Arbitrage November 10, 2008

Arbitrage  A “riskless profit.”  The simultaneous purchase and sale of an asset in order to profit from a difference in price.

Risk Arbitrage  Arbitrage that contains an element of risk.  May include:  Merger Arbitrage  Liquidation Arbitrage  Pairs Trading  Hedge fund trades.

Merger and Buyout Arbitrage  Merger arbitrage usually involves buying shares of one company and shorting shares of another company (in the case of an equity exchange deal).  Buyout arbitrage involves “betting” that a buyout will in fact occur.  For the buyout setting to be profitable, the stock must trade at a discount to the buyout price.

Rohm and Haas Co. (ROH)  DOW offered to acquire ROH for $78 per share in cash.  ROH shareholders approved deal.  Financing, etc. should be secured.  Expected to close in early  ROH currently trading around $  Potential for a 5% gain.

Annualized Rate of Return  Calculate as a point of comparison.  What is the annualized rate of return if the deal closes in 3 months and you can buy shares at an average cost of $74?  That comes out to a 23% annualized rate of return.  Annualized return looks pretty good.  Market turmoil could be preventing this from trading closer to $78. Under usual merger circumstances, the spread would be much smaller, like $1-2.

Meadow Valley Corp. (MVCO)  Private equity buyout at $11.25 per share.  Phoenix/Las Vegas area construction company.  Currently trading around $7-8 per share.  Big spread, which could be indicative of higher risk.  Construction has slowed considerably.  Private equity may have trouble securing financing.  Although financing seems to be secure, it’s hard to tell under what circumstances the buying party can cancel the deal.

Where to Find More Information  SEC Filings  Proxy Filings: DEF 14A or PRE 14A  Contact the company’s investor relations department.

Share Class Arbitrage  An attempt to profit from a discrepancy between the price spread between two different classes of shares.  Usually involves holding a long position in the undervalued shares class and a short position in the overvalued position.  Creates a hedged position that in theory eliminates the risk the underlying stock.

Reminders on Short Selling  Borrowing shares you don’t own and selling them, hoping that the price of the stock goes down and you will be able to cover at a lower price and make a profit.  Requires a margin account and your broker must be able to find shares for you to borrow.

MWA and MWA.B  Example where the board of directors approved a conversion of B shares into A shares.  Spread closed now.  Spread varied from close to 0 to 25% +

CMG and CMG.B  Chipotle’s two share classes.  CMG trading around $49.  CMG.B trading around $43.  $6 spread.  Arbitrage profit if the share prices converge.  Historically, the share prices do converge and they could also merge the share classes in the future.  B shares have 10 times the voting rights of A shares, but B shares are somewhat less liquid and have no options.

GEF and GEF.B  GEF trading around $37.  GEF.B trading around $30.  B shares are attributed 150% of the earnings and dividends of A shares.  Again, B shares are less liquid but hold ALL of the voting rights.  Management and family own a large proportion of B shares.

Going Private Transactions  Essentially a “cash-out” for small shareholders.  A company can avoid the filing costs of being a public company by reducing its shareholder count below a certain number (usually 200).  To accomplish this, the company submits a proposal to a shareholder vote to buy back shares from any shareholder owning less than, say 500, shares at a given price.  These transactions are often completed by a reverse stock split immediately followed by a forward stock split.

Shareholder of Record  Read proxies carefully because some companies may require shareholders to be shareholders of record in order to be eligible for the cash-out.  Shares held at brokerage firms are held in “street name.”  In order to become a registered shareholder, you must get physical stock certificates (and of course pay a fee to your broker).  These transactions are also subject to shareholder approval.

Entrx Corp. (ENTX)  Going private by means of a cash-out of shareholders holding less than 500 shares.  Cash-out price of $0.35 per share.  Trading (or at least recently priced) around $0.20 per share.  Potential for a quick 75% gain, but only allows for an investment of $  That’s still a potential profit of around $70.

Katy Industries (KATY)  Going private by cashing out shareholders holding less than 500 shares.  Cash-out price of $2 per share.  Currently trading at $1.1 per share.  Huge potential payout, but this one looks risky.  Lost $3.2 million this past quarter.  Could easily cancel the deal.  Financing may be difficult.  Consider potential losses if the deal falls through.

Questions?

Club Portfolio Update  Motion to buy $1,000 of Core-Mark (CORE) passed.  Order executed on 10/28 to purchase 52 shares at $19.  Total cost of the position was $995.  Current value (as of 11/7) was $949.  We still have $19,005 to work with!

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