In the book Warren Buffett and the Art of Stock Arbitrage (Scribner, 2010) by Mary Buffett and David Clark, Warren’s daughter and her co-writer explore just one of the great investor’s profit-making strategies.
Arbitrage, as defined by Webster’s Dictionary:
- the nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies
- the purchase of the stock of a takeover target especially with a view to selling it profitably to the raider
It is the second definition that Buffett uses to make profits. Simply explained by an example, it is the practice of buying stock A for $9 and selling it later for $10.
Buffett has been able to generate outstanding returns by arbitrage. The book references that from 1980 to 2003, Buffett, through his company Berkshire Hathaway, used arbitrage 59 times and generated an average profit of 81.28% per transaction. Obviously, arbitrage can be very profitable.
Buying Takeover Candidates
For a real world example, investors can look at today’s headlines. Private Equity firm Gores Group announced they were acquiring auto parts supplier Pep Boys (stock symbol PBY) for $15 a share.
At various times during the day, PBY was selling under $15. It ended the day selling at $14.95. If an investor bought the stock at the current price, and the deal goes through at $15, the investor would make a profit of five cents on the transaction.
Why would the stock be selling at less than the buyout price?
- There is always a risk that the deal will not be completed. Before the offer, PBY was selling near $12. If the deal collapsed, it might likely return to that price.
- There is a time value of money. If investors do not have at least the opportunity to make a profit, they will put the money elsewhere.
Sometimes the stock will sell at price higher than the offer if the market feels there is a possibility of another bidder, or some other reason the price might increase. The book states that Buffett is less interested in this type of investment, and is more likely to invest when the transaction is likely to be as done deal.
The stock price may continue to fluctuate until the deal is complete. Sometimes new information will cause investors to demand more or less return for their money, or occasionally, events affecting the overall market will result in an opportunity for higher profits in the arbitrage situation. Investors should monitor the stock price carefully in order to pick up on these situations.
There are relatively simple mathematical formulas for calculating the return in an arbitrage situation. Investors should know how much they stand to make so they can compare against alternatives.
It Takes Money to Make Money
Deals like the one above are available to all investors, but because of his large treasure chest Warren Buffett will have access to transactions that are inaccessible to small investors. Even though you will not be able to make the kind of profits The Oracle can, arbitrage is still a way to make good returns with lower risk.
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