Arbitrage trading is defined by the Corporate Finance Institute as “the strategy of taking advantage of price differences in different markets for the same asset. For it to take place, there must be a situation of at least two equivalent assets with differing prices. In essence, arbitrage is a situation where a trader can profit from the imbalance of asset prices in different markets.”
So, essentially, you’re looking for a pricing discrepancy in prices between the same ticker symbol in different markets and then simultaneously buying the lower priced option and selling the higher priced option.
While this is the historical definition of arbitrage trading, Warren Buffett talks about a different version of arbitrage trading that they implement at Berkshire Hathaway in his book “The Essays of Warren Buffett”.
In the book, Buffett talks about how Berkshire will invest short-term cash by looking for companies that have an announced purchase offer for them and then buying that stock to try to find some value between the price that they can buy at and the price that the company will eventually be sold for.
To effectively be able to find a good arbitrage opportunity you need to be able to evaluate the four questions below, taken directly from The Essays of Warren Buffett:
- How likely is it that the promised event will indeed occur?
- How long will your money be tied up?
- What chance is there that something still better will transpire – a competing takeover bid, for example
- What will happen if the event does not take place because of an anti-trust action, financing glitches, etc.
If you can answer these questions, then you’re on a good track for being able to effectively evaluate the potential opportunity.
An example of arbitrage trading that Buffett uses is in 1981 when Arcata and Kohlberg Kravis Roberts & Co (KKR) agreed to a deal for Arcata to sell their company to KKR for $37/shar plus 2/3 of any additional amounts paid by the government for the redwood lands.
You see, Arcata was just an average business, but the government had taken title to 10,700 acres of their land in 1978 alone, earning the company $97.9 million, for the land.
When this opportunity arose, Berkshire had to continue to evaluate those four questions listed above to determine the potential that they deal would actually go through and if there would be sufficient value for the risk. Berkshire determined that the risk was in fact worth the reward, so they began to buy shares of the company.
Initially, Berkshire was buying stock at a price of $33.50/share and they had purchased 400,000 shares within a couple weeks. Everything didn’t go smooth and the transaction of the sale continued to get delayed but rather than Berkshire panicking, they doubled down and continued to buy shares around $38 and now we’re sitting at 655,000 shares in total.
Long story, short, the transaction finally did go through and the company made right around $22 million off their initial investment of ~$23 million. Not bad at all. They were able to stick to their roots and find a company that was severely undervalued in the short term, not necessarily because of their business operations, but because of they land that they owned which was by far the largest reason for the large amount that Berkshire received.
All in all, I think that arbitrage trading is a pretty risk game for the common investor, but I do think that major lessons can be learned here. This is quite simply just another example of the greatest investor of all time, Warren Buffett, finding a new, unique way to invest in undervalued companies.
Rather than Buffett finding the arbitrage between two different markets, he’s using arbitrage trading to identify the difference between what the purchase/sale price of a company is and the current price that the company is selling for on the open market.
As always, it is very important not to speculate and to stick to your guns so that you’re not overpaying for a company. You’ll notice in the chapter that Buffett talks about how much they evaluated the opportunity before jumping in headfirst.
They were extremely extensive in their analysis of the situation to make sure that they opportunity truly did have value because there is a great opportunity to lose your ass doing something like this, but that’s why Buffett is the greatest investor of all time.
For the common investor, I think that arbitrage trading in the sense that Buffett uses it can be hard to accomplish. Many times, you might see an announcement take place for a sale of a company at a 30% increase over the current stock price and then the stock price will immediately appreciate to that amount.
If you can get in and buy the stock before that price appreciation occurs, by all means go for it – but know that you’re no longer buying on financials – it’s purely on the speculation of the sale of that company and if it falls through for whatever reason, you’re SOL.
I’ll admit – I have done this before and it did work out, but it doesn’t always. If things start to look like the deal won’t get done, you’re likely going to see the stock price drop back down a bit. At the end of the day, this is the definition of speculation, and you know how I feel about speculating. You can speculate if you want, but it better not be a huge portion of your portfolio because there’s a very real chance that you lose it all.
“But Andy, Buffett did it! Why can’t I?” You can! But Buffett only did this in very specific situations and only with short-term cash – never anything long-term. Buffett was doing this to try to find a quick way to take advantage of cash that was sitting around and somewhat useless at the time.
This was such a small part of their portfolio, and it should likely be an even smaller part of yours.