situations - spinoffs, liquidations, stubs and reorganizations.  Arbitrage is a broad term that refers to an opportunity to capture a spread between two prices, such as gold selling at a higher price in one market than another, even when accounting for currency differences.  But Buffett pursues stock arbitrage, where the price being offered for a security is higher than the price currently prevailing in the market.  If Company A, for example, offers to buy Company B for $100 per share, B's stock may settle around $95.  The $5 spread, which exists because there is always some uncertainty - financing, regulatory, legal etc. - about whether the deal will successfully close, offers arbitrageurs the chance to profit.
Buffett considers arbitrage deals once they've officially been announced, and acts only if he feels there's a high probability that the transaction will be completed.  His analysis boils down to a few variables.  On the upside, he calculates the likelihood the deal will be completed, the percentage return, and the approximate amount of time to completion.  On the downside, having already estimated the likelihood that the deal goes through as planned, the major factor left to figure out is how far the stock will fall if the deal fails.
Returning to the above example, the upside for arbitrageurs in Company B is 5.3% (5/95).  Assuming the deal is certain to close in six months, the annualized (non-compounding) return would be 10.6%.  Since most other investments are quoted in annual returns - on bonds, in the stock market etc. - this return could be compared to other potential investment opportunities, as well as alternative arbitrage deals.  (The calculation becomes somewhat more complex when adjusting for the probability of the deal closing as planned, as set out in the book's fifth chapter).  The basic concept holds for stock-for-stock deals, cash offers, and hybrids.
The math's laughably easy, but estimating the probability that a deal will close can be tricky.  Any deal faces several possible hurdles: legal impediments could nix a proposal, financing could fall through, shareholders could reject the deal, and so on.  Friendly mergers are most likely to close, since shareholders tend to vote in favor of proposals that are endorsed by management and the board.  Of those, Buffett prefers self-financing, strategic buyers that are pursuing a company to complement their existing business - think Procter and Gamble's purchase of Gillette - rather than hedge funds or LBO firms that rely heavily on financing which might dry up unexpectedly in tough markets.  Buffett is wary of deals that might attract serious scrutiny from regulators or anti-trust commissions: not only do prolonged investigations erode the time value of money, they occasionally scuttle a deal altogether.  While not all stars must be perfectly aligned - Buffett has even played hostile takeovers in the past, though rarely - these are the basic parameters that he looks for.
Buffett has also found opportunity in companies changing form, usually from corporations to royalty trusts or master limited partnerships (MLP).  Surprisingly, the market often doesn't immediately recognize the shift with an increased stock price until after the change has been made, even though the transformations are usually almost certain to be implemented.  The authors helpfully offer an example of Buffett's investment in each situation - Tenneco, a natural gas producer, which converted to a trust, and Service Master, a collection of different businesses that became an MLP - and his approximate return.
Additionally, Buffett has invested in spin-offs, where a company that owns multiple businesses breaks into two or more stand-alone firms that figure to be worth more separate than together.  Buffett's interest in spin-offs lies in the chance to acquire excellent businesses that have previously been unavailable to invest in directly.  Buffett takes his position in the parent company before the spin-off occurs, then sells the parent and holds the new stand-alone firm.  This is just what he did, for example, when Dun & Bradstreet spun off Moody's in the late 1990s.  This chapter is thin on analysis, and leaves important questions unanswered: for example, why doesn't Buffett wait until after the spin-off has concluded to purchase the preferred company, as Joel Greenblatt has done with great success? 
Given that Buffett is the greatest investor in history, any serious book about his methods is worthwhile.  However, nagging questions sometimes remain about just how accurate Buffett commentators are.  For example, on the all-important matter of how he values a business (not a concern in this particular book, granted) Buffett and Clark offer one explanation (found in Buffettology), Robert Hagstrom another (basically a standard discounted cash flow model) and Alice Schroeder still another (according to her, he requires a 15% return, and makes a "yes-or-no" decision accordingly).  All are leading authors on Buffett, yet offer differing accounts on a basic and important aspect of his approach, leaving students of investing puzzled. 
Despite the authors' past work on Buffett and their personal ties to him - Mary Buffett was married to Buffett's younger son, David Clark has been a long-time Berkshire Hathaway shareholder and student of Buffett, and they refer to him in the book familiarly as "Warren" - this book prompts a few similar doubts in places.  There's little sign that Buffett participated in this book's creation, made factual corrections or personally endorsed it.  There are other clues that the authors reach conclusions based on deduction, rather than first-hand conversations with Buffett.  For example, when discussing his 1998 investment in a liquidating REIT, they state, "Warren would have had five thoughts..." (104). There’s ample reason to suspect that their after-the-fact re-creations are largely right, but Buffett's thinking may have been different from what the authors imagine.  It would have been helpful if they'd been more forthcoming about the evidence they used to arrive at their conclusions, ideally in the form of footnotes.  Though there are no obvious errors, parts of the book seem slightly vague.
Still, Mary Buffett and David Clark have written yet another first-rate book on Buffett, and have illuminated one of the few remaining areas of Buffett's career that hasn't been widely studied.  In just over 140 short pages, they cover a range of non-standard investments that Buffett has made, while offering enough detail for investors to begin pursuing similar opportunities.  Though picky readers may have some small doubts about Buffett's precise methods, the authors discuss each topic clearly and knowledgably.  Besides, Clark runs a partnership that pursues special situation investments, so he brings insight of his own to any areas where Buffett's approach may not be entirely clear.  To complement the theory that fills most of the book's pages, they offer practical advice about how to search for ideas, what relevant filings to study, and how events such as tender offers play out in reality.  Overall, Arbitrage lives up to the high standards that Buffett and Clark have set for themselves in their past work.

Buffett, Mary and Clark, David. Warren Buffett and the Art of Stock Arbitrage: Proven Strategies for Arbitrage and Other Special Investment Situations.  New York: Scribner, 2010.
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