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The next topic in the book is on arbitrage and merger securities. Risk arbitrage is the purchase of stock in a business that is subject to an announced merger or takeover.

Risk arbitrage involves two kinds of risk. The first risk is event risk. The deal or merger may not go through due to various problems such regulatory issues, financial problems, unforseen events.

The second nature of risk is the timing risk. For ex: A company A announces the buyout of another company B. Company B trades at 200. The buyout offer is at a premium of 20%. As a result of the announcement, the stock rises to 230. This is still below the deal price of 240 and give rise to an arbitrage of 10 per share (4.3%). Now the time take for the deal to play out will have a big impact on the eventual returns. If the deal takes 2 months, the returns are 25%+. However if the deal takes a year, then the return falls to around 4% which is below the risk free rate.

Finally the area of risk arbitrage is now fairly competitive and the typical returns have come down over the years. As a result the risk/ reward equation is not compelling in several situations and hence the author advises that non-professional investors should stay away from this area of arbitrage

The next sub-topic is on merger securities. These are securities such as warrants, bonds, shares etc which are issued by the acquirer to pay for an acquisition. These securities, issued during the merger, may not really be desired by the large investors for various reasons (similar to the spin-offs). The reason could be the restrictions on the institutional investor such as a stock fund may not be allowed to hold bond securities issued during a merger. In addition some securities such as warrants may not be large enough for the large investors to get interested. Finally due to the various reasons, these securities are sold off without regard to the investment merits. As a result these securities can be purchased below their intrinsic value

Thus merger securities are similar to spin-offs and an investor who is able to do a certain amount of analysis and due-diligence may be able to profit from both the special events.

My thoughts : I have seen a few merger and acquisition announcements in the past. However these coporate events are not as frequent in the Indian market as compared to other foreign markets. Also the pricing in quite a few of these merger announcements is fairly efficient and these is little opportunity for a small investor to earn a good return (without leverage). However it is still a good area to investigate if one is interested in extra returns. A word of caution though – aribitrage of any kind requires continous effort and may not be too truly appropriate for a part time investor.

The first topic in the book is Spin-offs. When a company decides to ‘spin-off’ a subsidiary or business, it may issue shares of the division being spun off to the existing shareholders. This spin-off may be 100% where in the parent company distributes its entire holding of the spun-off division to the exisiting shareholders based on the valuation of the division.

For ex: when reliance was split into the petrochemical, communication and other businesses, the shareholder were given shares in the spun off divisions based on the valuation of each business.

Spin-offs may partial where the parent wants the market to realize the value of the division and so by doing a partial spin off, the newly spun off company is now valued by the market independently. This enables the company to demonstrate the hidden value of its subsidiary and get a better valuation for the whole company.

In addition there are a few additional reason for spin-offs

a. The company wishes to spin-off a poorly performing division and improve the valuation of the parent company
b. In a regulated industry, by spinning off the regulated division, the parent can operate in a non regulated environment c. The company wishes to improve the valuation of the company by making the subsidiary an independent company with its own management and policies. This improves the valuation of the parent and the spun off company as both can now focus on their core businesses.

The reasons why spin-offs create an opportunity for the investor are listed below

a. The spun off division may be very small with a low market cap. As a result large instutional investors may not be interested in holding it due to various constraints. This creates a selling pressure and drives down the price.
b. The spun off division with its independent management can now focus on the business better and hence perform better in the future
c. The market may give a better valuation to the spunoff business depending on the nature of the industry in which it operates

update : 03/29

An additional approach to profit from spin offs is to look for situations where the company plans to conduct a rights issue instead of an outright spin-off of the subsidiary. In such cases the company is planning to ‘sell’ the division to its shareholders via a rights issue and raise some capital at the same time.

This modified and rare type of spinoff approach is profitable for the same reason as the usual spin off. In such cases large institutional investors may not subscribe to the offer due to illiquidity of the new issue. In addition if the spin off via rights is beneficial to the insiders , then it would make a lot of sense to subscribe to this spin off via rights purchased from the market or via direct purchase of the parent company’s stock.

An additional point repeated by the author several times in this section is that an investor should analyse closely the actions and motivations of the insiders during the spin off. Does the spin-off benefit the insiders ? do they have a stake on the upside ? Answers to these questions would help an investor make a good decision

I am currently re-reading the book by ‘Joel Greenblatt’. I will post my thoughts and key points which catch my eye. It is not a book summary or review. Look at it more as running notes on the book (based on memory).

– 8-9 stocks can help one diversify almost 80-90% of the non-market risk. With 20+ stocks the non-market risk reduces by almost 95 % (quoting from memory)
– don’t depend on broker recommendations. They are baised on buy side as they make commision if you buy stocks. Also as there are always more stocks to buy (for an investor) than to sell (one’s holding is limited in comparison to the total universe of available stocks), brokers are more interested in generating buy recommendations. Have seen the same in india. As a result I tend to look at sell recommendations more closely than buy recommendations.
– small cap and midcap is a fertile ground to find undervalued stocks as these stocks are neglected by brokers and also by large investors due to various size, legal and other types of restrictions.

I will keep posting more notes as I continue reading the book