Compounding Life

Arbitrage in the purest sense exists when there are multiple markets for something and one of the markets prices said something lower than the other. For a real simple example lets say that a certain collectible baseball card sells for $30 in California over the counter. You can take the same baseball card to a card shop in Boston and sell it $50. There is a very low risk opportunity to make a $20 profit per card if you can buy them in California and sell them in Boston. So you buy a bunch of these cards in California and ship them to your old friend from High School who lives in Boston. The shipping averages out to $1 per card and you cut your friend in at $5 per card. 

  $50  Market price in Boston

- $30  Market price in California

______

  $20  Spread

  -$1  Shipping 

  -$5  Comission 

  $14  Total profit per card

What you are doing here is a form of arbitrage.

Some people might call this
scalping; it won’t surprise you that practitioners opted for the
French term, arbitrage.

- Buffett in the 1988 Berkshire Letter to Shareholders

There are many different forms of arbitrage. People sometimes engage in arbitrage on sports betting, where they can place bets at different books at different odds in such a way that no matter what the outcome of the game or race they are guaranteed a profit. Casinos practice “statistical” arbitrage. All the games they offer have a statistical advantage in favor of the house that guarantees over time they will profit. 

Warren Buffet was engaged in a unique arbitrage situation involving cocao beans while working for Ben Graham’s Graham-Newman Corp. Buffett writes about in the 1988 Berkshire Letter to Shareholders:

 
Some offbeat opportunities occasionally arise in the arbitrage field.  I participated in one of these when I was 24 and working in New York for Graham-Newman Corporation.  Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 50 cents per pound.  In 1954 a temporary shortage of cocoa caused the price to soar to over 60 cents.  Consequently Rockwood wished to unload its valuable inventory – quickly, before the price dropped.  But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

     The 1954 Tax Code came to the rescue.  It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business.  Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity.  Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share.  

     For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.  The profits were good and my only expense was subway tokens.”

 

Risk arbitrage is the most popular type of arbitrage when it comes to securities markets and involves “merger & aquisition” situations. For example Lester Floor Tiling announces it is attempting to buy out Smith Carpet Company (company names are made up) and offering $20 per share of Smith Carpet Company stock. If you purchase Smith Carpet Company stock for under $20 you can profit from this transaction when and if it happens. 

As the name implies there is risk involved in these situations. Smith Carpet shareholders may vote against the buyout, regulatory agencies might step in and say that this would create a flooring product monopoly that would not be in the interest of consumers. In M&A activities there are endless lists of things that can prevent deals from happening.

Take all of these risks and then factor in the current credit freeze and market volatility. Things can get hairy and do.  Mergers that seemed likely months ago can now fall apart quite easily.

Value investing blog Oldschoolvalue has been dilligently following a risk arbitrage opportunity regarding Emageon Inc. (symbol EMAG) and Health Systems Solutions Inc. (symbol HSSO). HSSO made an offer to purchase EMAG at 2.85 share. HSSO had a hard time meeting deadlines for the deal but ultimately ponied up $9 million in an escrow account to be paid to EMAG in the event that they could not follow through on the deal. $9 million may not seem like a lot, but put it in context HSSO’s market cap as of this writing is $8.3 million and the deal value of $69 million, its a fairly substantial deposit. So when news hit the deal was going to close February 11th the stock price started soaring up to $2.60 as people started getting in on the deal. The day before the deal was supposed to close the price started droping and investors were worried. Was there insider information about the deal falling through that was causing people to sell? The market in general was taking it in the pants so a lot of people (myself included) attributed the price drop to a combination of market volatility and people selling early to lock in their profits. 

The deal fell apart.Stanford International Bank in Antigua decided not to fund HSSO’s purchase and EMAG shot down to the $1 dollar level. To make it even more interesting, the decision to not fund the purchase has brought more attention to Stanford International and there is some speculation that the bank which has had abnormally high return rates on its certificates of deposits might be up to no good. In fact they are the subject of a probe.

I am left holding EMAG shares for quite a bit less than what I paid for them as are alot of other people. After doing a mental post mortem I have a couple of lessons learned.

1. Coming off of a successfull arbitrage with Puget Sound Energy I was probably not as critical of the EMAG deal as I should of been. Had the Puget Sound Energy deal fallen through I would have been content holding my position through the current market and collecting the dividends. In assessing the deal I did not put enough weight on the fact that EMAG is not a stock I would be content with holding an extended period of time. I think looking forward, my overall feelings about holding the secuirty in question should have a heavy weight on my decision. Even if the odds look like they are 90% or greater, the quality of the stocks in question should be paramount to my decision because I do not engage in enough arb situations to balance out the losses.

2. More due dilligence on Stanford International Bank may have set off some flags that I should steer clear of the deal. The fact that they offer abnormally high returns on CDs and are based in Antigua a place where I have little knowledge of the local financial regulations might have tipped me off. But of course hindsight is 20/20. 

