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Marketplace Roundtable: Arbitrageur's Delight

By SA Marketplace :

There is no free lunch, but that doesn't stop investors from looking for it. Assets that are distinctly mispriced and that can yield profits in a low or no-risk fashion is something of the holy grail in investing. Or at least, in the quest for arbitrage.

But while arbitrage has a book definition (see below), the ways it can be interpreted and used are legion. So are the quotes and justifications for the practice. Warren Buffett reportedly said, "Give a man a fish and you will feed him for a day. Teach a man to arbitrage and you will feed him forever." On the other side of the trade, speaking about merger arbitrage specifically, Joel Greenblatt wrote in You Can Be A Stock Market Genius that, "I'm trying to lead you to investment areas which, because of the way the system works, will continue to offer extraordinary opportunities. Frankly, risk arbitrage doesn't qualify."

It takes two sides to make a trade, which is probably why arbitrage opportunities remain available. We asked a few Marketplace authors who practice one form or another of arbitrage to share how they do it.

Our panel:

Seeking Alpha: The Merriam-Webster definition of arbitrage is: "the nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies". Which markets do you seek arbitrage in, and what types of arbitrage do you seek to profit from regularly in your investing?

Chris DeMuth Jr., author ofSifting the World:AQR founder Cliff Asness said that the word in academia means "certain profits but in practical investment it often means "a trade we kind of like." In both its strong and weak form, the idea focuses on the key to investing: mispricing. Arbitrage is a big focus in Sifting the World . Where are we finding exploitable price discrepancies across markets? I will answer by categories:

Each have current examples that we are exploiting in our fund and discussing on our forum.

Richard Berger, author of Income fromCovered Option Writing: As a subset of writing covered options to boost income and yield, I have been developing and refining a risk arbitrage strategy that pairs dividends about to go ex-div and a short term deep-in-the-money covered call.

Safety in Value, author ofSafety in Value's Microcap Review: I seek arbitrage type transactions in markets that are overlooked. Generally that means looking in small capitalisation companies, sometimes in markets outside the US (often Canada, Europe). I conduct arbitrage type investing in two ways. The first is merger and acquisition or tender arbitrage, where I purchase securities with open offers and wait for the deal to close to collect a spread. The second is a less pure form, where I conduct time arbitrage. By this I generally mean liquidations, where the value of the company will be distributed to shareholders, and asset sales, where a company has sold an asset for cash that exceeds its current market capitalisation.

Stanford Chemist, author ofCambridge Income Laboratory: We seek arbitrage in closed-end funds (CEFs), and primarily exploit mean reversion in premium/discount values in order to execute pair trades. Examples of successful CEF arbitrage trades conducted by the Cambridge Income Laboratory in 2016 are presented here .

SA: One doesn't have to be an efficient market theorist to assume that most obvious price discrepancies will be corrected over time, and that there is no 'free lunch' in the markets. So what allows the sort of arbitrage you pursue to persist?

CDM: My colleague Andrew Walkersays that,

I like to hunt in two places: where no one else is looking (small caps) or where everyone else is panicking.

That says it perfectly - where no one is looking (mostly small, overlooked opportunities ) and where everyone is panicking (securities with superficial drama but value beneath the surface such as certain securities that are out of compliance with the SEC or expelled from an index for relatively benign reasons).

RB: The arbitrage opportunity exists for reasons built into stock share pricing, which adjusts share price "instantaneously" on the ex-div date, along with option pricing (Black-Scholes) that projects smooth decay curves for both time value and price volatility going forward. The "quantum" adjustment nature of the ex-div share price adjustment creates a window when both these pricing models are invalid.

SIV: The biggest reason arbitrage continues to exist in micro-cap and small-cap stocks is that it hasn't been competed away. Anyone conducting arbitrage with large capitalisation stocks is competing against huge specialised funds (such as Glazer Capital about whom I've previously written ). That generally means the market has full time analysts, significant information sources, low cost of borrow for short positions, and a low cost of capital. But these advantages work against a big fund in a small deal, where they wouldn't be able to take a large enough position to move the needle. As an example, Glazer Capital's largest position at last report was close to $40 MM. They couldn't buy into the sub $100 MM deals that are my bread and butter. The lack of sophisticated competition in smaller deals means spreads are often higher.

SC: Sentiment is a powerful beast, though it is not entirely rational. Distribution cuts or special dividend announcements in CEFs often trigger a visceral reaction in income investors, even though, by the Modigliani-Miller theorem, the dividend policy of a fund per se should not have a fundamental effect on its value. Thus, from these reactions premium/discount discrepancies are born.

