Learn to invest with Buffett

Chapter 16

Chapter 2, Section 7 Using Appropriate Chance Arbitrage

If cash assets are used for arbitrage, it will provide greater profit margins than other short-term investments.

--Warren Buffett
Arbitrage is actually an investment that can grasp the timeliness.It is to buy securities in one market and immediately sell the same securities in other markets. It makes profits through the price difference between the two markets, and has little to do with the absolute price level.Its purpose is to earn market price difference.

For example, if a company's stock is priced at $20 per share in the London market and $20.01 per share in the Tokyo market, arbitrageurs can simultaneously buy stocks in the London stock market and then sell the same stocks in the Tokyo stock market, thereby benefit.In this case, no funds are at risk.Arbitrageurs simply take advantage of the inefficiencies between markets in various places and profit from them.Because these transactions involve no risk, they are called risk-free arbitrage.On the other hand, risky arbitrage is the hope of making a profit by buying and selling securities at open prices.

The most typical risk arbitrage is to buy shares for less than the company's future value.This future value is often based on a company merger, liquidation, stock purchase or reorganization.The risk that arbitrageurs face is the uncertainty of future stock prices.

In the early days, Buffett Partners invested nearly 40% of the company's funds in arbitrage activities every year.In the darkest era of 1962, when the entire market fell, Buffett relied on arbitrage to make profits through the dark period, and then turned things around by making profits through arbitrage.They made the company a 13.9% gain, while the Dow lost a disastrous 7.6%.
Buffett said that any company change of hands, reorganization, merger, capital withdrawal or takeover by a rival is an opportunity for arbitrage.For example, Company X announces that it will sell all its shares to Company Y at a price of $120 per share on a certain day in the future.But there is a way for the arbitrageur to buy the stock at $100 per share close to the transfer date, so that the arbitrageur can make a profit of $20 per share, which is the difference between the market price of $100 and the selling price of $120 (120 USD - USD 100 = USD 20).The question is, how do arbitrageurs time their close transfers so they can sell at $120 and make $20 a share?

So, the biggest sticking point is time.The longer the period between the date of acquisition and the date of transfer, the smaller the annual return for the arbitrageur.

So how do investors assess arbitrage conditions?Buffett believes that this must answer the following four questions:
1. How likely is it that what was promised will happen?

2. How long will the invested money be locked?
3. How likely is it that something better will come along -- such as a more competitive takeover bid?
4. What if things don't happen because of antitrust lawsuits, financial mistakes, etc.?
As an ordinary investor, how to learn arbitrage like Buffett?It is very important to grasp the principles of arbitrage trading.According to Buffett's arbitrage experience, the following principles are summarized:
1. Invest in "cash" deals rather than "equity deals" and only trade when the news is officially announced

一个现金形式的50美元报价是应当优先考虑的。因为这时交易具有固定的交换比率。这就可以限定目标股票下降的可能。一定要避免有可能使你的最终收益低于原始报价的交易。假定一家股票市值为50美元的公司准备交付1.5份股票，如果到交易结束时股价降到30美元，那么你最终只能得到45美元。

2. Determine your lower bound on expected rate of return
Before getting involved in an M&A transaction, calculate the potential profit and loss and their respective probability of occurrence, and then determine the time required to complete the transaction and your potential annual profit.Avoid deals that don't offer annual returns of 20% to 30% or more.

3. Make sure the deal is finalized

If the deal fails, the price of the target stock suddenly drops.A number of factors can derail a deal, including government antitrust intervention, a sudden drop in the acquirer's stock price, disputes among policymakers over compensation, or a vote by either company's shareholders to reject a proposed merger.Certain mergers and acquisitions, including those involving utilities or foreign companies, can take more than a year to close, which can tie up your capital for a considerable amount of time.

4. If you decide to get involved in a "merger" transaction (where the target company's shareholders accept a stake in the acquiring company), be sure to choose ones that have high price capabilities

M&A activity should ensure that the target stock's price does not drop after the deal is announced.Typically, the acquirer will offer a variable amount of shares based on its own stock price.

5. Don’t place too much profit on arbitrage trading

The market generally misprices a stock as much as it correctly prices it.Blindly picking a deal may yield mediocre returns in the long run.You must develop the habit of making a careful study of all relevant facts.When the gap between the market price and the acquisition price is large, it is a sign that participants are concerned about the failure of the deal, and some people may have received information that the transaction will not go ahead.

6. Don’t worry about buying arbitrage shares on margin (aka borrowing money)

If you can often raise capital to acquire arbitrage shares, you can further increase your portfolio returns.

Investment motto:

If cash assets are used for arbitrage, it will provide him with greater profit margins than other short-term investments.In fact, over the past 30 years, Buffett has actively invested in various types of arbitrage, and he estimates that the average annual pre-tax return is 25%.These are real and verifiable.

(End of this chapter)