These days, Warren Buffett is known for buying massive businesses with huge competitive advantages. There's a good reason for this. Companies like Wells Fargo (NYSE:WFC), Moody's (NYSE:MCO), and American Express (NYSE:AXP) have such dominating positions that they're likely to grow for years, providing excellent returns for long-term shareholders.
But if you look a bit closer, you'll find that Buffett owns these businesses not simply because they provide great returns, but also because he has no choice! Berkshire Hathaway is so big that it takes a Wells Fargo or Moody's to move the needle. If Berkshire owned 20% of a $100 million company, and the stock doubled, Berkshire's portfolio would grow by less than 0.1%.
That brings to mind an interesting question: If Buffett had a small portfolio (like, say, mine) what would he do?
What would Buffett do?
To answer that question, look at what Buffett did before Berkshire Hathaway, back in the 1960s, when he was managing much less money. Buffett focused on three types of opportunities:
- Generals: Undervalued companies where Buffett was simply a shareholder.
- Controls: Companies in which Buffett took a large position to influence the management of the business.
- Work-outs: Special situations like mergers, liquidations, and spin-offs.
A lot has been written about the first category, while the second category isn't relevant to small investors. But the third category can provide small investors with some intriguing opportunities.
The skinny on work-outs
Work-outs are particularly interesting now because of two factors. First, implementing the internal controls required by Sarbanes-Oxley is proving so expensive that many small companies are choosing to go private by buying out small shareholders for cash. Second, we're at the top of a liquidity cycle, resulting in a near-constant string of acquisitions. In combination, these factors result in many work-out opportunities.
The basic strategy when companies are going private or being acquired for cash is to buy the stock for less than acquisition price. When the transaction is finalized, you make a small profit. You might think a small profit isn't worth the effort, but if you look at it on an annualized basis, the returns can be excellent. For instance, an 8% return in four months is 26% annualized. Not too shabby!
If a deal is made for shares rather than cash, you can potentially profit through arbitrage -- buying the shares of the acquiree and short-selling an appropriate number of shares of the acquirer. For instance, Hologic (NASDAQ:HOLX) is offering 0.52 shares plus $16.50 cash for each share of Cytyc (NASDAQ:CYTC). You could buy 100 shares of Cytyc for $43.30 each, sell 52 shares of Hologic for $55.46 each, and then pocket $200 in profit when you use the 52 Hologic shares you receive from owning Cytyc to cover the short.
The risks
Work-outs aren't without risks. If the deal goes sour, you can lose money as the share prices dramatically readjust. This can be a big problem for the strategy, as one large loss can wipe out several profitable trades. What's more, when you look at large deals, the probability of the deal falling apart is often reflected in the potential profits. Often, the spread isn't wide enough to make the deal worthwhile.
Take, for example, Microsoft's (NASDAQ:MSFT) acquisition of aQuantive (NASDAQ:AQNT). Microsoft is offering $66.50 in cash for each share of aQuantive. But aQuantive shares are trading for $64.65, which means that shareholders can get less than a 3% gain from here. That's almost nothing once you factor in transaction costs, taxes, the length of time until the deal closes, and the risk of the deal falling apart.
But this is where being a small investor can be advantageous. You can buy into deals that are too small for professional arbitrageurs to enter. For instance, I own shares of Monarch Community Bancorp, a tiny $30 million bank currently trading for $11.95 per share. It's going private and buying out shareholders who own less than 1,000 shares for $13.50 per share. The size of the investment and potential payoff here is pocket change for a pro, but it's a reasonable 12% gain for a small investor.
The Foolish bottom line
The key to identifying these opportunities is keeping your eyes open and being willing to read through SEC filings to find the gems. If you're interested in special situations, our Inside Value investing service, which primarily recommends Buffett's Generals, has a new Jokers Wild section focusing on unusual opportunities. In it, we discuss intriguing investments that may not be appropriate for every investor, but offer a huge upside. You can check it out with a free trial.
Flabby Fool contributor Richard Gibbons avoids work-outs unless there's money involved. He owns shares of Monarch, but does not have a position any of the other stocks discussed in this article. Microsoft is an Inside Value recommendation. Moody's is a Stock Advisor pick. Berkshire Hathaway is an Inside Value and Stock Advisor pick. aQuantive is a former Rule Breakers selection. Motley Fool has a disclosure policy.
