Mary Buffett and David Clark continue their series of “Buffettology” books by focusing on Special Situations with their latest, Warren Buffett and the Art of Stock Arbitrage. While Warren Buffett is known for investing in high quality businesses at low prices, much of his success has come from arbitrage or special situations. True “Buffettologists” will remember that in the days of the Buffett Parnership he categorized many investments as “workouts” which fall into this category. The book begins with a few chapters explaining the basics of arbitrage and why Warren Buffett invests in them.
The authors cover several types of special situations, including:
- Merger Arbitrage
- Self-Tender Offers
Special situation investing consists of making a relatively small profit over a short period of time, generating high annualized returns. For example, let’s say a company announces that it is buying back its stock through a tender offer at $15 per share and immediately the stock price jumps to $14.50. A successful arbitrageur can make a 50 cent profit per share or about 3.4%, which seems like a very small return. However, if this money can be made in a 1 month period, it equates to a 41% annualized return. The book also explains how Buffett uses margin (borrowed money) to juice these returns even higher.
As the authors point out, the key to successful arbitrage investing is “certainty”. Successful investors like Buffett analyze each situation to assess 1) the probability of the event occurring, and 2) how long it will take for the event to occur. In the example above, if it takes 8 months to receive the 50 cent profit, then the annualized return drops all the way to 5.1%. For beginners, the book includes an entire chapter on calculating the annualized return and weighting the probabilities. Those familiar with the math can use a spreadsheet or online calculator like the one here.
The strength of the book lies in the case studies. Every type of arbitrage situation includes at least one real-world example, most beginning with the public announcement and continuing to the event’s conclusion. The book is also written in a very easy-to-read style. It took me only a few sittings to get through the entire book.
This breezy style may also be the book’s biggest weakness. The book is targeted at beginners, so it glosses over some of the finer points of special situation investing. It provides little detail on evaluating the likelihood of success, the length of time for completion, or the proper timing of the buy decision. It also skips demonstrating to readers how to properly value a spin-off. Most frustratingly, the book barely covers finding or researching an attractive situation other than “read the Wall Street Journal“. I would have liked a brief summary of key SEC filings and what to look for in those documents since they are the primary research tools for a special situations investor.
Weaknesses aside, I think this book is worthwhile for those starting out in arbitrage or special situations investing and can serve as a refresher for those with a little experience. For those seeking an in-depth look at special situations and arbitrage, I strongly recommend Joel Greenblatt’s 1997 poorly titled classic You Can Be a Stock Market Genius, which covers much of the same territory but is a bit advanced for a beginner.
Because of easy access to data and low trading costs, individual investors can profit significantly from special situations, and better yet they are uncorrelated with the general market. In times of high stock prices, these special situations can help generate positive returns while waiting for the price of quality businesses to fall. Buffett and Clark’s latest is a good introduction to special situation investing.