Book Review: Warren Buffett and The Art of Stock Arbitrage

There are a lot of professional investors out there.  And with all due respect, most of them pretty much stink, getting the market average (or less) for much of their career.  That’s why the few investors who are highly successful over a long period of time gain so much attention and fame.  None such investors are more famous than Warren Buffett, a man whose name is all but synonymous with successful investing.  But what are some of the maneuvers that push his investment returns so far above those of regular investors?

Warren Buffett and The Art of Stock Arbitrage looks at one such maneuver, arbitrage.  Written by Mary Buffett (Warren’s daughter-in-law) and David Clark, it explains the meaning of arbitrage, looks at several methods of executing arbitrage maneuvers, and details some of the maneuvers that Warren Buffett has carried out in his years at Berkshire Hathaway.  To find out if it give you the insight you’d need to follow in his footsteps, let’s read on!

Summary of Warren Buffett and The Art of Stock Arbitrage

Art of ArbitrageThe book begins with a short Introduction, showing how stock arbitrage has proven vital to Warren Buffett’s success and why it is becoming easier for individual investors to engage in these types of investments.

Chapter 1: Overview of Warren’s Very Profitable World of Stock Arbitrage and Special Investment Situations

The first chapter opens with a discussion of stock arbitrage, noting how it works and how it can yield profits if done correctly.  (Short version: By buying a stock now that we know will sell a higher amount in the future, due to a scheduled merger or similar situation, we can guarantee a profit.)

Chapter 2: What Creates Warren’s Golden Arbitrage Opportunity

This chapter covers two reasons why this difference in present and future stock price develops.  First, all the conditions (merger deals, spin-offs, etc.)  that lead to an arbitrage situation have a potential not to go through.  Second, there’s the time value of money to be considered; buying a stock to hold for three months means not having that money available for other uses during those three months.

Chapter 3: Overview of the Different Classes of Arbitrage that Warren Makes Millions Investing In

Here is a short summary of the types of events that create arbitrage situations, including mergers, hostile takeovers, corporate self-tender offers, spin-offs, stubs, and reorganizations.  Each is discussed in more detail later in the book.

Chapter 4: Where Warren Begins – The Public Announcement – the Beginning of the Path to Arbitrage Riches

This chapter looks at the difference between arbitrage that seeks to find deals before they are made public (‘risk arbitrage’) and the sort of arbitrage that Warren Buffett practices, which waits until a deal is announced, trying to find the deals that are as close as possible to ‘absolutely certain’ to go through.

Chapter 5: The Arbitrage Risk Equation Warren Learned from Benjamin Graham and How It Can Make Us Rich

Chapter five covers some of the math looking at the risk involved in arbitrage, considering how Warren Buffett (and before him, Benjamin Graham) calculates how worthwhile a particular deal will be.  It looks at the relative chances of a deal going through and the profit possible, to help calculate whether the arrangement is worthwhile.

Chapter 6: How Warren Uses the Annual Rate of Return to Determine the Investment’s Attractiveness

Continuing on the subject of the math of arbitrage, this chapter covers how to compare the return on different types of investments, converting them all to the annual rate of return to determine how good each investment will on an equal basis.

Chapter 7: Leverage and Arbitrage – How Warren Uses Borrowed Money to Triple His Returns

Chapter seven rounds out the opening portion of the book, discussing the concept of leverage, how it works, when Warren Buffett uses it, and how to use it safely.

The Arbitrage and Special Situations Deals

Chapter 8: Overview of Mergers and Acquisitions – Where Warren Has Made Millions

The section of the book that looks into the arbitrage and special investing situations opens with a brief discussion of the difference between mergers and acquisitions.

Chapter 9: Friendly Mergers – Warren’s Favorite Arbitrage Investment

This chapter covers several different types of friendly mergers, looking at what an acquiring company can offer in exchange for the target company’s stock (cash, stock, or a combination of the two).  It also notes how to profit from such a deal, discussing how to ensure that you can profit by getting shares of the target company’s stock.

