"Berkshire's arbitrage activities differ from those of many arbitrageurs. First, we participate in only a few, and usually very large, transactions each year."
-- Warren Buffett
A true arbitrage is riskless, such as agreeing to simultaneously buy and sell a barrel of oil (while accounting for transaction, transportation, and tax costs) at a profitable spread. However, true arbitrages rarely exist, and if they do, it's usually only momentarily, because capitalists will quickly bid up the underpriced oil and sell the overpriced oil and close the spread.
Arbitrage spreads are at the heart of all profit-seeking transactions, whether by individuals or businesses. We go to college because a lifetime of higher earnings power usually outweighs the tuition and opportunity costs. JPMorgan Chase (NYSE:JPM) makes a loan to a business because it might cost JPMorgan 4% to borrow money and it will earn 8% on the loan, a 4% arbitrage spread.
We can use arbitrage spreads to estimate the value of a business. To start, we need to ask three questions: How wide is its arbitrage spread, how long will it last, and how much risk am I taking?
Big arb or little arb?
The firm Long Term Capital Management was built on the principle of capturing teeny, tiny arbitrage spreads. For example, an "on the run" Treasury is the one most recently issued by the U.S. government, and an "off the run" Treasury isn't the most recently issued. On-the-run and off-the-run Treasuries, even if they have the exact same maturity, issuer (the U.S. government), and cash flows, will sometimes trade at small price differentials because of liquidity differences and market distortions. Capturing this small price differential -- sweeping up nickels is how Long Term Capital Management thought of it -- is an example of a tiny arbitrage spread.
Every business has to spend money to produce its product or service, then sell it for a price to customers, thus earning a spread on the difference. For example, Coca-Cola (NYSE:KO) and Coach (NYSE:COH) take easily obtainable, cheap raw materials like sugar, water, and leather, manufacture and package those raw materials into the finished good, and sell them at a huge markup cost -- their operating margins are 26% and 38%, respectively, a huge spread.
Fast-acting or long-lasting?
Wait a minute: Who wouldn't want to make mouthwatering operating margins like that? Well, the problem is that Coke and Coach have competitive advantages. When consumers buy Coke and Coach products, they buy them by name. If you produced Foca-Cola and Foach and tried to sell them, you wouldn't be able to sell them for much, and you'd probably get sued.
The simple question to ask is, why are these companies able to exploit this pricing spread, and how long will they be able to do it? In Coach's and Coke's case, customers identify with the brands, which are reinforced through constant advertising.
However, looking at the source of the spread, Coke has a brand that is almost handed down through generations -- as with many of the most successful brands. For example, families take their kids to Disney (NYSE:DIS) theme parks, thus introducing the next generation to its magic. While there, they probably drank Coca-Cola's products, thus creating the positive brand image in the child's mind. Perhaps on the drive to Disneyland, they stopped and ate at a McDonald's (NYSE:MCD), and drank Coke there as well. Then when they got home, they washed their dirty clothes with Procter & Gamble's (NYSE:PG) Tide detergent. You see how this works? Those brands aren't going anywhere, so their arbitrage spreads could last several generations -- maybe even forever.
On the other hand, Coach, which has a great brand, depends more on women's fashion tastes, which can be more fickle. Although companies like Louis Vuitton have managed to exploit this spread for a long time, it's a tougher game with much more cutthroat competition. I'd clearly prefer to have Disney's arbitrage spread.
What's the 60-40 proposition?
This ties in to the point above. The more risky a spread is, the less it is worth. For example, Wal-Mart (NYSE:WMT) and Safeway (NYSE:SWY) both sell groceries and are solid companies. However, Wal-Mart has a huge competitive advantage built on its distribution, foot traffic, brand, and incumbent status. As a result, even if Wal-Mart and Safeway had similar operating margins and balance-sheet ratios, Wal-Mart would be able to borrow money from banks and bondholders at a lower price because debtholders know that Wal-Mart's ability to earn a spread between its cost to sell its products and selling price is extremely secure, and so the company's ability to pay back its loans is unquestionable. Then Wal-Mart's cash flows are more valuable because they can be leveraged more safely, and at a lower price (a lower cost of capital).
Thus, the value of a business is a function of the width, durability, and riskiness of the spread between its production and selling costs. Of course, there's more to it (return on capital, time period, growth, etc.), but these three key components are a great start to valuing a business.
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Coca-Cola and Wal-Mart are Motley Fool Inside Value recommendations. Disney is a Stock Advisor recommendation, and JPMorgan Chase is an Income Investor recommendation. Try any one of our investing services free for 30 days.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
