By shortly after 9:30 a.m., my former boss -- whom I'll call "Mr. T" to satisfy his request for anonymity -- was in a frenzy, scrambling to put on positions. Then a trader and analyst at a hedge fund, Mr. T was setting up a merger arbitrage -- a strategy that, at least according to academia, generates average returns of 1.6% per month. Only Mr. T was about to make almost 9% overnight.
Merger arbitrage is a fascinating microcosm of stock market psychology. And though the trade isn't something I'd suggest you try at home, the principles that made Mr. T money are simple -- simple enough that you can put them into practice in your own portfolio.
Basic arbitrage begins when a buyout is announced. A trader quickly takes a long position in the target company and short sells the acquirer; both actions exploit anticipated price drift later. The money received from the short sale is used to assume the long position, meaning the trade literally pays for itself.
But it doesn't always pay the trader so well. "Limited Arbitrage in Mergers and Acquisitions," the self-explanatory title of a fairly recent academic paper, says it all: No longer a secret trove of the investing cognoscenti, merger arbitrage these days usually amounts to market behemoths leveling huge positions to exploit ever-shrinking profit margins. Usually.
Mr. T manhandles the market
A December day in 1998 presented the exception -- a brief exception for the right audience, which is about the most the market allows for all but the very gifted.
DirecTV (NYSE:DTV) -- at the time a subset of Hughes Electronics, a company named for eccentric businessman Howard Hughes, a man as much known for building planes, making movies, and buying Las Vegas from the Mafia as for mental breakdowns that would leave him sitting naked in a chair for hours on end in fear of germs, and which was in turn a tracking stock of General Motors (NYSE:GM) -- announced it was buying a satellite TV company called USSB for the option of either $13.85 in cash or 0.3775 shares of Hughes (worth about $14.72 based on Hughes' price that morning) per share of USSB.
Being, among other things, a telecommunications and media analyst, Mr. T leapt into action as one of the first to start trading.
Arbitrage: Investment nerds have all the fun
When a merger is completed, shareholders of the target company receive the buyout price. Simple enough. But the acquiring company's stock price usually declines. Why? Acquisitions tend not to work out, and tend to be overpriced events that primarily benefit investment bankers and acquirees. Moreover, a purchase made with issued stock means dilution for the acquirer's existing shareholders. Traders, being well aware that a deal's closing will bring these price movements, seek to get a jump on this by placing trades when the deal announced and holding them until it closes.
Here's how Mr. T set up his trade: For every share of USSB he bought that morning -- for around $11.50 per share -- he shorted the corresponding quantity of DirecTV shares it'd be worth at the merger's consummation; namely, 0.3775 of a share. Breaking it down to the smallest units for comparison, Mr. T received $14.72 in cash for every 0.3775 shares of DirecTV he sold short. That cash covered the $11.50 he spent per USSB share, with $3.22 to spare.
Were he to wait months for the merger to close, Mr. T would pocket that $3.22 spread.
But why is that $3.22 on the table to begin with? Why wouldn't USSB's stock just go right up to the cash buyout price, at a minimum? Uncertainty.
Simply put, whatever spread the market allows represents its collective doubt about the deal going through. Financing can fall through, an acquiree may resist being acquired, or the Justice Department may snag the deal for antitrust reasons. More time till closing means more risk of this stuff happening. And vice versa. So as the settlement date approaches, the acquiree's stock price will creep closer to the buyout price, and the acquirer's stock will drift downward a bit.
How does this parallel investing in the market as a whole? They're both gambles on certainty. In most investing situations, the major facts are known to just about everybody -- it's pretty rare to have a significant piece of information all to yourself. Actually, this collective knowledge goes beyond the facts: I'd say most of the time, the main "watch this" performance metrics and key upcoming events are known as well. Meaning it comes down to one investor's certainty -- typically based on incrementally better judgment or knowledge -- relative to another's.
Mr. T had certainty on tap. Being intimately familiar with these companies, he didn't need precious time to realize that DirecTV and USSB had been pals since 1991, offering complementary regular and premium service. Since they'd already been longtime partners, the competitive landscape -- mainly Echostar's (NASDAQ:DISH) DISH network and Primestar in satellite, plus usual suspects like Comcast (NASDAQ:CMCSA) (NASDAQ:CMCSK) in buried cable -- wouldn't be any different after the merger, meaning antitrust concerns weren't an issue. And DirecTV, thanks to its parent company, had huge financial backing, spelling no money trouble for this deal. Finally, USSB's top brass included three members of the Hubbard family -- Chairman Stanley Hubbard, the patriarch, and sons Robert and Stan, vice president and president, respectively. The Hubbards' heavy stock ownership and positions meant USSB wasn't likely to reject the buyout internally.
Head above the fog
And Mr. T had another advantage: He was focused in the midst of a distracted crowd.
That December day saw many other deals, meaning the Hughes-USSB merger didn't earn exclusive coverage on everyone's radar screen. When Mr. T phoned the arbitrage desks of the big shops like Goldman Sachs (NYSE:GS) and Bear Stearns (NYSE:BSC) (merger arbitrage is surprisingly user-friendly for institutions; they simply phone an "arb desk," discuss their deal of interest, and the arb desk takes it from there) that morning, he was surprised, he claims, to discover that their usual immediate fluency in the terms and inner workings of mergers wasn't present in this deal.
Or maybe it was, and Mr. T just knew much more this time. It doesn't make a difference, actually. In this case, as with the deal, and as with the market in general, it's the relative spread that matters.
To keep his full $3.22, Mr. T was looking at a solid six-month wait; the deal wasn't expected to close until mid-1999. Instead, he closed out the next day, pocketing $2.27 -- a flat-out outrageous 70.5% of his potential six-month return made overnight. Considering his initial investments -- a $14.72 short position and an $11.50 long position, totaling $26.22 -- his return came to 8.7%.
OK, we all know 9% in a day is the exception to just about any form of investing. But what about a jaw-dropping 44.27% return since July 2003 (versus 7.46% for the S&P 500) with no need for specialized industry knowledge or phone calls to arb desks? I'm talking about our Hidden Gems newsletter, which you can try free for 30 days.
James Early has no position in any of the companies mentioned in this article. He'd tell you if he did.
