| blast_investor Tue Nov 27, 2007 12:52 pm |
|
|
Buffett Arbitrage Play in 1988
Arbitrage Chapter from Buffett 1988 annual letter:
http://www.berkshirehathaway.com/letters/1988.html
Author: Warren Buffett
------------start--------
Arbitrage
In past reports we have told you that our insurance
subsidiaries sometimes engage in arbitrage as an alternative to
holding short-term cash equivalents. We prefer, of course, to
make major long-term commitments, but we often have more cash
than good ideas. At such times, arbitrage sometimes promises
much greater returns than Treasury Bills and, equally important,
cools any temptation we may have to relax our standards for long-
term investments. (Charlie’s sign off after we’ve talked about
an arbitrage commitment is usually: “Okay, at least it will keep
you out of bars.”)
During 1988 we made unusually large profits from arbitrage,
measured both by absolute dollars and rate of return. Our pre-
tax gain was about $78 million on average invested funds of about
$147 million.
This level of activity makes some detailed discussion of
arbitrage and our approach to it appropriate. Once, the word
applied only to the simultaneous purchase and sale of securities
or foreign exchange in two different markets. The goal was to
exploit tiny price differentials that might exist between, say,
Royal Dutch stock trading in guilders in Amsterdam, pounds in
London, and dollars in New York. Some people might call this
scalping; it won’t surprise you that practitioners opted for the
French term, arbitrage.
Since World War I the definition of arbitrage - or “risk
arbitrage,” as it is now sometimes called - has expanded to
include the pursuit of profits from an announced corporate event
such as sale of the company, merger, recapitalization,
reorganization, liquidation, self-tender, etc. In most cases the
arbitrageur expects to profit regardless of the behavior of the
stock market. The major risk he usually faces instead is that
the announced event won’t happen.
Some offbeat opportunities occasionally arise in the
arbitrage field. I participated in one of these when I was 24
and working in New York for Graham-Newman Corp. Rockwood & Co.,
a Brooklyn based chocolate products company of limited
profitability, had adopted LIFO inventory valuation in 1941
when cocoa was selling for 50 cents per pound. In 1954 a
temporary shortage of cocoa caused the price to soar to over
60 cents. Consequently Rockwood wished to unload its valuable
inventory - quickly, before the price dropped. But if the cocoa
had simply been sold off, the company would have owed close to
a 50% tax on the proceeds.
The 1954 Tax Code came to the rescue. It contained an
arcane provision that eliminated the tax otherwise due on LIFO
profits if inventory was distributed to shareholders as part of a
plan reducing the scope of a corporation’s business. Rockwood
decided to terminate one of its businesses, the sale of cocoa
butter, and said 13 million pounds of its cocoa bean inventory
was attributable to that activity. Accordingly, the company
offered to repurchase its stock in exchange for the cocoa beans
it no longer needed, paying 80 pounds of beans for each share.
For several weeks I busily bought shares, sold beans, and
made periodic stops at Schroeder Trust to exchange stock
certificates for warehouse receipts. The profits were good and
my only expense was subway tokens.
The architect of Rockwood’s restructuring was an unknown,
but brilliant Chicagoan, Jay Pritzker, then 32. If you’re
familiar with Jay’s subsequent record, you won’t be surprised to
hear the action worked out rather well for Rockwood’s continuing
shareholders also. From shortly before the tender until shortly
after it, Rockwood stock appreciated from 15 to 100, even though
the company was experiencing large operating losses. Sometimes
there is more to stock valuation than price-earnings ratios.
In recent years, most arbitrage operations have involved
takeovers, friendly and unfriendly. With acquisition fever
rampant, with anti-trust challenges almost non-existent, and with
bids often ratcheting upward, arbitrageurs have prospered
mightily. They have not needed special talents to do well; the
trick, a la Peter Sellers in the movie, has simply been “Being
There.” In Wall Street the old proverb has been reworded: “Give a
man a fish and you feed him for a day. Teach him how to
arbitrage and you feed him forever.” (If, however, he studied at
the Ivan Boesky School of Arbitrage, it may be a state
institution that supplies his meals.)
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.?
Arcata Corp., one of our more serendipitous arbitrage
experiences, illustrates the twists and turns of the business.
On September 28, 1981 the directors of Arcata agreed in principle
to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR),
then and now a major leveraged-buy out firm. Arcata was in the
printing and forest products businesses and had one other thing
going for it: In 1978 the U.S. Government had taken title to
10,700 acres of Arcata timber, primarily old-growth redwood, to
expand Redwood National Park. The government had paid $97.9
million, in several installments, for this acreage, a sum Arcata
was contesting as grossly inadequate. The parties also disputed
the interest rate that should apply to the period between the
taking of the property and final payment for it. The enabling
legislation stipulated 6% simple interest; Arcata argued for a
much higher and compounded rate.
