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.

Source:

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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Book Review - The Dhandho Investor, by Mohnish Pabrai

"What does "dhandho" mean?"  That's likely the first question book browsers ask when their eye catches the spine of Mohnish Pabrai's The Dhandho Investor.  The ethnic group that the word belongs to defines it as a low risk, high return investment, which contradicts the conventional wisdom that outsized returns can only be had at the cost of high risk. As Pabrai likes to say, "Heads, I win; tails I don't lose much."

Many investors have helped affirm Pabrai's motto: the Patels, a people from India that account for just 1 in 500 Americans, but own half of all US motels; Richard Branson, who started serving an ignored niche in the airline industry, while risking little capital by leasing an unused plane; Lakshmi Mittal, who restored dying steel mills to profitability, but paid very little for them; or Warren Buffett, who amassed jaw-dropping returns, while taking on very little risk.  The "high-risk-high-reward" concept has been proven wrong. 

Pabrai is heavily influenced by Buffett and Charlie Munger.  As they do, he encourages investors to buy simple, predictable businesses.  Moreover, worthwhile businesses have a competitive advantage and resulting high returns on capital.  These gems, however, must be bought on the cheap.  Strangely enough, temporary market inefficiencies will give patient investors opportunities to buy gold for the price of brass.  But golden opportunities are rare enough that when they do arise, investors must bet heavily. 

Though Pabrai doesn't break much new ground in this book, he puts more emphasis on certain points than many other investors do.  For example, he broadens the term "arbitrage" from a narrow fixation on price differences, and uses it as a metaphor for investing in general.  What's a competitive advantage, after all, if not a form of arbitrage?  If one company is able to offer lower costs than competitors, it will draw in more customers; over time, though, high-cost producers will perish, and remaining ones will become leaner, narrowing the gap between the market leader and the also-rans.  Fortunately for investors, though, many "moats" last for decades.  Pabrai analyzes GEICO, owned by Buffett's Berkshire Hathaway, which has enjoyed a low-cost "arbitrage" spread for decades, and is likely to do so for decades to come.

One of the high points of the book is Pabrai's discussion of the difference between risk and uncertainty, a crucial distinction that many investors fail to make.  Risk is the potential for capital loss, while uncertainty is a wide range of possible outcomes.  Confusing uncertainty for risk frequently leads to underpriced securities - investors wise to the difference stand to make a lot of money. 

Along with case studies of Level 3 and Frontline, he candidly discusses his investment in Stewart Enterprises, a company that "rolled up" hundreds of locally-owned, mom-and-pop funeral homes, but amassed too much debt in the process.  Worried about the potential of default, the market pummeled the stock.  Pabrai wasn't fazed.  He calmly assessed the company's major alternatives: reselling some locations to their original owners, refinancing, or restructuring via bankruptcy were the most likely options.  Then he assigned a probability to each, and estimated the share price that would result from each option.  He decided that the bankruptcy would leave enough of the business intact to break even, and the other two options would give him a large profit.  Uncertainty was high, but the risk of loss was low.

Pabrai doesn't just vaguely advise investors to bet heavily when the odds are in their favor, he points them specifically to the Kelly Formula as a guideline for how much to wager given certain odds.  Much of the value of the Kelly Formula is that it encourages investors to consider a range of possible outcomes and attach probabilities.  It carries risks, though: it suggests precision, where only approximations can be made, and it suffers from the same "Garbage-in-garbage-out" weakness that many formulas do.  Pabrai recognizes the drawbacks to the Kelly Formula, and he devotes 10% of assets to each investment. (The book was published in 2007.  Pabrai got walloped in the Great Recession, as nearly all investors did, and now runs a somewhat more diversified portfolio).

Most investors agree that selling is an imprecise art.  With the help of the epic poem the Mahabharata, Pabrai offers some wise advice.  First, allow at least two to three years for the story to play out, unless it has become undeniably clear that the investment was a mistake.  Stocks often decline after investors buy them, even when the business is succeeding.  Jittery investors frequently panic and sell, only to watch the stock appreciate later.  In more serious cases, the business itself may stumble.  But all businesses face challenges, and investors must be patient and wait for improvement.  Pabrai did just that with USAP, a specialty steel maker: his investment fell by nearly two-thirds before roaring back and doubling from his initial purchase price.

Many investors offer a recipe for success that's long on theory, but scant on practical advice for finding undervalued stocks.  Pabrai, however, offers helpful suggestions about how to hunt for value: scan Value Line for battered stocks, consult www.portfolioreports.com and www.gurufocus.com for the holdings of prominent value investors, visit Joel Greenblatt's www.valueinvestors.com, www.magicformulainvesting.com and read his book The Little Book that Beats the Market.  Don't be afraid to clone or copycat, Pabrai urges.

Pabrai is an excellent investor.  From 1999 to 2007, he returned 28% a year, though that number has fallen since the Great Recession.  The Dhandho Investor is a success.  He wisely sticks closely to Buffett and Munger, but has the judgment to borrow from others, too.  His book, however, isn't just an collection of other people's ideas, despite his cheerful admission to copying others.  He cites several examples that don't typically make it into case studies, but also draws on more familiar ones.  He reinterprets basic ideas and gives them much more explanatory power.  Short, clear, fun and wise - this book is a must read for any serious investor.

Sources:

(1) Pabrai, Mohnish. The Dhandho Investor. Hoboken: John Wiley and Sons, 2007.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.