3. I know very little about the industry that EMAG and HSSO are involved in. One nice thing about the Puget Sound Energy deal was that I live in Puget Sound and hence was close to the pulse. In addition I know a person that had been Puget Sound Energy shareholder for a long time who gave me some valuable insight as well.

Typically those who engage in arbitrage when faced with this type of situation sell their position, take their losses and move on. I was tempted to do this but I have decided not to for the following reasons:

1. Sell off. There are alot of people closing out their positions and driving down the price. I don’t believe the current price reflects the value of the stock and I do not have an existing opportunity waiting for the funds currently invested in EMAG. 

2. EMAG recieved 9 million in cash because the deal fell through. As of this writing EMAG is trading right around their book value and a little bit over their cash per share not including the 9 million in cash they just recieved. While the cash will not bring the book value up to my purchase price, I think they are better positioned or ride it out. 

While I understand the “cut your losses and move on” way of thinking, I believe the exit much like the entrance into the position requires some thought and in this case my thought is to hold on for a little while and not let the actions of the masses sway my judgement.

Some good arbitrage related reading:

1988 Berkshire Hathaway Letter

Buffett on Valuation: Risk Arbitrage Edition

Arbitrage: Emageon (EMAG)

Updates:

1.Turns out that the Stanford International is the focus of probe and key people are facing criminal charges.

2.I ended up selling my EMAG position because I feel I have found a good investment idea that will be a much better allocation of remaining funds instead of waiting for EMAG to recover.

Lately I have been reading the quarterly and annual reports from the “Oak Value Fund”. Not because I am interested in investing in their fund but because they are well written reports that summarize the market weather from the perspective of a value investor and they go into good details about their holdings and their reasons for buying or selling their positions.  

The Oak Value reports are reminiscent of the Berkshire Hathaway annual letter to shareholders but offer yet another perspective because they do not buy entire companies and they will open and close positions more often.

I reiterate, I have no intentions of investing in this fund nor do I make any recommendation that any one else does. I just feel there is some good reading in their reports.  One interesting note is that OAKVX is a fairly small fund with only around 58 million is assets.

Got a tweet from DividendStocks ( website link ) about a dividend increase post on Seeking Alpha. One of the companies increasing their dividend is Wesco Financial  (WSC). WSC is run by Charlie Munger and 80% is of the stock is owned by Berkshire Hathaway.  I have a small position in WSC and while the dividend increase of 1 cent from 0.385 to 0.395 is not very much it is still signifigant because WSC has consistently increased their dividend payment for 37 years.  As the Seeking Alpha article states:

Wesco Financial Corporation is a dividend champion and an achiever

Some people consider WSC to be a mini-BRK but Charlie states his own thoughts on that subject in the 2007 annual letter:

 

Business and human quality in place at Wesco continues to be not nearly as good, all factors considered, as that in place at Berkshire Hathaway.Wesco is not an equally-goodbut-smaller version of Berkshire Hathaway, better because its small size makes growth easier. Instead, each dollar of book value at Wesco continues plainly to provide much less intrinsic value than a similar dollar of book value at Berkshire Hathaway. Moreover, the quality disparity in book value’s intrinsic merits has, in recent years, continued to widen in favor of Berkshire Hathaway.

All that said, we make no attempt to appraise relative attractiveness for investment of Wesco versus Berkshire Hathaway stock at present stock-market quotations.

One interesting thing to note is that from a value perspective WSC is trading at a discount to its cash and book value. Considering who is at the helm I think you can trust their accounting  practices and valuations a lot more than most. 

On a slightly humorous note it looks Wesco and Berkshire do share the same web designer

Burlington Northern Santa Fe has been getting some attention because Buffet has been steadily increasing his position. This past week another  purchase of approximately 4 million shares was reported:

NATIONAL INDEMNITY CO  10% owner 1,800,000 $62.19 $1.11946E8 7.1889E7

NATIONAL INDEMNITY CO  10% owner 681,000        $63.43 $4.31969E7 7.257E7

NATIONAL INDEMNITY CO  10% owner 1,882,000 $61.65 $1.16031E8 7.4452E7

It should be noted that National Indemnity is a Berkshire Hathaway company.  It’s an Omaha based insurance company that Buffet purchased on behalf of Berkshire. If memory serves correct I believe this was one of first insurance companies he purchased and hence the beginning of his “float”  investing career.  The story of Buffett and National Indemnity is covered in some detail in “The Snowball” which I would highly reccomend reading.

The only reason I bring this up is because when reading information about insider purchases and sales you have to keep in mind that it might not always be clear who is purchasing the stock. In this case someone not familiar with Berkshire and it’s history of  buying BNI stock might not realize who is actually making the purchase.  As far as insider information goes InsiderCrow is the best site I have found so far for that info but please let me know if you have any others you use. Insider filings are available from the SEC site, but the search functionality on InsiderCrow is far better.