Buying a company with a highly-speculative, large-sized
claim in litigation creates a negotiating problem, whether the
claim is on behalf of or against the company. To solve this
problem, KKR offered $37.00 per Arcata share plus two-thirds of
any additional amounts paid by the government for the redwood
lands.
Appraising this arbitrage opportunity, we had to ask
ourselves whether KKR would consummate the transaction since,
among other things, its offer was contingent upon its obtaining
“satisfactory financing.” A clause of this kind is always
dangerous for the seller: It offers an easy exit for a suitor
whose ardor fades between proposal and marriage. However, we
were not particularly worried about this possibility because
KKR’s past record for closing had been good.
We also had to ask ourselves what would happen if the KKR
deal did fall through, and here we also felt reasonably
comfortable: Arcata’s management and directors had been shopping
the company for some time and were clearly determined to sell.
If KKR went away, Arcata would likely find another buyer, though
of course, the price might be lower.
Finally, we had to ask ourselves what the redwood claim
might be worth. Your Chairman, who can’t tell an elm from an
oak, had no trouble with that one: He coolly evaluated the claim
at somewhere between zero and a whole lot.
We started buying Arcata stock, then around $33.50, on
September 30 and in eight weeks purchased about 400,000 shares,
or 5% of the company. The initial announcement said that the
$37.00 would be paid in January, 1982. Therefore, if everything
had gone perfectly, we would have achieved an annual rate of
return of about 40% - not counting the redwood claim, which would
have been frosting.
All did not go perfectly. In December it was announced that
the closing would be delayed a bit. Nevertheless, a definitive
agreement was signed on January 4. Encouraged, we raised our
stake, buying at around $38.00 per share and increasing our
holdings to 655,000 shares, or over 7% of the company. Our
willingness to pay up - even though the closing had been
postponed - reflected our leaning toward “a whole lot” rather
than “zero” for the redwoods.
Then, on February 25 the lenders said they were taking a
“second look” at financing terms “ in view of the severely
depressed housing industry and its impact on Arcata’s outlook.”
The stockholders’ meeting was postponed again, to April. An
Arcata spokesman said he “did not think the fate of the
acquisition itself was imperiled.” When arbitrageurs hear such
reassurances, their minds flash to the old saying: “He lied like
a finance minister on the eve of devaluation.”
On March 12 KKR said its earlier deal wouldn’t work, first
cutting its offer to $33.50, then two days later raising it to
$35.00. On March 15, however, the directors turned this bid down
and accepted another group’s offer of $37.50 plus one-half of any
redwood recovery. The shareholders okayed the deal, and the
$37.50 was paid on June 4.
We received $24.6 million versus our cost of $22.9 million;
our average holding period was close to six months. Considering
the trouble this transaction encountered, our 15% annual rate of
return excluding any value for the redwood claim - was more than
satisfactory.
But the best was yet to come. The trial judge appointed two
commissions, one to look at the timber’s value, the other to
consider the interest rate questions. In January 1987, the first
commission said the redwoods were worth $275.7 million and the
second commission recommended a compounded, blended rate of
return working out to about 14%.
In August 1987 the judge upheld these conclusions, which
meant a net amount of about $600 million would be due Arcata.
The government then appealed. In 1988, though, before this
appeal was heard, the claim was settled for $519 million.
Consequently, we received an additional $29.48 per share, or
about $19.3 million. We will get another $800,000 or so in 1989.
Berkshire’s arbitrage activities differ from those of many
arbitrageurs. First, we participate in only a few, and usually
very large, transactions each year. Most practitioners buy into
a great many deals perhaps 50 or more per year. With that many
irons in the fire, they must spend most of their time monitoring
both the progress of deals and the market movements of the
related stocks. This is not how Charlie nor I wish to spend our
lives. (What’s the sense in getting rich just to stare at a
ticker tape all day?)
Because we diversify so little, one particularly profitable
or unprofitable transaction will affect our yearly result from
arbitrage far more than it will the typical arbitrage operation.
So far, Berkshire has not had a really bad experience. But we
will - and when it happens we’ll report the gory details to you.
The other way we differ from some arbitrage operations is
that we participate only in transactions that have been publicly
announced. We do not trade on rumors or try to guess takeover
candidates. We just read the newspapers, think about a few of
the big propositions, and go by our own sense of probabilities.
