Nick asked me about doing arbitrage on mergers. His point is that the market has jumped massively since last March when I said to get back in and he's made out well ... but what now? Is this an opportunity to profit from buying into potential mergers?
So called 'merger arbitrage' is a risky business that Mr. Buffett plays from time to time. It can be a Rule #1 strategy. Here's how it works: Rupert Murdoch wants to buy the Wall Street Journal. It is selling its stock for $36. He makes an offer and its accepted by the WSJ board - $60 a share. On the announcement of the deal, the stock price initially jumps from $36 to $59 but then news comes out that a family with pile of WSJ stock doesn't like Mr. Murdoch and doesn't want to sell and the stock price falls to $54. The gap between the $54 price and the $60 value (the value was defined by a firm and accepted offer) creates a classic Rule #1 opportunity. We like to buy $10 bills for $5, right? But if we can buy $60 for $54 and get our $6 profit in a couple of months, that can work out well, too.
There are two things we have to know: 1) Will the deal happen? and 2) How long will it take? If we know these things we can figure out our annualized risk adjusted rate of return and decide if its high enough to do the deal.
Why 'risk adjusted'? Well, no one knows for sure the deal will happen because this family has the power to block the deal and they seem intent on doing so. On the other hand, Mr. Murdoch is an intense guy who usually gets what he's after. So there is some risk here that the deal won't go through. What we do to determine whether this is a good deal for us is to apply a specific type of risk evaluation that creates a kind of Margin of Safety (MOS) analysis. You have to know these five things:
1. Probability the deal goes through (Prob%):
2. Probability the deal fails to go through (Fail%)
3. Potential profit (Prof$):
4. Potential loss (Loss$)
5. Time to realize profit (Time%):
The 'risk adjusted' formula is: (Prob% * Prof$) - (Fail% * Loss$) = Risk Adjusted Profit
Here's how that looks for the Dow Jones deal:
1. Prob% is 95% because Murdoch is intent on it and the WSJ CEO wants a payday
2. Fail% is 5% (100%-95%)
3. Prof$ is the $60 offer minus $54 current stock price. Prof$ = $6
4. Loss$ is $54 price we have to pay minus what the stock sells for if deal fails - say back to where it was - $36. So $54-$36=$18. Loss$ = $18
5. Time% is the Time for deal to go through: best guess based on news from board or completion date. 2 months. 2 months / 12 months = 17% of a year.
Do the formula: (Prob% * Prof$) - (Fail% * Loss$) = Risk Adjusted Profit
(95% * 6) - 5% * 18) = RAP
5.7 - .9 = 4.8
$4.80 is the Risk Adjusted Profit
Now calculate your Risk Adjusted Return (RAR): $4.80 / $54 equals 8.9% RAR.
Time% is 17% of a year so the Annualized RAR is the RAR divided by the Time%. 8.9% / 17% = Annualized RAR = 52%
We're looking for an Annualized RAR of over 20%. This is 52%. Therefore we can do the deal.
That's how it works. Kind of cool, huh?
Now go play,
