Author: Ben Tewey
Date: 5/7/21
Defining Arbitrage
Basic (or risk free) arbitrage, in its most simple form, is buying a security in one market and simultaneously turning around and selling it in another in order to take advantage of pricing inefficiencies in securities between two markets. Arbitrage acts as a supplement for a cash position in the investor’s portfolio. An investor will engage in arbitrage as a short term substitute for holding cash in order to increase their buying power or capital position while waiting for better opportunities to come along. So let’s say, for example, Company X’s stock is selling on the London Stock Exchange for $20, however on the New York Stock Exchange it is selling for $20.05. Of course, you would buy the shares on the London Exchange and immediately sell on the New York Exchange netting a 5 cent profit. It is true that basic arbitrage has been rendered nearly impossible by high frequency trading and computers/ algorithms trading.
So why am I writing this lesson if the average investor can’t reasonably pull this off?
Spac-bitrage and Merger Arbitrage
There are still opportunities to conduct arbitrage in today’s markets in two areas: mergers and SPACs. To cover mergers let’s take a look at the Microsoft and Nuance Communications case study. Microsoft announced in early April to buy Nuance for 19.7 billion or about $56 a share, but shares are currently trading at $53 dollars a share which is about a 5% difference. Therefore, in theory if one were to go out and buy Nuance shares right now and the merger were to be approved and go through the arbitrageur would net a 5% gain. This is known as merger arbitrage. Taking advantage of the difference between market prices and the price of an announced merger or acquisition.
The second type of arbitrage that exists in markets today is SPAC arbitrage. For those readers who are not familiar, a SPAC (a special purpose acquisition company) is a shell company which exists as a pile of cash for a private company to merge with in order to go public. The SPAC route offers an alternative to the traditional IPO and direct offering routes for going public. These companies have something called a trust value- a guarantee for shares to be worth $10. In this case, when shares of a SPAC trade for less than trust, that is, less than $10 per share for the run-of-the-mill SPAC one can conduct arbitrage. This allows the arbitrageur to have an interest in the upside while protecting or negating any downside risk. For example, Starboard Value Acquisition Corp ( ticker symbol $SVAC) is trading below trust at the time I am writing ($9.90 a share) but has announced a merger with a company called Cyxtera. If the deal is well received and the investor likes the merged company they can let their stock run and it is then treated as a normal stock with a chance of going to 0 but unlimited upside, but if the investor doesn’t like the merger proposition they can redeem their shares prior to the ticker switch for $10 netting a 1% return. There is no downside risk and thus this is a form of arbitrage. As a side note, if you want to look for opportunities I will recommend two sources. One, Andrew Rangeley is a portfolio at Rangeley Capital and runs just a terrific blog on his site Yet Another Value Blog where he talks extensively about SPACs. The second is FinViz which is a phenomenal, free screener that can help you search for SPACs trading below trust.
Disproving the Efficient Market Theory
The second reason I bring up the topic of arbitrage is that these two previous examples, merger and SPAC arbitrage completely nullify the Efficient Market Theory. Warren Buffet summates the EMT in his incredible essay The Superinvestors of Graham-and-Doddsville writing, “The efficient market theory postulates that stock prices reflect everything that is known about a company’s prospects and about the state of the economy. There are no undervalued stocks, these theorists argue, because there are smart security analysts who utilize all available information to ensure unfailingly appropriate prices.” Conversely, if arbitrage situations continuously exist in public markets as they do it directly disproves this hypothesis. To bury the EMT one last time: it helps to be a company that ships goods around the world on a boat and have all your competitors believe the world is flat. Just as those competitors will not try to sail around the other way around the world, your EMT believing competitors in the stock market will not look for undervalued or inefficiently priced securities. If the EMT were true, business classes would be very short indeed: you would walk in day one, the professor would say security markets are wholly efficient and that there is no sense in trying to find undervalued stocks because there aren’t any, and class would be dismissed!
How can we Assess Arbitrage Opportunities
Of course, no opportunity proposes guaranteed return and no downside risk. Therefore, the next logical step is to ask what questions do we have to rationally ask ourselves to ensure asymmetric upside opportunity in an arbitrage situation. I will heed Warren Buffett in his 1988 letter because he laid out the frame of reference and arbitrage checklist so-to-speak much more eloquently than I ever could. He writes, “To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire – a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?”
The first question makes intuitive sense, we want to know how likely it is for us to make money, of course. Questions two and three deal with opportunity cost, the intelligent investor must ask his or herself “What is the likelihood that I can do something better with my money while it is tied up in the arbitrage situation?” The fourth question Buffett recommended is the most important for a value investor. By nature, value investors are downside biased. An intelligent, true value investor will always look at downside risk before looking at upside potential because rule number 1 in investing is don’t lose money and rule number is don’t forget rule 1.
Math of Gains and Losses
In order to drive this point home let’s take a look at this graph which lays percentage losses on the x axis and the gains that would be necessary with the new capital base to offset the loss on the y axis. As you can see initially the small losses do not need much subsequent gain to break even. A 5% loss basically off set by a 5% gain, however quickly the necessary gains get dramatically more difficult. A 25% gain is needed to offset a 20% loss. Of course a 100% gain is necessary to offset a 50% loss, but what happens when the percent changes get really big? Take for example a 70% loss, what is needed to get back to the original capital base? Well, about a 233% gain. For an 80% decrease a 400% increase is needed. Only a 10% more from there, so a 90% loss, will need a subsequent 900% return to break even. Think about that a difference of 10% on the downside leads to 500% more gains on the upside to get back to even. Because of this math all investors should minimize downside risk and prevent permanent loss of capital. Remember– you only need to get rich once.
KSU CP CN Merger Arbitrage
Great so with this math in mind let’s apply this Buffet’s frame of reference to a current situation in the market. Remember we need to ask ourselves (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire – a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?” So here’s the scenario: It has been announced that Kansas City Southern, a railroad operator in the southern U.S. through Missouri to Texas down the gulf coast and deep into Mexico, that holds important access to southern ports in the gulf and is the smallest of the 7 Class I railroads is being acquired by Canadian Pacific a Canadian, obviously, railroad that operates in the North United States and Canada but has one overlapping railyard with Kansas City Southern. The bid was announced on March 20th at 25 billion for CP to buy KCS in the deal, Kansas city southern shareholders would receive $90 in cash and 0.489 shares of CP for each KCS share they own which all in all is about $275 dollars. For reference CP was trading for $374.58 at close yesterday. The new entity would be the smallest of six US Class I railroads by revenue and have a combined railroad network of about 20,000 miles and is likely to not be blocked by regulators at the Surface Transportation Board. This is all well and good, but the shares are trading at $290– that doesn’t seem much like a great arbitrage deal does it? Well the story gets interesting, Canadian National a rival railroad swooped in with a higher bid for KCS last week on April 20th offering to buy the company for 30 billion, topping the 25 billion CP deal. In this offer KCS shareholders would receive $200 cash and 1.059 shares of CN which was trading at 108.99 at close Wednesday. This amounts to about $315 dollars per share for KCS or a 8% upside from current market price. So there’s the opportunity and a thought experiment.
Bibliography
Yet Another Value Blog by Andrew Rangeley
Microsoft Acquires Nuance for 19.7 billion
The Superinvestors of Graham-and-Doddsville
1988 Berkshire Letter to Shareholders
Reuters Initial KSU-CP Merger Release
Exact Details of what KSU shareholders receive in each deal