SA: Related to that, what are the risks you take on in your arbitrage approach and how do you address them to ensure your best risk-adjusted returns?

CDM: We are counters, not soothsayers. So our risks are that either 1) we miscount (hopefully infrequent or at least immaterial) or 2) things change in the future (sadly, happens all the time). We often find and exploit a mispricing that has some durational risk as an event is occurring. We, for example, buy a bank in one market (say in a mutual conversion) and sell in another (say a strategic merger) yet we can still get buffeted by interest rate risk in the duration. The investment was mispriced, but it is only profitable so long as the mispricing stays greater than the subsequent noise. It usually does, but not always.

RB: The risk in a dividend-premium arbitrage is that a very sharp drop in market price (deep enough to fall below your contract strike price combined with dividend payout) will occur during your short term arbitrage hold period (usually less than 2 weeks). In this case, you will be left holding shares at a net total loss and clearly in some sort of distressed state which led to such a steep plunge.

I address these issues in two basic ways; A) The arbitrage itself makes the holding period very short (thus limiting the time you are exposed to market risk from unexpected major down moves) together with the use of deep in the money strike prices whereby only a very large plunge will result in no call-away occurring, and B) by focusing on only targeting these dividend-premium arbitrage trades on very high quality tickers at or below fair value. The value based targeting of reliable dividend shares further lowers risk by resulting in a "failed" arbitrage simply converting itself into a longer term hold of the shares providing a good dividend yield at an adjusted basis price below fair value, along with continued covered call writing to boost income and yield while further lowering market risk.

SIV: The biggest risk in merger arbitrage is that a deal doesn't close. Happily, small deals are often less complicated. For example, transactions less than $80 MM are not subject to Hart-Scott-Rodino review. Additionally, financing is often less of an issue when deals are small (subscribers recently participated in the Teck ( TCKRF ) acquisition of AQM Copper ( APQUF ), which Teck paid for in cash. The cash amount was inconsequential to them). All that being said, I tend to diversify arbitrage ideas (usually adding 3-6 per month) to spread risk, as well as thoughtfully consider the downside if the deal doesn't close when sizing a position. For liquidations, the risks tend to be more on the order of things taking longer and costing more than expected. I primarily deal with this risk by only entering liquidations where there is a margin of safety to account for surprises, which are admittedly usually negative. I also cover odd lot tenders and other types of low risk small situations.

SC: One risk of our arbitrage approaches is that the fund we identify to be relatively overpriced becomes even more overpriced by virtue of activist activity. These risks are addressed by keeping up to date with SEC filings to monitor institution ownership.

SA: What led you to discover this type(s) of arbitrage? Are there any past or present examples of the arbitrage that would help illustrate the opportunity?

CDM: My discovery process was filled with childhood antics - capturing price anomalies in Circuit City sales, duty-free shops, and i-bonds. Once I cornered the market in JC Penney ( JCP ) hand towels when they issued an electronic coupon for more than the price of the towels and shipping. As I grew up somewhat, my attention wandered to capital markets where I focused on such phenomena as parent-subsidiary stubs with negative costs and SPACs with treasury bond risks and double digit yields.

RB: Dividend capture trading has long been a recognized and popular trading strategy for some investors. By buying-in shortly before the ex-div date and exiting quickly after ex-div, the holding period is reduced from a quarter down to just a few days. The capital can then be re-invested in another ticker about to go ex-dividend, repeating the process. In this way, the dividend capture strategy seeks to capture far more than 4 dividends per year, sometimes as many as 2 dividend distributions per month from the same investment capital tranche. For a simple illustration, a company may pay quarterly $1.00 dividends. A $100 stock would thus have a 4% yield to a long term holder. A dividend capture trader moves in and buys shares just days before the ex-div and then exits again soon after, not holding the shares 365/year but instead perhaps 30 days per year in total to capture all four $1.00 dividends. The trader re-employs his capital tranche many time, in many different tickers, throughout the year so as to have the same $10,000 in capital capturing perhaps $50.00 or even $100 per an num instead of the $4.00 they would earn from just holding the single 4% dividend yield ticker throughout the year. I have taken this strategy to the next level by combining it with a covered call trade. The strike price of the call includes cash that effectively lowers your cost basis to below a deep market price plunge, thus insulating the investment from this risk that simple dividend capture traders are exposed to. Furthermore, the very high probability of early call away (before expiration), so as to capture the dividend by the call buyer, eliminates the need (and risk) of waiting for share prices to rebound from the automatic ex-div downward market price adjustment. Finally, in those circumstances where a sharp plunge does occur and we are left holding shares at expiration, we have harvested both the dividend and the large option premium, instead of just the dividend that the non-arbitrage dividend capture trader has received. With shares held at deep value price bargain, the eventual rebound is very likely and our dividend-option arbitrage in such case simply converts to the equivalent of cash covered put presentation at bargain value price which we then harvest dividends boosted by covered call writing above cost and fair value.

