Latticework of Mental Models: Arbitrage

In 1954, a temporary shortage of cocoa in US caused its price to increase from 5 cents to 60 cents per pound, a whopping 12 times.

As a result, Rockwood & Co., a brooklyn based chocolate products company, found itself in a sweet spot. They were sitting on 13 million pounds of excess inventory of cocoa which instantaneously became a huge asset because of cocoa price increase.

So selling the inventory to make a handsome profit was a no-brainer except that there was just one catch to it. Rockwood & Co. followed LIFO (last in first out) inventory valuation which would have created a 50% tax liability on profits from sale of inventory.

So to avoid this tax, they came up with an ingenious way to exploit the temporary opportunity. They extended a share buyback offer which allowed the shareholder to tender a share in exchange for 80 pounds of cocoa. This maneuver, according to 1954 tax code, was perfectly legal and didn’t invite heavy tax liability.

This caught the attention of a 24 year old investment analyst who was working in New York for Graham Newman Corp. It was obvious to him that one could buy Rockwood shares for $34, sell them back to the company for 80 pounds of cocoa beans (worth $36), and then sell the cocoa beans making an instant profit of $2. Considering the transaction could be done in less than a week, it worked out to a sky-high annualized return.

“For several weeks I busily bought share, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.”, recounts Warren Buffett, the protagonist in the story above, “The profits were good and my only expense was subway tickets.”

What Buffett did is called an Arbitrage. It’s a process of identifying market inefficiencies. The classic idea is that of buying an item in one place and selling it in another. In the very early days the word applied only to the simultaneous purchase and sale of securities or foreign exchange in two different markets.

Mohnish Pabrai, in his wonderful book The Dhandho Investor, explains –

Arbitrage is classically defined as an attempt to profit by exploiting price differences in identical or similar financial instruments. For example, if gold is trading in London at $550 per ounce and in New york at $560 per ounce, assuming low frictional costs, an arbitrageur can buy gold in London and immediately sell it in New York, pocketing the difference.

Here’s Salman Khan from Khan Academy explaining the idea in a very simple language.

Just like any other profitable opportunities, arbitrage plays don’t remain open for long. As people execute these arbitrage trades, the price spread collapses and the arbitrage opportunity eventually vanishes. While these arbitrage spreads seem virtually risk free and it is free money while it lasts, most of them are only available for fleeting moments.

For people who don’t know, Warren Buffett indulged in quite a few arbitrage kind of investments early in his career. He used to call them workouts. Explaining arbitrage, Buffett writes –

…arbitrage – or “risk arbitrage,” as it is now sometimes called – has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behaviour of the stock market. The major risk he usually faces instead is that the announced event won’t happen.

Arbitrage is a powerful construct and a fundamental tool in the arsenal of any value investor. Although many different types of arbitrage exist, here are few that Pabrai mentions in his book –

Traditional Commodity Arbitrage

This is the one we saw above where the price difference for a commodity like gold can create a short window of arbitrage opportunity.

Correlated Stock Arbitrage

A typical example is Berkshire’s class A and class B stocks. BRK.B is economically worth 1/30 of BRK.A. So these two stocks should trade in lockstep with each other – or perhaps BRK.B should trade at a small discount due to its inferior voting rights and one-way conversion feature. However, in reality, on many days the two stocks differ by up to 1 percent. Assuming minimal frictional costs, an arbitrageur can potentially benefit from this spread.

Another example is holding companies. Sometimes holding company stocks trade at a discount to a sum of the parts even if the parts are individually publicly traded.

Merger Arbitrage

Let’s say a public company A announces it is to buy public company B for Rs. 100 a share. Prior to the announcement, B was trading at Rs. 75 a share; immediately after the announcement, B goes to Rs. 95 a share. If an investor buys B at Rs. 95 and holds the stock until the deal closes, then the Rs. 5 spread can be captured for a tidy profit in a few months. However, there is always some risk that the deal doesn’t close. In that case, B’s stock price might head back down to Rs. 75 (or lower). So you see that this is not completely risk free, however the downside is limited.

Here’s Sal Khan again, explaining the Merger Arbitrage –

There are well-documented statistics on percentages of announced mergers that never close, don’t get government approval, don’t get shareholder approval, or the like. If you don’t understand the business and these dynamics, it’s better to stay away from such transactions. These kind of corporate events – mergers, spin-offs, open offers, buybacks, restructuring etc. – are also known as special situation investing.

