98Dec-97Dec-96Dec-95Dec-94
21808197291795316670166571868118819199091769511132
133283390321965753218215051064745
6.14.251.33.92.8NA7.666.7
$12.65$11.09$9.35$8.11$9.95$11.80$11.30$12.82$10.67$9.63
21.514.619511.75NA17.514.914.8
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
Current Holdings
67
to the company. With all of these eggs lined up, Simpson was probably confident that the write-offs were truly one-time events and that the companywould get back on track, becoming profitable again.
IRON MOUNTAIN INC.Symbol: IRM (NYSE)Date Purchased: 2001Buffett began buying up shares of Iron Mountain, the nation’s largest document storage company, in late 2001, accumulating the bulk of his holdingsin Q3 of 2002. This is another company that was consistently losing moneybut still had a strong enough model that Buffett decided to buy. During itsgrowth phase, the company bought over 110 other companies involved inthe same business. That, plus building new facilities for storage, kept earnings down but at the same time increased the company’s moat over thecompetition. Once you have hundreds of thousands of your company’s documents stored at an Iron Mountain facility, it is unlikely you are going toswitch vendors. And with the complete accounting busts of Enron, WorldCom, Global Crossing, Tyco, and others in the 2001 and 2002, documentstorage became more important than ever.Buffett began reducing his shares in 2003. Iron Mountain exemplifies thefact that debt, by itself, is not a bad thing, although it is usually consideredso by many value investors. The very same value investors that are eager tosee companies buy back shares and pay high dividends are usually loathto buy companies saddled with heavy debt. However, debt can be thought ofas a type of equity whereby the company is forced to do a “share buyback”(an interest rate payment). That buyback can be more easily predicted thanthe “normal” share buyback. The end goal is that the debt gets reduced tozero, making the enterprise value per share that much higher than it was initially, even though no dividends have been paid or real shares bought back.Debt is only a negative when it is used to buy growth and earnings to hidethe fact that the organic business and model is faulty. For instance, WCOMused debt to fuel acquisitions that, in turn, hid the fact that the core companywas not making any money. When WorldCom failed to buy Sprint, the jig wasup and the only way to hide the lack of earnings was through massive accounting fraud. Because the addition of debt makes due diligence that much harder(and also, any debt at all always increases the risk of bankruptcy during hard
68
TRADE LIKE WARREN BUFFETT
EXHIBIT 4.13
IRM
Year
Revenues
Net Income
Margin
Book/Share
ROE
3-Dec2-Dec1-DecDec-00Dec-99Dec-98Dec-97
1501.31318.51171.1986.4519.5270.3183.5
84.667–32.2–24.9–1.1–11–9.2
5.65.1–2.7–2.5–0.2–4.1–5
$8.31$7.41$7.01$7.42$6.10$1.50$1.46
7.97.2NANANANANA
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
times), value investors tend to shy away from companies with debt. It isimportant to note, however, that Buffett doesn’t avoid these companies, provided that all the other characteristics of the business are positive.