Back to BNI. Well I think there are two major things to consider:

1. Rail is the cheapest way to move goods across the country. When people start spending money again and gas prices work their way back up (both of which will happen eventually, nay sayers be damned) railroads will be in high demand.

2. Moat. This is a no brainer. When it come to moats railroads have it locked down. The threat to their competitive advantage (Moat) is that a cheaper way to move goods comes along.  

Riding on Coattails

Warren Buffett has talked about “riding on coattails”. Well here is a situation where it may be possible to ride on his.  We know what Berkshire has paid for all of its BNI stock.  So we can come up with an idea of what he considers to be a “fair” price. One thing to keep in mind is that in some cases he bought the stock on “puts” which means he collected a premium for taking on the obligation to buy the stock at a certain price.  In these cases he technically paid less than the price reported because that does not reflect the discount for the premium. 

With recent purchases its obvious he thinks its a good deal in the low 60′s and coincidentally it has also recently hit its 52 week low. But am I saying mimic what he does blindly? No.

 The thing I like about this situation is that I can research BNI on my own, come up with my own valuation for the stock, my own opinion and then compare it to someone elses. This someone else just happens to be far more knowledgable then I am. I am not saying buy a stock just because Buffet buys it.

In alot of cases Buffet gets deals that we can’t. With GE and GS he got high interest perferred shares with lots of consequences in his favor. Those are unique and should not be read as “Buffet is buying GE stock!”. While he is technically buying GE stock he is getting alot more reward and protection than anyone buying their common stock. In this case he is buying BNI common stock without any special deals.  

Risks and other thoughts

There are some things to take in consideration when looking at BNI from the perspective of a personal investor:

1. Buffett has to make large investments. There are great companies selling for great prices right now, alot that will probably make you more money than BNI but they are too small for large investors. This is where you have an advantage over Buffet. BNI is a good long term play but for someone who is not managing billions of dollars there are probably better oportunities. 

2. Buyout. It is possible that Buffett is working his way to a complete purchase of BNI for Berkshire Hathaway. If this happens sooner rather than later you will not get the same return and if it were to happen within a year of your purchase date you could pay higher taxes on your gains. Keep in mind there has been no talk of a buyout, but I think its something to consider. 

Personal thoughts

As I mentioned in a previous post, I look at investing as far more than a vehicle for income. I personally like BNI because I live in South Seattle close to alot of rail activity so I constantly get a personal real life view of my holdings and I derive much joy from that.

I am not going to go into detail about the Puget Sound Energy deal, it has been covered in depth in many other places which I will list at the end of this post. 

But I wanted to bring it up because it was my first taste of risk arbitrage. I started my initial position in PSD (PSE’s ticker symbol is PSD, confusing) around a month ago.  The deal gives all share holders $30 a share cash in exchange for their shares. So the idea is quite simple buy it for less than $30, the deal goes through you get your cash and profit. The reason merger deals are called “risk” arbitrage is well… because there is risk. In true arbitrage you have two simultaneous markets with different prices and you have essentially a risk free profit. 

The risk is that the deal had to be approved by the Washington UTC and this had not happened a month ago. In fact it just happened this week. In addition some of the communities in WA are not in favor of the merger hence there was risk that this could prevent the UTC from approving it.

On the downside if the deal did not get approved I was quite content with holding the stock and collecting dividends in the event that I could not sell it for a profit in the short term. For someone who might not want their money tied up in the long term, the downside is different. 

Interestingly enough with news of the approval the stock traded Wednesday below the sale price so there was still an option to make a quick very low risk profit.  It will be interesting to see if it continiues to trade at this price tomorrow on Friday. 

Mucho thanks to the Old School Value Blog for consistently posting updates on this deal.

PSD Merger at OldSchoolValue

Puget Sound Energy Website

I am unabashed fan of Warren Buffett and I really enjoyed watching this video of him speaking to a MBA class at University of Florida.  Its a little over an hour but its time well spent.  

The video is from 2000, but like all of his advice its timeless. One the things mentioned in the talk that really stuck out in my mind is the following in reference to the failure of Long Term Capital:

 

 

To make money they didnt have and didnt need they risked what they did have and what they did need.

 

He goes on to make an example with someone who has 100 million dollars. If this person can earn 10% a year on his 100 million dollars without leverage at almost no risk, or take some risk and leverage his 100 million dollars to make a 20% return this person would be crazy to risk losing their 100 million for an additional 10%. Especially because they already have 100 million bucks, how is the additional 10% going to make their life that much better? It isn’t it. But the downside if they loose is obvious, they no longer have any money.

The google video link above is for the whole 1 hour talk, its also on youtube broken up in smaller chunks.

Other Warren Buffett videos:

Warren Buffett talks Business

Charlie Rose Interview