Buffett has practiced arbitrage for decades and according to his own estimates he has averaged annual pre-tax returns of at least 25% from arbitrage. In his 1986 letter to shareholders, Buffett wrote –

You will notice that we had significant holding in Beatrice companies at year end. This is a short-term arbitrage holding – in effect, a parking place for our money (though not a totally safe one, since deals sometimes fall through and create substantial losses). We sometimes enter the arbitrage field when we have more money than ideas, but only to participate in announced mergers and sales.

So how do you evaluate arbitrage opportunities? Here’s the blueprint from Warren Buffett –

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 doesn’t take place because of anti-trust action, financing glitches, etc.?

If that’s not enough for you, Joel Greenblatt has written a wonderful book – You Can Be A Stock Market Genius – on this subject.

Now before you get too excited about arbitrage style of investing, you should note that in today’s world where information flows too quickly, you have to stay on top of your arbitrage bets all the time. It’s quite different from the long term value investing which requires you to buy good businesses and holding them for long time.

Mind you, even Buffett got into arbitrage deals only to utilize the uninvested cash. It wasn’t his first choice either. Explaining Berkshire’s take on arbitrage investing, Buffett writes –

Arbitrage positions are substitute for short-term cash equivalents, and during part of the year [1989] we held relatively low levels of cash. In the rest of the year, we had a fairly good-sized cash position and even so chose not to engage in arbitrage. The main reason was corporate transactions made no economic sense to us; arbitraging such deals comes too close to playing greater-fool game.

Another aspect of special situation investing you have to keep in mind is that usually the arbitrage opportunity arises out of corporate events and the quality of underlying business becomes irrelevant in this operation. Which means an adequate diversification is required to bring in the margin of safety. Because betting a significant part of your capital on a single arbitrage deal, even if it’s a short term bet, can be dangerous.

Buffett says –

Berkshire’s arbitrage activities differ from those of many arbitrageurs. First, we participate in only a few, and usually very large, transactions each year. Most practitioners buy into a great many deals perhaps 50 or more per year. With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks. This is not how Charlie nor I wish to spend our lives. (What’s the sense in getting rich just to stare at a ticker tape all day?)

Here’s what Prof. Sanjay Bakshi mentioned in his interview with Safal Niveshak –

You can make a lot of money doing risk arbitrage where you have to monitor — perhaps 20 deals at any given point of time and be ready to react quickly when odds change. But it’s stressful.

The concept of arbitrage isn’t limited to investing only. The arbitrage mental model is based on the mis-pricing mindset and can be applied just as well in business. Outsourcing, for example, is the buying of labour in one location for sale in another.

The biggest indian IT companies like TCS, Infosys, and Wipro derive most of their revenues by exploiting the low-cost offshore arbitrage model. These businesses incurs most of their expenses in rupees (as salaries and other costs for offshore employees are borne in India) and revenues are billed in dollars.

Time Arbitrage

Here’s another interesting take on the idea of arbitrage. When you buy a good quality business for a cheap price and hold it for long time, what you are essentially doing is an arbitrage – buying cheaper from one place (present) and selling at higher price another place (future), thus pocketing the spread.

This is time arbitrage and it’s a huge advantage for a small investor who is willing to stay invested for long term. If Mr. Market and its other participants are discounting things 12-15 months down the line, and if you can look out 5-10 years, you will have a time arbitrage advantage, which is a structural advantage to have.

Time arbitrage is not easy. A few months of a falling market or seeing your stocks going nowhere can feel like years. The impulse to “do something” can be overwhelming. Unfortunately, that impulse, more often than not, would hurt your long-term returns.

Time arbitrage yields tremendous financial and psychological benefits for those with the discipline to hold fast against the noise. This is an edge worth cultivating. It costs nothing but time and can be applied by anyone, including you.

Conclusion

Speaking at Columbia Business School, Warren Buffett once said –

Because my mother isn’t here tonight, I’ll even confess to you that I’ve been an arbitrageur.

That should give you a clue that it’s not something even Buffett feels very proud of. The game of arbitrage is exciting but has the potential to derail your focus from long term investing.

Take this advice from Buffett, which he dispensed in his 1989 letter, seriously –

Arbitrage has looked easy recently. But this is not a form of investing that guarantees profits of 20% a year or, for that matter, profits of any kind. As noted, the market is reasonably efficient much of the time. An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better a strategy than selecting a portfolio by throwing darts.

Learning arbitrage gives you insights about its presence in different business models, but applying it in your own investing is something which needs a close evaluation of your own temperament.

If you want to learn more about arbitrage, go to Prof. Sanjay Bakshi’s blog and search for the word ‘arbitrage’. The results will keep you busy for weeks.

Take care and keep learning.