$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.

In my opinion no news is good news. There really should not be much to report unless something goes wrong, so they silence has me quite content that share holders will be getting their $30 per share sometime this month.

One interesting thing to note though is that PSD annouced its quarterly dividend to shareholders on record as of January 21st 2009.  This is a nice added bonus if we end up getting the dividend for this quarter and the buyout share price. 

For more details on the PSD deal read the posts at Oldschoolvalue.

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