Learn to invest with Buffett

Chapter 61

Chapter 10 Section 2 Apply the arbitrage formula and seize the opportunity to trade
Taking arbitrage as an example, in fact, we don’t care about losing money in M&A transactions with a very certain profit rate, but we don’t want to enter some investment opportunities with a high probability of expected loss.For this reason, we hope to calculate the expected profit probability, so that it can really become the only basis for deciding whether to invest in this target.
--Warren Buffett
Buffett believes that within the scope of possible arbitrage, you must seize the opportunity to trade, so as to avoid the impact of the general environment of the stock market on your investment.In view of the complexity of investment and the possible variables in arbitrage, Graham once developed a set of formulas to calculate the potential profit in individual transfer cases.Buffett puts this formula to good use, and the formula is:
Annual remuneration = CG - L (100% - C) / YP
Among them, G is the expected profit when the event is successful; L is the expected loss when the event fails; C is the expected success chance, expressed as a percentage; Y is the time of holding stocks in this period, in years; P is the current price of the security.

Applying this formula calculates the probability of loss and works for all types of transfers.On February 1982, 2, Bayek Cigar Company announced that it would sell its cigar operations to Metz Productions of America for $13 million, or nearly $1450 per share.It also stated that it will be liquidated and the proceeds from the sale will be distributed to shareholders.So Buffett bought 7.78% of the problematic stock of Bayek Cigar Company for $572907, or $5.44 per share.Buffett used the current market price of $5.71 per share to take the difference between the share price distributed to shareholders after the sale of Bayek in the future, which is estimated to be $5.44 per share.

The specific application method is that first Buffett estimates his estimated earnings per share.This gain can only come from the share price distributed after the sale, which is $7.87 per share, while the market price Buffett paid is $5.44 per share, and Buffett's expected benefit is $2.43 per share ($7.87 - $5.44 = 2.43 Dollar).Then multiply the expected benefit of $2.43 by the expected probability of success.That is to say, Buffett can set the success rate, or the chance that the transaction will go through, at 90%, which will result in $2.18, and the final result can be determined by the probability of success.

Buffett also calculated how much he would lose if the transfer didn't happen.If the sale plan is cancelled, the price per share may fall back to the price before the sale.If the sale plan is not executed, Bayek Cigars' stock price will fall back to $4.50 per share, which was the market price before the sale and liquidation announcement.That is to say, if the stock Buffett bought at $5.44 per share falls to $4.50, Buffett will lose $0.94 per share.

Remember, Buffett is also calculating the probability of loss.This can be calculated by simply subtracting 100% of the success rate from 90%, that is, there will be a 10% probability that the transfer plan will not happen.Now, multiplying the estimated loss of $0.94 by 10% gives Buffett an estimated loss of $0.09.

Afterwards, Buffett has to calculate the time required for the transfer. The company must complete the capital liquidation action during the fiscal year, otherwise there will be problems with value-added tax.So Buffett can estimate when it will happen and when it will be sold, and this process will be completed within the current year.Because Buffett set that it will be sold and liquidated within a year.

Here's what it looks like when Graham's formula is applied to Bayek cigars:
G=2.43 US dollars, the possible benefits when successful;
L=0.94 USD, the possible loss in case of failure;
C=90%, possible probability of success expressed in percentage;
Y=1 year, the possible time to hold stocks, expressed in units of years;
P = $5.44, the stock's current going price;

年度回报＝90%×2.43-0.94（100%-90%）/5.44
If the transfer and liquidation of Bayek's company can be carried out according to the original plan, Buffett can calculate his annual return rate of 38%.As far as short-term trust fund investment is concerned, the rate of return is quite impressive.

Buffett has manipulated various types of arbitrage opportunities.In addition to the Bayek-RJR deal, he has also bought a number of companies such as Texas National Petroleum, Elegis, and Crawford under the premise of arbitrage.Sometimes there may be more than 20 different arbitrage cases at the same time in a year, and sometimes there are none.

Investment motto:

According to past experience, investors should pay attention to the fact that in the scope of arbitrage, they must first understand that the real wealth will be generated on the date of transfer.This investment will be in its best interest on this particular date.

Small profits continue to flow through M&A arbitrage

In my opinion, Graham, Newman, Buffett Partnership, and Berkshire's continuous 63 years of arbitrage experience show how stupid the efficient market theory is. A few lucky examples do not change this conclusion. We Instead of unearthing confusing facts or delving into the mysteries of product and management—we just do what's obvious.

— 1982 Buffett Annual Report
By pooling together a chain of arbitrage trades, investors can turn each low-yielding trade into a lucrative annual return if each trade works in your favor.Part of their funds will be used for short-term profits to obtain certain irrational price differences.These short-term profit opportunities include restructuring, liquidation, hedging involving convertible bonds and preferred stock, and mergers and acquisitions.

In 1915, Buffett's mentor, Jamin Graham, bought a stake in Guggenheim & Co., a holding company worth $69 a share.Guggenheim owns small stakes in four copper mining companies: Kennecott Company, Chino Copper Company, American Smelting Company, and Ray's Consolidated Company.Combined, Guggenheim's stake topped $4 per share.On paper, an investor has acquired $4 worth of assets for only $76, a situation that cannot be maintained indefinitely.Because Guggenheim's stock price must rise to at least $69, it can earn a steady profit of $76 per share.

并购套利的运作，实际上是在试图获得股票的市场价格与交易的市场价格之间的差价。交易价格就是一个公司并购另一个公司时支付的价格。例如，甲公司或许会以每股85美元的价格买人乙公司。如果乙公司每股的市价为80美元。那么一个投资者就可以买人乙的股票，并一直持有到交完达成时再卖给甲公司。这样他就会锁定一个5美元的利润。5美元的利润表示你的80美元的投资带来了6。25%的收益。如果B公司的股价跌到80美元以下，潜在的收益就更高于。

In this example, a $5 profit would represent a 12.9% annual gain if the deal happens to close within 6 months of your purchase.If the trade is made within 4 months, your annual return will be more than 20%.This is quite attractive.Once the deal closes and funds are recovered from Company A, the investor can invest the proceeds in another deal that yields similar profitable opportunities.

If the investor can achieve a rate of return of 3% in a series of consecutive transactions completed within 10 months, assuming that the investor reinvests the profits of each previous transaction, then the compound interest income of the investor will be 46.4% throughout the year. Will reach a staggering 35%.He told his clients that [-] percent of their money was in one stock and the rest was in undervalued stocks and merger arbitrage.

In general, the second major element of Buffett's partnership assets is M&A arbitrage.Buffett rarely tells investors exactly what kind of arbitrage trades he is operating, but he does disclose the size of the trades he is operating and the financing he uses to finance certain trades.

Investment motto:

For those investors who are trying to be sure of winning in the stock market, it is enough to look at Buffett's amazing arbitrage record starting in the 20s.In Buffett's case, it is clear that a crucial factor in driving annual returns beyond the level expected by a sophisticated investor is M&A arbitrage, as simple as that is, and most admirable.The beauty of M&A arbitrage is that it can maximize the investor's annual income and minimize your loss.Companies often withhold information about when deals are struck, which can have a significant impact on investor returns.

(End of this chapter)