QUALIPORT
Buffett On Arbitrage

By Maynard Paton (TMFMayn)
October 20, 2003

"While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company.  Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire. Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%." -- Warren Buffett.

Arbitrage has served Warren Buffett well. According to Mary Buffett's book Buffettology, up to 40% of his early investments may have been invested in short-term arbitrage situations. In fact, they helped produce positive returns for the Buffett Partnership in the years when the market headed south. Mary Buffett noted: "It was the arbitrage profits that turned disaster into the stuff financial legends are made of." 

Anomalies

Arbitrageurs exploit market anomalies. A good example of a possible arbitrage situation is the proposed takeover of Amersham (LSE: AHM) by General Electric (NYSE: GE). GE has offered 800p a share for Amersham, but the share price of the medical device company today stands at 745p. (Note: Barring a substantial decline in the dollar relative to sterling, GE has ensured investors will receive 800p worth of GE paper for every Amersham share held.)

An arbitrageur would therefore look to buy Amersham shares for a simple 7.4% gain? Not exactly. Buffett again: "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.?"

For starters, GE's acquisition is not a certainty. Regulatory clearances in the European Union and United States have to be obtained, which may not be forthcoming. Any investigation may take some time, so there's the 'opportunity cost' to consider as well.

In terms of the investment calculations, an arbitrageur needs to determine the probability of success, the time for 'promised event' to complete, the possible upside and the possible downside.

So, assuming there's a 90% chance that GE's bid for Amersham succeeds, a year goes by before shareholders get their money, a possible upside of 55p per share (800p less today's 745p) and a possible downside of 193.5p (745p less 551.5p, the share price prior to Amersham's announcement that it was in talks), the prospective annual return would be:

     (55p * 90%) - (193.5p * 10%) 
     ----------------------------   =  4.05%
                745p

With risk-free gilts offering a 4% annual return, it appears the market is leaving little opportunity for an arbitrage investment. If the Amersham deal takes six months to complete however, the 4.05% return obviously becomes more attractive. You pays your money and takes your choice.

MMT

The weekend Financial Times lists those shares that are currently subject to a formal bid. Scouring the latest table, an offer for IT services firm MMT Computing (LSE: MMT) by rival Microgen (LSE: MCGN) looks to be the only arbitrage possibility.

MMT shareholders have been offered 42p in cash and 2.318 Microgen shares for every MMT share held. With Microgen shares at 46.5p, MMT shares are therefore worth 149.79p. But they presently have a market price of 132.5p.

As well as the bid falling though, MMT arbitrageurs take on another risk. Should Microgen's shares decline, their return will decline also. Unlike the GE/Amersham deal, there's no fixed takeover value in place. However, there are no regulatory issues and with 45% of MMT shares having already accepted the offer, the time to completion should not be too long.

So the MMT upside is 17.28p per share, while the downside is 2.5p per share (MMT shares were 130p prior to the offer announcement.) Using a 95% success probability, the potential return comes to 12.32%:

     (17.28 * 95%) - (2.5p * 5%) 
     --------------------------   = 12.32%
                132.5p

Of course, there are dealing costs and spreads to consider, but the possibility of a 13% profit over what could be a few months may tempt a few arbitrage players.

Quality arbitrageurs?

Arbitrage for the Qualiport then? Not really. Though Buffett can make money from it, arbitrage is a whole new investment ball game. For the Qualiport, straying from a long-term buy and hold strategy to look at special situation 'side bets' will only increase the chance of trouble. Indeed, it could be argued the Qualiport has still to prove the success of its current approach.

More: 1988 Berkshire Hathaway Letter To Shareholders