At yearend, our only major arbitrage position was 3,342,000
shares of RJR Nabisco with a cost of $281.8 million and a market
value of $304.5 million. In January we increased our holdings to
roughly four million shares and in February we eliminated our
position. About three million shares were accepted when we
tendered our holdings to KKR, which acquired RJR, and the
returned shares were promptly sold in the market. Our pre-tax
profit was a better-than-expected $64 million.
Earlier, another familiar face turned up in the RJR bidding
contest: Jay Pritzker, who was part of a First Boston group that
made a tax-oriented offer. To quote Yogi Berra; “It was deja vu
all over again.”
During most of the time when we normally would have been
purchasers of RJR, our activities in the stock were restricted
because of Salomon’s participation in a bidding group.
Customarily, Charlie and I, though we are directors of Salomon,
are walled off from information about its merger and acquisition
work. We have asked that it be that way: The information would
do us no good and could, in fact, occasionally inhibit
Berkshire’s arbitrage operations.
However, the unusually large commitment that Salomon
proposed to make in the RJR deal required that all directors be
fully informed and involved. Therefore, Berkshire’s purchases of
RJR were made at only two times: first, in the few days
immediately following management’s announcement of buyout plans,
before Salomon became involved; and considerably later, after the
RJR board made its decision in favor of KKR. Because we could
not buy at other times, our directorships cost Berkshire
significant money.
Considering Berkshire’s good results in 1988, you might
expect us to pile into arbitrage during 1989. Instead, we expect
to be on the sidelines.
One pleasant reason is that our cash holdings are down -
because our position in equities that we expect to hold for a
very long time is substantially up. As regular readers of this
report know, our new commitments are not based on a judgment
about short-term prospects for the stock market. Rather, they
reflect an opinion about long-term business prospects for
specific companies. We do not have, never have had, and never
will have an opinion about where the stock market, interest
rates, or business activity will be a year from now.
Even if we had a lot of cash we probably would do little in
arbitrage in 1989. Some extraordinary excesses have developed in
the takeover field. As Dorothy says: “Toto, I have a feeling
we’re not in Kansas any more.”
We have no idea how long the excesses will last, nor do we
know what will change the attitudes of government, lender and
buyer that fuel them. But we do know that the less the prudence
with which others conduct their affairs, the greater the prudence
with which we should conduct our own affairs. We have no desire
to arbitrage transactions that reflect the unbridled - and, in
our view, often unwarranted - optimism of both buyers and
lenders. In our activities, we will heed the wisdom of Herb
Stein: “If something can’t go on forever, it will end.” |
|
| xuedong_zhang Thu Nov 29, 2007 3:56 pm |
|
|
Re: Buffett Arbitrage Play in 1988
He use this as an alternative to holding short-term equivalents?
So looks like he don't have a big position in such a play?
blast_investor wrote: Arbitrage Chapter from Buffett 1988 annual letter:
http://www.berkshirehathaway.com/letters/1988.html
Author: Warren Buffett
------------start--------
Arbitrage
In past reports we have told you that our insurance
subsidiaries sometimes engage in arbitrage as an alternative to
holding short-term cash equivalents.
|
|
| blast_investor Thu Nov 29, 2007 4:21 pm |
|
|
Re: Buffett Arbitrage Play in 1988
xuedong_zhang wrote: He use this as an alternative to holding short-term equivalents?
So looks like he don't have a big position in such a play?
See below text from above:
Berkshire’s arbitrage activities differ from those of many
arbitrageurs. First, we participate in only a few, and usually
very large, transactions each year. Most practitioners buy into
a great many deals perhaps 50 or more per year. With that many
irons in the fire, they must spend most of their time monitoring
both the progress of deals and the market movements of the
related stocks. This is not how Charlie nor I wish to spend our
lives. (What’s the sense in getting rich just to stare at a
ticker tape all day?)
Because we diversify so little, one particularly profitable
or unprofitable transaction will affect our yearly result from
arbitrage far more than it will the typical arbitrage operation.
So far, Berkshire has not had a really bad experience. But we
will - and when it happens we’ll report the gory details to you.
The other way we differ from some arbitrage operations is
that we participate only in transactions that have been publicly
announced. We do not trade on rumors or try to guess takeover
candidates. We just read the newspapers, think about a few of
the big propositions, and go by our own sense of probabilities. |
|
| |
Search Engine Indexer
BlastInvest @2005 p h p B B © 2001, 2002 p h p B B Group
|