A
nother type of arbitrage that both Buffett and his mentor Ben Graham specialized in was “relative value” arbitrage. This became a bread-and-butter part of Buffett’s “workout” strategy. The idea of the relative value arbitrage is to buy an asset when it is convertible into other assets that have more value than it does.The most prominent example of the past few years is the case of Palm Computing and 3Com. Palm was a division of 3Com when 3Com decided to spin off Palm’s shares to the public. On the first day of trading, Palm shares shot up so much that the stake that 3Com held in Palm was actually worth more than the market cap of 3Com. The market was effectively valuing 3Com’s ongoing business at less than zero—business that had been around for thirty years and was immensely profitable. We will discuss this example in more detail later.
Another example is from Benjamin Graham’s first steps in this arena.
In 1915, when Graham was working for Newburger, Loeb, & Company, he stumbled upon the following relative value arbitrage: Guggenheim Explo- ration Company. The Guggenheim family, now known for its art museum in Manhattan, made most of its fortune by buying and developing mining prop- erties. The Guggenheim Exploration Company was a holding company for many of the family’s mining properties. On September 1, 1915, the company
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122 TRADE LIKE WARREN BUFFETT
decided to dissolve and distribute the shares it held in other companies to its shareholders. On that day it was trading for $68.88. Graham added up the value of its holdings and came up with the table shown in Exhibit 6.1.
So Graham figured that buying one share of Guggenheim would net him an arbitraged profit of $7.35. He bought up Guggenheim and sold short shares in the corresponding companies, locking in his profit.
Another example occurred in the 1920s when DuPont, capitalizing on the cash it earned in its wartime successes, bought a large block of shares in General Motors. The market at that time, though, discounted DuPont’s other businesses in the same way the market later discounted 3Com’s busi- ness and valued DuPont shares only at the value of its GM shares, valuing DuPont’s other businesses at zero. Graham was able to buy Dupont and short GM to capitalize on this spread.
One can say “But all of this was 80 years ago—how can such an obvi- ous example of information arbitrage (the idea that information is not received equally by all market participants) exist now, with the existence of the Internet, analysts, computers to analyze these situations, etc.?” And yet, we see from the first example—PALM and 3Com—that the situation was even more extreme.
Buffett first dabbled in relative value arbitrage when he was working for Graham at the firm Graham-Newman. An amusing story about this is that Graham at first refused to hire Buffett because Buffett wasn’t Jewish.
Graham felt that Jews couldn’t get jobs at the mostly Waspish Wall Street, so he sought to counterbalance this by only hiring Jews. Buffett, not to be dissuaded, kept sending Graham ideas for stocks until Graham finally hired him. Graham called his results in arbitrage “Jewish Treasury Bills.”
EXHIBIT 6.1 Guggenheim Exploration Company Value on September 1, 1915 1 share of Guggenheim Exploration Company would equal:
.7277 share Kennecott Copper @ $52.50 = $38.20
.1172 share Chino Copper @ $46.00 = $5.39
.0833 share American Smelting @ $81.75 = $6.81 .1850 share Ray Consolidated Copper @ $22.88 = $4.23
Other assets = $21.60
Total: $76.23
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When Buffett first came to Graham-Newman, he was 24 years old and raring to go. In the 1988 Berkshire Hathaway letter to investors, he dis- cusses his first foray into arbitrage when he was working for Graham.
Rockwood & Company was a modestly profitable maker of chocolate prod- ucts that was sitting on an enormous supply of cocoa. In 1954 there was a shortage, and the price rocketed up. The company did not want to sell the cocoa outright because there would have been a tax consequence. A young investor by the name of Jay Pritzker helped Rockwood & Company to use the 1954 tax code to its advantage. He pointed out a provision that said it could distribute the cocoa to shareholders without incurring the almost 50 percent tax liability if it were part of a restructuring that reduced the scope of its cocoa business.
The company then offered to repurchase its shares in exchange for cocoa (as opposed to dollars). Buffett would buy shares on the open mar- ket, sell the shares to the company in exchange for cocoa, and then sell the cocoa for a nice profit. His only risk was that the price of cocoa would fall below the level he was paying for the shares. Since he would attempt to do these sales as simultaneously as possible, his risk was negligible.
