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You can be a stock market genius – arbitrage and merger securities

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The next topic in the book is on arbitrage and merger securities. Risk arbitrage is the purchase of stock in a business that is subject to an announced merger or takeover.

Risk arbitrage involves two kinds of risk. The first risk is event risk. The deal or merger may not go through due to various problems such regulatory issues, financial problems, unforseen events.

The second nature of risk is the timing risk. For ex: A company A announces the buyout of another company B. Company B trades at 200. The buyout offer is at a premium of 20%. As a result of the announcement, the stock rises to 230. This is still below the deal price of 240 and give rise to an arbitrage of 10 per share (4.3%). Now the time take for the deal to play out will have a big impact on the eventual returns. If the deal takes 2 months, the returns are 25%+. However if the deal takes a year, then the return falls to around 4% which is below the risk free rate.

Finally the area of risk arbitrage is now fairly competitive and the typical returns have come down over the years. As a result the risk/ reward equation is not compelling in several situations and hence the author advises that non-professional investors should stay away from this area of arbitrage

The next sub-topic is on merger securities. These are securities such as warrants, bonds, shares etc which are issued by the acquirer to pay for an acquisition. These securities, issued during the merger, may not really be desired by the large investors for various reasons (similar to the spin-offs). The reason could be the restrictions on the institutional investor such as a stock fund may not be allowed to hold bond securities issued during a merger. In addition some securities such as warrants may not be large enough for the large investors to get interested. Finally due to the various reasons, these securities are sold off without regard to the investment merits. As a result these securities can be purchased below their intrinsic value

Thus merger securities are similar to spin-offs and an investor who is able to do a certain amount of analysis and due-diligence may be able to profit from both the special events.

My thoughts : I have seen a few merger and acquisition announcements in the past. However these coporate events are not as frequent in the Indian market as compared to other foreign markets. Also the pricing in quite a few of these merger announcements is fairly efficient and these is little opportunity for a small investor to earn a good return (without leverage). However it is still a good area to investigate if one is interested in extra returns. A word of caution though – aribitrage of any kind requires continous effort and may not be too truly appropriate for a part time investor.

Wisdom of the crowds

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There is a new article by michael mauboussin on wisdom of the crowds (see here). There is also a book on the same topic which I read earlier (see here). Website of the book’s author here.
The key take-away for me from the article and book has been as follows

1. The crowd is usually smarter than an individual. This means that one should discount what the experts are saying (most of the times). One should not waste time in heeding to their forecasts. It makes sense to read the insights of investment masters or good investors. One can learn from that, but stay away from forecast (especially short term) by the so called experts. Most of the personal finance websites is full of this junk. I consider it mostly as noise

2. The crowd (market) is right most of the time. What that means is that the valuation of most of the companies is right. It is not always right, but most of the time it is right. As a result if I think that the stock is undervalued and a good buy, I try to analyse my assumptions in depth and check my variant perception in more detail to be sure that I have got it right and market is wrong on it. Almost 90-95 % of times I have found that the market is right and my edge is limted to 5-10 % of the cases.

3. Be humble – One should always have a growth mindset and learn from the market and others.

4. Even if individual investors are not extremely smart, the market as a whole is smarter than the smartest individuals ( see the article and book on how this is true)

5. There are a few situations (bubbles and crashes) when the diversity and collective wisdom breaks down. In such situations, it makes sense to diverge in your thinking from the market and not be swept by the euophoria or pessimism. For ex : the dotcom boom of 2000

I would recommend reading the article and the book as it would be a great addition to one’s mental models.

