How Arbitrage Can Create Risk-Free Profit
Earn 22% in 6 Months With Virtually No Risk
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In 1962, a 38-year old man approached a bank teller at a branch of the Union Bank of California.
“I need three million dollars.”
It wasn’t a bank robbery. It was a young Charlie Munger, preparing to go all-in on one of the biggest speculative trades of his life.
Munger had “bet the farm” on this trade. He’d liquidated the entire holdings of the investment partnership he managed – and then liquidated all of his personal assets as well.
But that wasn’t enough. He wanted to amplify the bet with leverage, so he borrowed as much as the bank was willing to lend.
“Sign here,” the teller replied.
Charlie Munger was investing his life savings, and more, in a Canadian utility provider.
It wasn’t exactly the “wonderful business at a wonderful price” that Munger today waxes poetic about at Berkshire Hathaway shareholder meetings. But that wasn’t important.
The only thing that mattered was that Munger knew British Columbia Power was about to get bought out… and the stock was trading at a discount to the buyout price.
The Canadian government had offered to buy the company for just over $22/share, but British Columbia’s stock was trading in the open market for around $19/share. The $3 spread between the trading price and proposed buyout offer reflected the market’s uncertainty about whether the deal would get done.
Munger, though, was certain that it would.
Funding wasn’t a problem: It was the government that was buying. So the only remaining question was whether or not the transaction would clear legal and regulatory hurdles. Here again, the question answered itself: It was the government that was buying. The regulators were the government.
Munger viewed the opportunity to capture the 15% spread between the current share price and the buyout offer as free money. Or as close to it as you’re ever going to find in this world.
As Munger himself once explained…
“You should remember that good ideas are rare – when the odds are greatly in your favor, bet heavily.”
As it turned out, Munger was right. The deal closed. And after the close, the shares traded as high as $25. Not only did Munger and his investors earn a tidy return, but so did a young Warren Buffett. After learning of the opportunity from Munger, Buffett put 10% of his investment partnership into the deal too. Corporate arbitrage has remained a key part of Buffett’s investing strategy ever since.
Ask 100 investors how Warren Buffett became one of the richest men in the world, and 99 of them will likely reply with something along the lines of: “Buying great businesses and holding them forever.” And it’s true that this well-publicized strategy allowed Buffett’s Berkshire Hathaway to compound capital at 20% over the last five decades – outperforming every publicly listed stock and money manager over the period.
But buried within this track record is a small subset of special investments that massively outperformed the rest of Buffett’s stock picks.
Two researchers studied every investment Buffett made using arbitrage from 1980 through 2003. Over that period, this group of Buffett investments returned an astronomical 81.3% average annual return. Buffett also relied heavily on this strategy during his early days of money management, when he ran the Buffett Partnership from 1957 - 1969. Over that period, Buffett generated a compounded annual return of 31.6%, compared with a 9.1% annual compounded return for the overall market.
What’s more, the Buffett Partnership took substantially less risk. During the entire 12-year stretch, Buffett never had a single losing year, while the broader stock market had four losing years over the same period.
Buffett was able to generate strong returns without a losing year by doing a lot of corporate arbitrage.
It’s a strategy we’ve personally used over many years to produce outstanding results.
Last year, Porter bought 30,000 shares of Twitter after Elon Musk agreed to buy the stock at $54.20. In less than two weeks, Porter sold his position for a profit of almost $200K. Of course, that’s pocket change compared to Wall Street’s best investors. Carl Icahn reportedly made half a billion dollars on the same trade!
Porter has also written about these kinds of special opportunities many times before, perhaps most famously (and effectively) during the financial crisis of 2008.
In 2008, with the shares of Budweiser trading in the $50s, Belgian brewer InBev pledged to buy Budweiser, America’s most dominant beer brand, for $70 in cash.
Porter had long recognized the opportunity in Budweiser, having recommended it two years’ earlier. In fact, the recommendation of Budweiser was the strongest recommendation Porter had ever made. The headline was: Will You Buy Enough?”
Porter urged his subscribers to make the stock at least 10% of their portfolios:
“My fear this month is that you won’t recognize the significance and the scope of the opportunity and you won’t buy enough…”
Most presciently, though, Porter forecast, back in 2006, that if there was a significant economic disruption, Budweiser would be acquired, putting a floor on its share price. “I believe it’s extremely unlikely that, barring a significant economic disruption, these shares will get much cheaper because this company would be eagerly acquired by almost any large institutional investor in America.”