So, again, that was then and this is now. Clearly such spreads wouldn’t exist right now, right? But then again, let’s look at the PALM-3Com example.
March 2, 2000, only eight days before the Nasdaq’s all-time peak (as of this writing in January 2004), Palm went public. Initially scheduled to go public in a range of $14 to $16 per share, demand was so great that the shares priced at $38 per share. This translated to a huge cash bonanza for the company. On the first day of trading the shares opened at $150, imme- diately traded as high as $165, before finally settling down and ending the day at $95.06. At this point only four percent of the company was available to the trading public. 3Com (Nasdaq: COMS) still owned 95 percent of the company and was preparing to distribute 1.5 shares of PALM for every one share of COMS. If the only value of COMS had been its share of PALM, that would value each share of COMS at 1.5 × 95.06. In addition, COMS had approximately $10 per share in cash and it had zero debt, not to mention that COMS had an ongoing profitablebusiness.
So one would think that COMS now would be trading . . . where? At least $152 / share (the value of PALM plus the value of its cash). Or maybe
$177 per share, since at least one analyst thought that its non-PALM assets
Relative Value Arbitrage 123
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were worth approximately $35. However, on the day of the IPO, COMS shares ended up at $81. This implied a spread of at least $60 between the value of the PALM shares and the value of the COMS shares, even if one valued all of COMS’ other assets (cash in the bank plus a profitable busi- ness) at zero (see Exhibit 6.2).
The stub value (the market-implied value of the 3Com assets minus its PALM shares) converged to zero, and finally above zero, by September of 2000 when 3Com finally spun out the shares to shareholders. This would have been an immensely profitable arbitrage. The difficulty in implement- ing it would have been in finding shares of PALM to short. Recent IPOs are often difficult to short.
An example of such a trade where investors lost an immense amount of money occurred in early 2003 in Japan with the Eifuku fund. A similar situation to the PALM/COMS spread occurred when Nippon Telephone became severely undervalued compared to its DoCoMo subsidiary. The
124 TRADE LIKE WARREN BUFFETT
EXHIBIT 6.2 Stub Value, 3Com
−70
−60
−50
−40
−30
−20
−10 0 10
−
3/20: 3 Com quarterly earnings, reorganization announced.
Spin off to be completed by 9/1, earlier than planned.
3/16: Exchange traded options introduced.
IRA approval announced, Palm shares will be distributed 7/27. Expended stock repurchases announced for 3 Com.
Dollars per share
2-Mar 9-Mar 16-Mar 23-Mar 30-Mar 6-Apr 13-Apr 20-Apr 27-Apr 4-May 11-May
Source: “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-outs.”
by Owen A. Lamont and Richard H. Thaler (National Bureau of Economic Research and University of Chicago), Journal of Political Economy,Volume III, Number 2, April 2003. Published by the University of Chicago.
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Eifuku fund made a massive leveraged bet that the spread would close.
Instead, the spread widened and within seven days the fund lost over 90 percent of its value, closing down when Goldman Sachs took control and closed all of its positions.
A similar situation occurred with Long-Term Capital Management (LCTM) and Royal Dutch Shell. Royal Dutch, which traded on the NYSE and Shell, which traded on the London stock exchange, were actually the same company, formed in 1907 by a merger between Royal Dutch and Shell Transport. The split between the two was 60/40 and should have traded accordingly (the value of Royal Dutch shares trading on the NYSE should be 1.5 times the value of the Shell shares trading on the LSE. Instead, the disparity is often much more.
Richard Thaler provides Exhibit 6.3, which shows the disparity be- tween the way the shares traded and the way they should have traded (the 60/40 split).
Relative Value Arbitrage 125
EXHIBIT 6.3 Royal Dutch Shell Pricing Disparity
Pricing of Royal Dutch Relative to Shell (Deviation from parity)
−10%
−5%
0%
5%
10%
15%
20%
Deviation
Source: “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-outs.”
by Owen A. Lamont and Richard H. Thaler (National Bureau of Economic Research and University of Chicago), Journal of Political Economy, Volume III, Number 2, April 2003. Published by the University of Chicago.
