Protect Your Portfolio With Arbitrage

The current market environment does not inspire near-term optimism. Businesses that were seemingly cheap a few months ago have continued to decline. In the long run, though, investors who maintain their discipline and focus on buying good businesses at bargain prices will be fine. The reality is that Mr. Market has no feelings for any investors, and investors will probably be waiting until 2009 for any meaningful turn in the market.

Whether the market gets better next week, next month, or next year is really anyone's guess. Investors looking to time the market should be ready to pay an expensive price, since market timing usually leads to pain. However, you can profit from arbitrage.

Use arbitrage
Arbitrage is a unique and captivating investment opportunity. Investors prize arbitrage opportunities, sometimes called workouts or special-situation investments. In 1965, while running the Buffett Partnerships, Warren Buffett described the desirability of workout investments:

Workouts ... are the securities with a timetable. They arise from corporate activity -- sell-outs, mergers, reorganizations, spin-offs, etc. In this category we are not talking about rumors or "inside information" pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper.

Arbitrage investments unlock value in a corporate action, and the market's general state usually doesn't affect them. These investments are securities for which investors can predict, with a high degree of confidence, when they will get a return, how much they can expect, and what might upset the apple cart along the way.

Some of the best arbitrage opportunities exist in sour markets. During periods of pessimism, the market doesn't think too highly of corporate promises, and as a result, the door opens for some great, virtually risk-free returns.

A bountiful 2007
Amid all of the credit-market turmoil, 2007 presented some opportunities to make meaningful profits using arbitrage. In the summer of 2007, Rupert Murdoch announced that his News Corp. (NYSE: NWS  ) was offering to buy Dow Jones for some $5.6 billion, or $60 a share. After the announcement, Dow Jones stock shot up to nearly $60.

When stories came out suggesting that the controlling Bancroft family would oppose the deal, the stock gradually declined, and for a time, it was trading well below $55 a share. With the deal expected to close by year's end, this arbitrage opportunity offered a return of more than 10% in a few months. The odds looked very favorable. And with an annualized return of more than 40%, this was a bet well worth making.

A risk-free Countrywide
A couple of weeks ago, Bank of America (NYSE: BAC  ) agreed to purchase Countrywide Financial (NYSE: CFC  ) for some $4 billion in stock. This offer represented about $7.16 per share on the day Bank of America made the offer. Countrywide Financial currently trades at around $5.40 a share, or a roughly $3.1 billion market cap. Countrywide's current price suggests an arbitrage premium of nearly 25%!

The wide gap exists for good reason. First, Bank of America, under the terms of the deal, can walk away if any legal surprises pop up during the due-diligence period. And given the mortgage mishaps recently, something could indeed arise. Second, since this is a stock deal, as Bank of America's stock price declines, so, theoretically, does the offer. In short, the probability that the deal will go through is not as high as it could be. As Buffett remarked in 1965, "... we are not talking about rumors or 'inside information' pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper."

Still, as events and information continue to come out on this deal, it wouldn't hurt to pay attention. Absent any serious legal setbacks, Bank of America could stand to benefit in the long run. Countrywide has a valuable mortgage-distribution platform, and Bank of America would originate nearly one out of every four mortgages if it does acquire the company. The additional deposits would extend Bank of America's lead over Citigroup (NYSE: C  ) , too. There are plenty of reasons that closing this deal stands a good chance.

Always do your homework
You should participate in arbitrage opportunities only after you perform the most rigorous of due diligence. Heed Buffett's advice, and wait until you get real proof of the opportunity. Never participate in arbitrages based on a hunch or rumor. if you use them prudently and carefully, they can enhance your investment returns.

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