Chapter 10: Friendly Merger Arbitrage – Things Warren Considers When Determining the Probability of Completion

A merger is only as profitable as its chance of going through.  This chapter covers several of considerations about those probabilities, from the nature of each company to the chances of getting shareholder and federal approval.

Chapter 11: A Friendly Merger Arbitrage Case Study: Berkshire’s Merger with BNSF

After the past two chapters have covered the principles of friendly mergers, chapter eleven goes through an example, looking at how Berkshire Hathaway merged with the BNSF railway company, illustrating how a friendly merger would work (and how you could profit from such a merger).

Chapter 12: Acquisitions – the Hostile Takeover – the Most Dangerous Place Warren Goes to Make Money

Chapter twelve looks at the other side of the coin, when a merger is not desired by the target company.  It covers both the methods that acquiring companies can use to take over another company and methods that target companies can use to defend against such a takeover (all of which makes such a hostile takeover less likely to occur).

Chapter 13: Securities Buybacks/Self-Tender Offers – How Warren Arbitrages Them to Make Even More Money

This chapter covers security buybacks and how to profit from the variety of different buyback situations that occur.

Chapter 14: How Warren Has Made Hundreds of Millions Investing in Corporate Reorganizations

The particular type of reorganization that is covered by this chapter are conversions of companies into different corporate types, in particular royalty trust and master limited partnerships, to benefit from different stock rules.

Chapter 15: Corporate Liquidations – How Warren Turns Them into Liquid Gold

Here, corporate liquidations are discussed, noting how they could be used to convert company assets into profits (particularly prior to 1986 when tax laws changed), and looking at the key elements to consider when investing for a corporate liquidation.

Chapter 16: Corporate Spin-offs – How Warren Made a Fortune Investing in Them

Much as a liquidation can allow shareholders to get access to corporate assets that are currently undervalued by the market, spin-offs (where a conglomerate that owns multiple companies makes one or more of the companies into stand-alone entities) enable undervalued companies to be more easily accessed and their value to be realized.  (Although less desirable companies are also spun off, when conglomerates cut down on dead weight.)

Chapter 17: Corporate Stubs – Where Warren Got His Start in Arbitrage

Corporate stubs are legal structures where there is a residual interest in a company (such as tax refunds or legal payouts that are due to the company) that is being made available due to a merger, liquidation, or other such situation.  This chapter looks into how they are created, what kinds exist, and most importantly, how to profit from them.

Chapter 18: Where Warren Looks to Find the Golden Arbitrage Deals

Chapter eighteen is a short one, looking at the sources for good information on such possible deals, such as the Wall Street Journal, search engines, and paid services.

Chapter 19: Tendering Our Shares  – How Warren Cashes In

The book rounds out with a short chapter on how to tender shares for an offer and profit from all the arbitrage situations laid out throughout the rest of the book.

Pros

  • Interesting Topic: It’s not too often you hear about arbitrage as investment possibilities, and it’s nice to get a look at how it works.
  • Unique Perspective: The book provides a nice look at how Warren Buffett invests in such arbitrage situations (not surprising, when one of the authors is his daughter-in-law).
  • Details on How to Arbitrage…: There are suggestions on how to find, study, and execute arbitrage opportunities throughout the book.

Cons

  • …Although, Sometimes They are Difficult to Follow: The book assumes a pretty healthy understanding of stock investing, making it high on the reading curve for investments books.
  • Limited Applications: As even the authors acknowledge, there aren’t too many opportunities to use arbitrage as a regular investment strategy.
  • Odd Use of ‘Warren’: Perhaps it’s just me, but the book’s references to Warren Buffett as ‘Warren’ just sound odd (but again, perhaps not surprising with an author who is related to him).

Overall

Warren Buffett and The Art of Stock Arbitrage is an interesting book looking at a fairly unusual investing strategy.  It’s not terribly applicable to most people’s portfolios, as you likely won’t be trying to profit from the more complicated corporate maneuvers (plus, they don’t occur that often).  But if you’d like a better idea of what corporate investors like Warren Buffett do to be so profitable, it’s an interesting read.

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