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In August 1998 this disparity reached an all-time high, precisely when Long-Term Capital Management was hanging on by a thread to this posi- tion as well as many other arbitrage positions that were experiencing a similar widening.
It is interesting that at this time, when LTCM was on the brink of losing its $3 billion fund, Buffett offered to pay approximately $100 million to take charge of its portfolio. They turned him down, but Buffett was definitely sniffing around for a good cause.
Are we wasting our time, then? Do these situations happen on a regu- lar basis and, if they do happen, is it unusual for the results to pay off? Mark Mitchell, Todd Pulvino, and Erik Stafford1examine every situation between 1985 and 2000 in which the market capitalization of a company traded for less than the sum of its parts.
They note that there are two types of risk in this strategy. The first is fundamental risk, the risk that the shares of the two securities might never converge. The parent company, for instance, can go bankrupt, having used the value of shares in the spin-off as collateral before finally collapsing. The other type of risk to the arbitrageur is financial risk, the risk that the secu- rities might converge, but first they might diverge in such a way that sub- stantial losses by the arbitrageur are incurred, as happened in the LTCM and Eifuku cases above.
Mitchell, Pulvino, and Stafford walk through the example of Creative Computers and Ubid. Ubid was an eBay-like auction site started by Cre- ative Computers. Creative spun out 20 percent of Ubid to the public on December 4, 1998. Like all good dot-com stocks at that time, Ubid shares began trading in a frenzy and at the end of the first day of trading after the IPO, UBID shares were trading at a market capitalization of $439 million, making the 80 percent that Creative Computers still held in UBID worth approximately $80 million more than the entire market capitalization of Creative. The authors go on to assume that an arbitrageur would have waited four days before trying to play the spread due to the lack of short-
126 TRADE LIKE WARREN BUFFETT
1“Limited Arbitrage in Equity Markets,” by Mark Mitchell, Todd Pulvino, and Erik Stafford, Journal of Finance, April 2001.
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able shares in Ubid immediately after the IPO. On the fourth day, the value of the stub value had increased from −$80 million to −$28 million.
Attempting to capitalize on this spread, an arbitrageur would have shorted 0.72 shares of UBID for every one share of Creative Computers.
Assuming that Creative was going to spin out the shares to shareholders within six months of the IPO, the return to the arbitrageur would have been approximately 45 percent.
However, within a few weeks the value of the stub would have decreased from −$28 million to less than −$700 million. The losses sus- tained by an arbitrageur would have been close to 100 percent assuming the arbitrageur met all of the margin calls, as detailed in Exhibit 6.4. Although the prices eventually did converge, the roller coaster was too painful for any investor to handle.
The authors assume that all margin calls are met, they assume trans- action costs and they also limit the initial investment in any one deal to 20 percent of total equity. Additionally, they assume short rebates of three
Relative Value Arbitrage 127
EXHIBIT 6.4 Creative Computers/UBID Arbitrage
Source: Mark Mitchell, Todd Pulvino, and Erik Stafford, “Limited Arbitrage in Equity Markets,” Journal of Finance 57, Issue 2, April 2002, Figure I, pp. 568.
Reprinted by permission from Blackwell Publishers Journal Rights, Email:
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percent a year, where the cash they make from selling the shares they bor- row yields interest. Exhibit 6.5 demonstrates their results.
The strategy of playing the spread between a parent and subsidiary resulted in an average return of 22 percent per year between 1986 and 2000.
128 TRADE LIKE WARREN BUFFETT
EXHIBIT 6.5
Pure Negative Stub
Year Value Portfolio
1986 9.5%
1987 44.4%
1988 17.5%
1989 –0.3%
1990 29.3%
1991 17.6%
1992 6.4%
1993 55.6%
1994 2.5%
1995 2.1%
1996 41.1%
1997 20.5%
1998 –14.2%
1999 15.7%
2000 77.4%
Mean 22.0%
Std 24.8%
Sharpe Ratio 0.676
Source: Mark Mitchell, Todd Pulvino, and Erik Stafford, “Limited Arbitrage in Equity Markets,” Journal of Finance 57, Issue 2, April 2002, Figure VI, pp. 575.
Reprinted by permission from Blackwell Publishers Journal Rights, Email:
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129 C H A P T E R 7