SIV: I became involved in M&A arbitrage and liquidations by reading filings. I have a tendency to look at hundreds of filings at a time looking for new investments (I generally cover US, Canadian, and UK regulatory sites). When I was looking for undervalued securities, I would often come across merger or liquidation filings, and explored them further. This is still the method I use to source many ideas, which is why my ideas are often on unpublished companies. As an example, subscribers were able to take advantage of Arpetrol's (RPTZD) liquidation which I first wrote up at $0.49 CAD in March. Subscribers had a month to purchase at prices as low as $0.41, and the company has paid out $0.56 by the end of 2016, with more payments to come. Because these deals are not big enough to attract large funds, the spread often remains large for some time. In this case, a couple of million shares traded below $0.50, but I never saw any other coverage on the idea anywhere else. Another great example was the Less Mess Storage deal, a self storage company that had a takeover for $1.415 completed less than 2 months after my write-up at $1.20. Again, because the deal was small it was completely uncovered, and I only found it by combing through individual filings.

SC: I was first drawn to the field of CEF arbitrage when I was deciding between which of two similar Eaton Vance funds, the Tax-Managed Global Buy-Write Opportunities Fund ( ETW ) and the Tax-Managed Global Diversified Equity Income Fund ( EXG ), to include in my CEF portfolio. By switching between one or the other fund depending on their relative valuations (e.g. here and here ), it has been possible to receive higher returns than if one had invested in one of the two CEFs all along. The results have been quitelucrative , at least as far as pair trades go.

SA: In Graham & Dodd's Security Analysis, the authors write, "While, viewed in the abstract, [arbitrage situations] are probably the most satisfactory field for the analyst's work, the fact that they are specialized in character and of infrequent occurrence makes them relatively unimportant from the broader standpoint of investment theory and practice." What do you think about that statement, especially on the relative importance and satisfaction of pursuing arbitrage opportunities?

CDM: The US equity market alone is worth over $24 trillion. If only 1% of it is egregiously mispriced, that still is enough to keep me pretty busy. If you think you are finding amazing opportunities every day in obvious places, they are probably not real opportunities. But you may find one or two a quarter after tons of research. Properly sized, even a few real opportunities each year should be impactful.

RB: The Graham & Dodd analysis of the arbitrage situation is a reasonable caveat. I am still refining my dividend-option arbitrage details but already have adjusted to limit the target ticker filters in many ways, such as only for dividends generally over $1.00 and only on highly liquid and actively trader tickers along with active and liquid underlying options. This limits the opportunities significantly.

SIV: I think arbitrage operations are important because they are at least partially uncorrelated to the rest of the market, and are generally readily available even when markets are high, unlike some other types of value investments. I also believe the risk-reward ratio in microcap arbitrage is extremely attractive, which makes it a satisfying place to deploy capital. That being said, it is also the type of space where satisfaction will probably need to come from portfolio returns as opposed to cocktail party stories. So far nobody has been too excited when I've mentioned over drinks that "I just found this great special situation that is likely to return 5% in 2 months," but the returns available from compounding over short periods have the potential to be remarkable. I personally find it very satisfying, but I'm also the type of person that enjoys reading through thousands of pages of regulatory filings looking for a gem, so I acknowledge my taste could be unusual.

SC: The satisfaction from arbitrage comes not from hitting multi-baggers, which would be unlikely anyway with CEF arbitrage, but from the knowledge that your position is well-insulated from macro factors due to the market neutrality of an arbitrage trade. For instance, in the muni trade we highlighted a few months ago, even though our long side IIM ( IIM ) fell by 5.85% in 3 weeks, our short side PMF ( PMF ) fell by over twice that amount (12.3%), given us a differential of over 6% in this time frame. 6% might not seem like a lot but it should be borne in mind that (( A )) it represents about 1 year's worth of distributions from PMF (( B )) the risk of the trade is much lower than a 100% long or 100% short position, given the arbitraged nature of the strategy.

SA: What's a current arbitrage idea available in the market, and what is the story?

