Even those new to investing would be familiar with Warren Buffett. His investment philosophy has inspired generations of investors and the mere mention of his name is synonymous with value investing. The purpose of this article isn’t to shine yet another light along the overly promoted path of value investing, but rather focus on a lesser known strategy Buffett uses instead of cash and in the absence of compelling value investments. It is a particular interesting strategy given the apparent difficulty in finding value in today’s markets.
“In past reports we have told you that our insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents. We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long-term investments.”
This quote is taken from the annual Berkshire Hathaway investor letter back in 1988. Like much of Buffett’s work, the lessons gleaned from the letter have stood the test of time and still offer investors valuable insight into capital allocation in current markets, which trade at historically high valuations while cash generates poor returns in a low interest rate environment.
Put simply, arbitrage seeks to capitalise on market pricing differences, such as a takeover offer, and, most importantly, it does not rely upon what broader markets are doing. It is a time intensive and skilled market neutral strategy which looks to provide a positive return regardless of which way the market moves.
Investa Office Fund (IOF.ASX), Capilano Honey (CZZ.ASX), and Gateway Lifestyle (GTY.ASX) are notable examples of arbitrage opportunities in what is a ubiquitous part of business today; mergers and acquisitions. In each case, the bids in their initial forms provided the opportunity of annualised returns well above the return on cash in the bank should the transactions complete, but also highlight additional benefits the strategy can bring through revised bid prices or counter proposals.
There is a misconception that the strategy is only an alternative to equity investments. It can have a similar return profile to equity investments over time, but with much less in the way of volatility; it can offer protection against wild downswings and large losses during periods of significant market weakness. Every stock experiencing a significant corporate event will have its own unique set of circumstances that decouples it from market movements. For example, the share price of a company subject to an unconditional takeover bid should not fall below the unconditional price regardless of how much equity markets fall - scooping up shares below the unconditional bid price is the equivalent of buying cents on the dollar for zero risk. An opportunity that wont last long.
A portfolio, then, built on multiple shares experiencing their own unique circumstances will mean that not only does it have limited correlation to markets, but there’s very little correlation within deals in the portfolio itself, creating valuable (and hard to find) portfolio diversification. In contrast, most equity strategies tend to largely move up and down together – they are market dependent.
Perhaps most interesting is Buffett’s comments on his use of arbitrage as an alternative to cash, rather than just equities. Arbitrage used in this way has distinct advantages; it can produce meaningful and outsized returns relative to the return received on cash, and it also mitigates the impact of cash drag on performance over time. Some investors are concerned that if they reduce their equity weightings they will suffer lower long-term returns – this is itself a debatable proposition given current market valuations and circumstances and the alternatives to simply using equities. However, for these investors also, arbitrage offers a valuable alternative to using cash alone.
Interesting article, although all three examples could not be classified as arbitrage opportunities at the moment. It's a great way to consider approaching risk adjusted returns given this market of heightened volatility.
Thanks Ashford. As you correctly state, all three of the opportunities mentioned in the article have largely passed however, there are many others that remain available at the time of writing. Best Regards - Luke