M&T BANK CORPORATIONSymbol: MTB (NYSE)Date Purchased: 1991
69
Current Holdings
In the early 1990s, Buffett began scooping up banks when the banking industry was going through one of its worst periods ever. Buffett had been buyingbanks since the 1960s, and if there was any business other than insurancethat he could be said to know well, it is certainly the banking industry. Buffett was familiar with M&T Bank, based in Buffalo, New York, by virtue of
EXHIBIT 4.14
MTB
Year
Revenues
Net Income
Margin
Book/Share
ROE
3-Dec2-Dec1-DecDec-00Dec-99Dec-98Dec-97Dec-96Dec-95Dec-94
2957.723542579.32097.517611622.41258.11167.61077.7871
573.9485.1378.1286.2265.6208176.2151.1131117.3
19.420.614.713.615.112.81412.912.213.5
$47.60$34.53$31.38$28.96$23.27$20.82$15.59$13.55$12.53$10.30
1015.212.910.614.81317.116.716.217.2
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
70
TRADE LIKE WARREN BUFFETT
his ownership stake in the Buffalo News. In fact, it was News publisher StanLipsey who introduced Buffett to Robert Wilmers, the CEO of M&T.Interestingly, this was not a straight stock investment for Buffett.M&T needed some cash to make two acquisitions so Buffett made a PIPEinvestment in the company, a private investment in a public equity. Buffettlent them $40 million in exchange for a note that yielded nine percent a yearand was convertible at anytime within five years into stock (pre-2001 split)of $78 per share, a 20% premium on where the stock was trading at thatmoment. In 1996, after collecting several years’ worth of the nine percentcoupons, Buffett converted his shares. His initial investment was $40 million and it is now worth well over $600 million.The key issue when doing due diligence on a bank like M&T is whetheror not the bank’s risk-taking is excessive when lending money. A goodshortcut to determining an answer to this is to look at insider ownership;then decide whether this is a shareholder-owned company or a companywhose managers have less stake in the future results. Robert Wilmers, theCEO, owns 3.5 million shares of the company and, prior to the bank’sacquisition of Allied Irish Banks in 2002, was the largest shareholder afterBerkshire Hathaway. When the CEO of a bank owns the bulk its stock,he or she is much less inclined to take excessive risks with the balancesheet. Whereas Buffett intuitively grasped this, it was also the conclusion reached through empirical means by Seok Weon Lee, professor atSoonchunhyang University.2
MOODY’S CORPORATIONSymbol: MCO (NYSE)Date Purchased: 1999–2000When the firm Dun & Bradstreet spun off its Moody’s division in 2000, Berkshire Hathaway became the largest shareholder. With the ballooning in corporate debt over the past two decades, Moody’s and Standard & Poor’s (thelatter owned by McGraw-Hill) became the two behemoths in the space, boththrough the strength of their own brand names and SEC regulations that put2
“Insider Ownership and Risk-Taking Behaviour at Bank Holding Companies,” SeokWeon Lee, Journal of Business Finance & Accounting, Volume 29, 2002.
71
Current Holdings
EXHIBIT 4.15
MCO
Year
Revenues
Net Income
Margin
Book/Share
3-Dec2-Dec1-DecDec-00Dec-99Dec-98
1246.61023.3796.7602.31971.81934.5
363.9288.9212.2158.5256246.4
29.228.226.626.31312.7
($0.22)($2.06)($1.97)($1.76)($2.59)($2.16)
ROE
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
them, along with Fitch, as the premier debt ratings agencies. With over $30trillion in the debt out there having been assigned Moody’s ratings, it is goingto be hard to knock the company off its pedestal.
NIKE INC.Symbol: NKE (NYSE)Date Purchased: 1999
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TRADE LIKE WARREN BUFFETT
Nike, like Coca-Cola and Disney, is a classic “brand story” for Buffett. Theworld’s largest seller of athletic footwear and apparel is held aloft by itsstrong brand and strong identification with athletic superstars like MichaelJordan and, more recently, Lebron James. Throughout the past three decadesthe company has had consistent earnings and ROE, so when the companyslightly faltered in 1998 (and its stock along with it), Buffett became a buyer,making a bet that the strength of its brand backed up by the strong ROE
EXHIBIT 4.16
NKE
Year
Revenues
Net Income
Margin
Book/Share
ROE
4-May3-May2-May1-MayMay-00May-99May-98May-97May-96May-95
12253.11069798939488.88995.18776.99553.19186.56470.64760.8
945.6740.1668.3589.7579.1451.4399.6795.8553.2399.7
7.76.96.86.26.45.14.28.78.58.4
NA$15.14$14.43$13.01$11.63$11.81$11.36$10.91$8.46$6.87
NA18.517.416.918.513.512.325.222.820.3
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
73
Current Holdings
would keep the company on top. In its latest report in 2004, Nike returned toits former ways, reporting its largest revenues, income, and margins ever.