CDM: Here is one that happens to be a merger arbitrage that is at the same time a true arbitrage: Fidelity & Guaranty Life ( FGL ) costs only about $26 per share. Using conservative assumptions, it is worth $27-28 by itself and a premium to that if a suitor such at Athene ( ATH ) makes a bid. This is a coin that you can buy for $26: if it comes up heads you get at least $27 and if it comes up tails you get closer to $30. The market price simply miscounted the value.

RB: Tupperware ( TUP ) does not quite fit my filter criteria but will serve as a fair example of the concept. Currently TUP trades at $59.77 and is ex-div for $0.68 on 3/16/17. An arbitrage for the dividend capture can be created using a buy-write with the market buy leg of $59.77 and selling the 3/17/17 covered calls for a strike of $55.00 @ $5.45 premium, for a net debit cost of $54.32 ($5.45 below market). The deep-in-the-money call makes it very likely that our shares will be called away before ex-div date of 3/16/17. An early call exercise on 3/15/17 for dividend capture is a holding period of 30 days on our net investment of $54.32. Our gain in this event is $55.00 strike minus $54.32 net cost = $0.68. This is identical to the dividend, an absolute gain of 0.68/54.32 = 1.252% for the 30 day holding. This is an annualized yield rate of 15.23%, a sharp improvment over the 4.55% annual yield rate of the dividend and we have lowered our market risk by almost 10% for the limited 30 day holding. Our break-even point (in event of a plunge) is $54.32 minus the $0.68 dividend we will capture if shares are not called-away. This is a net debit basis then of $53.64. Fair value is estimated at ~$60.00 to $63.00. In the unlikely event that we are left holding shares, our $53.64 basis is $6.36 (10.5%) below fair value, a bargain entry price. Dividend yield on our basis would be 5.07% rather than the 4.54% dividend yield at current market. In addition, we would boost income and yield by writing covered calls with a strike above $55.00 (and up to perhaps $65.00) depending on the individual investor goal for total yield rate and balance between yield and intrinsic gain.

It should be noted that exposure to market risk only begins if shares drop below the $55.00 strike price before 3/15/17. If not, then they will surely be called away at $55.00 for the call holder to capture the dividend. Failure to be called early for dividend capture would result in a breakeven point of $53.64, an additional $1.36 below the contract strike price. In this way, we are deeply protected from market risk where a simple long retail investor is not, while all the time boosting cash income and yield.

This summarizes my twist on arbitrage. It is a unique use as far as I know, not having read of this strategy anywhere in my years of investing and research. Such arbitrage is a minimal part of my subscription service "Income From Covered Option Writing", which focuses on value investing in high quality dividend income equities and boosting income and yield while reducing (but never fully eliminating) market risk by covered option writing. I hope I have provided some food for thought to readers today. You will find more about this arbitrage via the links in the Index To The Engineered Income Series or my subscription service reports .

SIV: Is it mandatory to pick just one idea? I always seem to have lots of favorites, but I'll try to stick with just a couple. Dee Valley (London:DVW) is being purchased by Severn Trent ( STRNY ). The market has left a relatively wide spread as there has been some legal uncertainty related to a challenge from the second bidder, and some irregularities about many new registered shareholders appearing to vote. That being said, the high bid is very likely to prevail, and it is 1825 pence. The current price is 1792 pence, up from 1747 pence when I wrote it up for subscribers February 2nd. One more quick idea is Paybox ( PBOX ), which is doing a 1000 for 1 reverse split, with holders of 999 or less shares receiving $0.80, compared to a current share price of $0.57. Insiders own a majority of the company and cash on hand should cover the costs, even assuming a relatively significant number of small holders have added positions.

SC: We have identified a potential CEF arbitrage opportunity with the Deutsche Municipal Income Trust ( KTF ) and the Pioneer Municipal High Income Advantage Trust ( MAV ). KTF is currently trading at a +8.24% premium with a +2.00 1-year z-score while MAV is trading at a -5.75% discount and has a -2.20 z-score. The reason for this valuation difference we attribute to a special distribution paid out by KTF recently, while MAV has suffered two distribution cuts in the last 12 months alone. Somewhat surprisingly, however, MAV has actually outperformed KTF over 1, 3 and 5-year time frames, and therefore it is by no means an inferior fund. When the market realizes this and recovers from the distribution cut-induced reactions, we anticipate that alpha may be gained as premium/discount values mean revert.

***

Thanks to our panel for joining our discussion. If you're interested in their work, you can follow them for free or check out their service at the respective links below:

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Next week's Roundtable guest: Michael Boyd of Industrial Insights

See also Li Ning: Leading Brand In The Structurally Growing Chinese Sportswear Industry on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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