Even so, as the financial crisis worsened in October, the market began to have doubts that the consortium of banks that were lined up to provide the funding would survive the crisis. Thus, the spread widened (at one point to 17%) between the trading price and the deal price. This created the opportunity, in the fourth quarter of 2008, to earn virtually risk-free profits in the midst of a financial crisis. Porter, who had already urged subscribers to build a huge position in Budweiser shares, pounded the table on the arbitrage opportunity as it unfolded, writing in October of 2008:
“Anheuser-Busch (NYSE: BUD) did exactly what you'd expect the world's largest brewer to do during a global recession... It sold more beer…. BUD also captured a bigger share of the U.S. market this year – 49.2% from 49%. BUD's stock is currently trading for less than $65, and InBev has a $70-per-share offer on the table. Horse, meet water.”
When the deal closed about a month later, investors who followed Porter’s advice made a killing. Total returns on the initial recommendation were almost 80% in about two years’ time. Returns on the arbitrage were as high as 17% in a month.
There are two things to remember about these situations. First, as we will detail below, arbitrage allows investors to make high percentage bets (90%+ win rates) and to earn almost unbelievable returns. But that’s not the best part. The more amazing thing is, often these deals involve great businesses (like Budweiser), corporations that you would happily own even if the deal falls through. In this way, arbitrage can sometimes offer you virtually risk-free, and nearly obscene profits.
Let’s go over how it works.
When a corporate transaction, like a merger or buyout, is announced, the stock no longer moves up and down with the vagaries of the market. Instead, the investment all comes down to a bet on whether the proposed deal will go through. It’s completely binary… yes or no.
When the answer is “yes,” and when the stock is trading at a discount to the buyout price, investors can make millions. In the ‘60s, when Munger marched up to the bank teller and asked for his $3 million, the more common term for this kind of arbitrage was a “workout.”
These workout situations played a big role in Buffett’s winning streak from 1957 - 1968. He once explained that he generated positive returns during losing years for the broader market by “having a large portion of our money in controlled assets and workout (arbitrage) situations rather than general market situations at a time when the Dow declined substantially.”
Buffett continued to use this playbook at Berkshire Hathaway, as he detailed in his 1988 letter to Berkshire shareholders:
“The gross profits in many workouts appear quite small. A friend refers to this as getting the last nickel after the other fellow has made the first ninety-five cents. However, the predictability coupled with a short holding period produces quite decent annual rates of return. This category produces more steady absolute profits from year to year than [undervalued stocks] do. In years of market decline, it piles up a big edge for us.”
These situations don’t come around often… but when they do, they offer the opportunity for high rates of return in short periods of time, even during bear markets. That’s why Buffett, a man who hates losing money, loves arbitrage trades. As he once said:
"Give a man a fish and you will feed him for a day. Teach a man to arbitrage and you will feed him forever.”
The merger-arbitrage situation we’re introducing today offers the ultimate safe play for a high-risk market.
We expect a resolution of a proposed buyout deal for this stock at some point within the next six months. If the deal goes through, investors stand to earn a quick 22% return, regardless of what happens in the economy or the broader stock market.
But here’s the beauty of this set-up. As we mentioned earlier, often these deals involve companies that represent great value to investors whether the deal happens or not. These set-ups are the ultimate “win/win” and shouldn’t be ignored. They represent the rare opportunity to make huge profits if the deal goes through, but not have much, or anything, at risk if it doesn’t. Heads you win, tails you don’t lose is not a common set up in the markets. These opportunities ought to be cherished by investors, but, strangely, they are largely ignored.
In this opportunity, if the deal falls apart, you’re buying one of the greatest technological media companies ever created. It has world-class profit margins and is extraordinarily capital efficient. It also owns the dominant brand in its industry. And it is trading at a discounted valuation to its peers. Plus, if the deal doesn’t go through, the company will earn a one-time cash windfall of between $2.5 billion - $3 billion in break-up fees. That represents roughly 150% - 200% of last year’s net income.
In other words, it’s the rarest kind of deal. The kind of opportunity we last saw more than 15 years ago with Budweiser. It’s an opportunity that we’d expect Charlie Munger and Warren Buffett would be licking their chops over. And, alas, it turns out, Berkshire Hathaway owns more than $4 billion worth of the stock.