When people think of Warren Buffett, the greatest investor of all time, they often focus on his knack for picking cheap stocks, or the extra free leverage gained by his massive insurance operations, or even Berkshire Hathaway’s new focus of buying whole companies to add to its already impressive empire.
What doesn’t get much attention is Buffett’s skill in stock arbitrage, a skill which has accounted for a surprising amount of his ability to generate wealth.
What exactly is stock arbitrage and how do investors use it to make money? Let’s take a closer look.
The basics of arbitrage
Arbitrage is the act of buying in one market and selling in another, taking virtually guaranteed profits in the process.
Say the price of gold was $1,000 per ounce in London and $1,005 per ounce in Paris. Since gold is gold no matter where it trades, a person could make a risk-free profit by loading up on gold in London and then selling it immediately in Paris.
Since information now moves so quickly, these types of situations never happen anymore. However, investors can still make money on stock arbitrage by investing in events that have a very high likelihood of happening.
The easiest situation is a friendly acquisition, like a company buying a competitor. Say shares of the competitor trade at $20 per share before the offer comes in. The acquiring company offers $30 per share, and everyone is happy with the deal. Closing is expected to take approximately six months.
In response, the market bids up shares of the target company to $28 per share. There are two reasons why shares don’t immediately trade at $30 each. Firstly, there’s a small chance the deal gets scuttled somehow. Perhaps regulators don’t like the amount of market share this new company will have. Or maybe the buyer’s financing is somewhat sketchy.
The other reason is because of the time value of money. Investors need a compelling reason to put their money into an opportunity. Without being compensated for both the risk and locking up capital that could be put to other uses, arbitrage opportunities wouldn’t exist.
A cash offer is the simplest arbitrage opportunity. Often, instead of offering cash for their prize, an acquiring company will offer a combination of cash and shares, or just shares. Investors can still make money on these sorts of arbitrage deals, but they’re much more complicated. I’d recommend leaving these deals up to the professionals.
Making money on arbitrage deals
There are two keys to making money on these kinds of situations.
Firstly, an investor has to be nearly 100% sure a deal will go through. It takes a lot of successful arbitrage transactions to make up for just one that goes badly.
You have to look at the details of the deal to determine the chances of success. A company with a controlling shareholder who wants the deal to happen is a good thing, for obvious reasons. So is a deal where everyone knows the company being acquired was for sale.
The ability of the acquiring company to buy should also be scrutinized. If a company agrees to pay $100 million for a competitor and it has $150 million in cash on its balance sheet, the deal is much more secure than if the same company has to borrow the $100 million.
Often, a company that needs to borrow the money for an acquisition will talk to bankers before the deal is even announced. Then the company will announce with the deal that financing is already in place. This is a good thing, almost as good as having the cash on hand.
But on the other hand, a company might have no idea where they’re going to get financing once an acquisition is announced. That could be bad news for the deal’s completion, which is what arbitrage investors want to avoid.
What kind of returns?
These days, depending on the deal, investors can expect about a 10% annual return on what I’d call safe arbitrage situations. Returns much greater than 10% annually are out there, but they’re from deals the market thinks are risky.
Generally, investors should be waiting until only a month or two before a deal is scheduled to close. Yes, returns are lower–at least compared to four or six months out–but these deals tend to have a higher completion rate. The key to successfully pulling off this strategy is minimizing losses, not going for the best gains.