Qualiport

All Together Now...

by Bruce Jackson (TMF Googly)

Kilburn, London -- Would the Qualiport 8 please mind moving in line? No more of this 3 up, 5 down routine. If you're going to have any hope of catching the FTSE 100 Index this year, you'll have to get your collective acts together.

And hey you, EMAP (LSE: EMA), what do you think you are doing? Giving us hope one day and despair the next. Please report to the headmaster and explain your underperformance of today. It's not good enough. If it wasn't for your 40p drop, we'd have taken swathes out of the index's lead. Take a leaf out of Independent Insurance's (LSE: IIG) book, up almost 9% today. Or PizzaExpress (LSE: PIZ), up to a new high today. And Rentokil Initial (LSE: RTO) -- what are you looking at? Another down day for you, too. Don't think this isn't being noticed.

Luckily, we're not too emotional about the share prices of our companies.

The new high for PizzaExpress was despite the decision of the Fools not to have lunch yesterday at their Baker Street branch. This was mainly for Nigel's benefit. We always drag him there, but he's yet to encounter the famed PizzaExpress "experience". But the good news is that the other nameless Italian restaurant we did venture into didn't do itself any favours, so it is struck off my list of future Fool HQ local restaurants. How about it, Nigel -- PizzaExpress next time?

Unilever (LSE: ULVR) also finished on the positive side today. However, come Monday morning, be prepared for a big fall in the underlying share price. This is because they will be quoted ex the 66.13p special dividend, which will be paid to shareholders on 9th June. There will also be a share consolidation whereby our holding will change from 298 shares to 266 shares. However, this won't change the percentage of Unilever that the Qualiport owns.

Probabilities

If you are to succeed as a stock market investor, whether you know it or not, you are often relying on probabilities. The stock market is an uncertain universe, and there's no guarantee that individual share prices will rise or fall, especially in the short term. However, your aim is to put the long-term odds in your favour.

Take latest purchase Misys (LSE: MSY), for example. After we bought the shares at 576p, they rose to as high as 604p before plummeting back down to today's close of 531.5p. Thanks to Admiral (LSE: ADC), the whole Information Technology (IT) sector took a pounding. How could you have predicted that? It's impossible.

(Some may argue that this is true to form for Qualiport shares. With the exception of Rentokil Initial, the other shares rose straight after purchase only to fall back in the weeks and months that followed. Bad timing, or bad management, or both? So far, 4 shares are back in the black whilst 4 still languish in the red)

Arbitrage refers to profiting from the discrepancy in the price of a security quoted in two different markets. For example, Vodafone (LSE: VOD) is quoted in pence on the London Stock Exchange and in US dollars on the New York bourse. The two prices will largely move in line with each other, adjusted for currency differences, but if for some strange reason one moved independently of the other, there would be an opportunity to gain.

A horse race or sporting event may throw up the odd opportunity to gain through arbitrage. In a 2-horse race, if the bookmaker offered you the odds of...

Silver Sovereign -- 6/4 Super Sleuth -- 2/1

you'd be in seventh heaven. Simply place 40 units on Silver Sovereign and 33 units on Super Sleuth, a total outlay of 73 units. Whichever horse won, you'd collect a total of 100 units. The chances of this happening in real life are virtually zero. Bookmakers know all about probabilities, and instead of pricing their book at 77% (as above) they usually have it at 110% or more. That 10% is their margin.

In these arbitrage type situations, there is no risk involved. But, courtesy of computers and advanced communication systems, the chances of pure arbitrage these days are very small. In contrast, Warren Buffett sometimes partakes in arbitrage, but with a risk factor involved. He simply weighs the probabilities and places a large bet when he thinks the odds are in his favour.

On the message boards, many Fools have been attempting to predict the nameless British company that Buffett is allegedly buying into. It was last week's featured thread of the week. One such company may be Allied Domecq (LSE: ALLD), although this is pure speculation on my behalf. However, I want to use the company as an example of how an investor could practice risk arbitrage.

Early this week, it was announced that Whitbread (LSE: WTB) was in talks to buy the pub division of Allied Domecq. Not to be outdone, a couple of other companies expressed an interest in bidding for Allied's pubs, and this has raised the prospect of a bidding war. The figure being bandied about was £2.3 billion. At 540p, that sees the rest of the business valued at about £3.35 billion.

With an opening salvo of £2.3 billion, the pubs business is being valued at 40% of the total company, or 216p per share. Given that the pubs make up 33% of the total turnover, you could conclude that the rest of the Allied Domecq business is fairly valued, at worst, and quite possibly undervalued. And, with other potential bidders hovering for the pubs business, £2.3 billion may turn out to be on the low side.

However, there is a chance that the bid will fall through completely, and that will see Allied Domecq's shares slide back to 486p, the price they were at before the news of Whitbread's potential bid. On the other hand, the pubs could be sold for, say, £2.6 billion, and the rump of the business could be valued at, say, £4.0 billion, or a total of 631p.

Here's where the probability calculations come into play. You assume the chances of the bid falling through are 30% (the NO camp) and the chances of it going through and ultimately being reflected in a total share price value of 631p are 70% (the YES camp). The current share price is 540p.

Using subjective probability...

YES: 70% * (631p less 540p) = 63.7p NO: 30% * (540p less 486p) = 16.2p

That gives a total mathematical expectation of 47.5p (63.7p - 16.2p). If you bought one share now at 540p, there is a potential mathematical return of 8.8% (47.5p / 540p). Putting a time frame on things, if you thought it would all be resolved in the next 6 months, the annualised return on the investment would be 17.6% (8.8% / 6 months * 12 months). This is then compared to the returns on other forms of investments. You can, of course, fiddle with the odds and valuation and come up with a variety of different results.

Now, Buffett probably wouldn't touch this type of risk arbitrage, because there's a little too much uncertainty involved. He prefers to look at situations where the whole company has been bid for and the shares of the acquiree are trading at a discount to that offer. Using probabilities, he would calculate the expected returns and make an investment decision from there.

Risk arbitrage is not some desperate ploy that the Qualiport is going to engage in to try and boost its beleaguered 1999 returns. However, the laws of probability are something to take into account when making any investment, whether it be on a horse race or in the stock market. You want to stack the odds in your favour. Having done the above exercise, it will be interesting to follow the progress of Allied Domecq over the next 6 months.

If you want to learn more about risk arbitrage and probabilities, it's all in Robert Hagstrom's new book called The Warren Buffett Portfolio, available from our bookshop. It's a good read and full of very sound investment and portfolio management theory.

That's all for today. Have a great weekend, and see you on the Qualiport message board.

Company  Change    Bid
DELL   -$1.80   $39.30
EMA     -0.40    12.95
IIG     +0.23     2.90
MKS     -0.01     4.13
MSY     -0.01     5.30
PIZ     +0.30     9.40
RTO     -0.03     3.58
ULVR    +0.22     5.82

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