Disclosure : I have no financial interest in anyone buying ,borrrowing or stealing the book. Unlike stocks, I am always happy to recommend books as there is a limited downside to these recommendations

How I am reacting to the interest rate tightening

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I got the following comment from ranjit and gave the response below

Hi Rohit,
Today RBI has increased repo & CRR again. Please can you give me your historical perspective on these high interest rates and also what would you do in such situations, would you move into FD’s for some time or would you stay invested fully.

hi ranjit
my personal experience with interest rates has been from 95 onwards when i saw the rates move to 15% and since then it has been a downwards movement.my stock market positions are not based entirely on interest rates (at least not in the past). if i find a compelling buy, i go ahead with it if the expected returns are good.since 2003 i have moved into floating rate funds and plan to continue . floating rate funds are more tax efficient than FD’s and far more liquid , although absolute returns are less

In addition I plan to do the following

1. continue with a laddered approach to fixed deposit investing. What I mean by laddered approach is that I would be investing in FD’s over the next few months across the most attractive maturities. Currently the 1yr+16 day duration seems to be most attractive to me (the 2yr + 16 days gives 0.25 % more , but is not attractive for the extra duration). In addition, I do not plan to put all my funds into FD’s as one go as I do not have an idea how interest rates will move in the next 6 months. I expect them to stay as is or harden a bit, but frankly your guess is as good as mine. So my fixed income investing will be spaced out over the next few months.

2. Continue with floating rate funds which are more tax efficient than FD’s and far more liquid. The absolute returns are low, but they can serve as a good place to park extra funds

3.The bar for the stock market investing is now higher. I generally use a discount rate of 11-13% . I do not plan to revise it.

4. FD’s and fixed income mutual funds have now started to become a viable alternative to investing in index funds. I am not too keen on the index till the index drops by another 20% or remains flat while earnings catch up.

5. Finally, bad time to take any kind of loans – housing or otherwise.

See here for an earlier post on the same topic

You can be a stock market genius – Spin offs

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The first topic in the book is Spin-offs. When a company decides to ‘spin-off’ a subsidiary or business, it may issue shares of the division being spun off to the existing shareholders. This spin-off may be 100% where in the parent company distributes its entire holding of the spun-off division to the exisiting shareholders based on the valuation of the division.

For ex: when reliance was split into the petrochemical, communication and other businesses, the shareholder were given shares in the spun off divisions based on the valuation of each business.

Spin-offs may partial where the parent wants the market to realize the value of the division and so by doing a partial spin off, the newly spun off company is now valued by the market independently. This enables the company to demonstrate the hidden value of its subsidiary and get a better valuation for the whole company.

In addition there are a few additional reason for spin-offs

a. The company wishes to spin-off a poorly performing division and improve the valuation of the parent company
b. In a regulated industry, by spinning off the regulated division, the parent can operate in a non regulated environment c. The company wishes to improve the valuation of the company by making the subsidiary an independent company with its own management and policies. This improves the valuation of the parent and the spun off company as both can now focus on their core businesses.

The reasons why spin-offs create an opportunity for the investor are listed below

a. The spun off division may be very small with a low market cap. As a result large instutional investors may not be interested in holding it due to various constraints. This creates a selling pressure and drives down the price.
b. The spun off division with its independent management can now focus on the business better and hence perform better in the future
c. The market may give a better valuation to the spunoff business depending on the nature of the industry in which it operates

update : 03/29

An additional approach to profit from spin offs is to look for situations where the company plans to conduct a rights issue instead of an outright spin-off of the subsidiary. In such cases the company is planning to ‘sell’ the division to its shareholders via a rights issue and raise some capital at the same time.

This modified and rare type of spinoff approach is profitable for the same reason as the usual spin off. In such cases large institutional investors may not subscribe to the offer due to illiquidity of the new issue. In addition if the spin off via rights is beneficial to the insiders , then it would make a lot of sense to subscribe to this spin off via rights purchased from the market or via direct purchase of the parent company’s stock.

An additional point repeated by the author several times in this section is that an investor should analyse closely the actions and motivations of the insiders during the spin off. Does the spin-off benefit the insiders ? do they have a stake on the upside ? Answers to these questions would help an investor make a good decision

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