OUTBACK STEAKHOUSE INC.Symbol: OSI (NYSE)Date Purchased: 2001
EXHIBIT 4.17
OSI
Year
Revenues
Net Income
Margin
Book/Share
ROE
3-Dec2-Dec1-DecDec-00Dec-99Dec-98Dec-97Dec-96Dec-95Dec-94
2744.42362.12127.1190616461358.91151.6937.4664451.9
170.2160.8133.4141.1124.397.261.571.653.739.3
6.26.86.37.47.67.25.37.68.18.7
$13.82$13.88$12.25$10.54$8.95$7.37$5.90$4.76$3.77$2.68
16.615.314.217.517.917.814.120.921.122.8
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
74
TRADE LIKE WARREN BUFFETT
In 2001, for the first time in years, Outback Steakhouse reported earningsthat were down from the prior year. The stock languished as a result andBuffett became a buyer. Once again, there are similarities between thisstock and many of the other stocks reported in this chapter: consistentearnings, ROE, margins, and growth in Book/Share for years, followed byone downswing in earnings. The stock is published and Buffett is a buyer,knowing that at the very least he is buying a company that knows how togenerate profits from its equity base, has a strong brand name, and knowshow to generate consistent earnings. Note that despite the consistent earnings and the clear strength of the business, Buffett only started taking thedip in when the water got warm enough, that is, when the company experienced difficulties in its growth. The idea once again was that if a turnaround were in the works (as could be expected by the prior strength inROE and the consistency of earnings), then that turnaround would be a catalyst for the shares.
SUNTRUST BANKS INC.Symbol: STI (NYSE)Growing earnings, consistent ROE, increasing book/share every year.But perhaps the most important aspect of this investment, one of Buffett’slargest, is that SunTrust contains the only handwritten formula of theCoco-Cola syrup in a safe in Atlanta, Georgia. Buffett has to protect thisinvestment!
WASHINGTON POST CO.
Symbol: WPO (NYSE)Date Purchased: 1973The purchase of Washington Post Co. has been detailed in countlessbooks and articles about Buffett. Buffett loved the newspaper industrysince he was a paperboy as a youth, and when he had the opportunity tobuy WPO at 20% of book value, he seized it. The Washington Post probably is the best example of a “cigar butt” stock in the Graham-Dodd sense
75
Current Holdings
(a company trading well below book that is perhaps good to “pick up andtake one more puff but that’s it”). It then grew up to become a growing,permanent holding in the Berkshire stable.Much has been written about Buffett’s influence on the board of WPOand his effect on its corporate governance practices, but I think that
EXHIBIT 4.18
Year
3-Dec2-Dec1-DecDec-00Dec-99Dec-98Dec-97Dec-96Dec-95Dec-94
STI
RevenuesNet Income
7071.87526.98435.486197620.27392.14584.940643740.33252.3
1332.31331.81369.21294.11124971667.3616.6565.5522.7
Margin
Book/Share
ROE
18.817.716.21514.813.114.615.215.116.1
$34.52$31.04$28.97$27.81$24.73$25.47$24.77$22.13$18.86$14.93
13.715.216.415.714.711.912.812.613.215.1
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
76
TRADE LIKE WARREN BUFFETT
WPO has had just as much of an effect on Buffett. This was really Buffett’sfirst major permanent holding. Even American Express, a great companythat Buffett was able to buy in turnaround fashion in the mid-60s, did notnotch in a permanent place until the 1990s. Without the success of WPO,Buffett may have never taken more aggressive chances with companieslike Coca-Cola.
EXHIBIT 4.19
WPO
Year
Revenues
Net Income
Margin
Book/Share
ROE
33-Dec2-Dec1-DecDec-00Dec-99Dec-98Dec-97Dec-96Dec-95Dec-94
2838.92584.22416.72412.22215.62110.41956.31853.41719.41614
241.1216.4229.6136.5225.8417.3281.6220.8190.1169.7
8.58.49.55.710.219.814.411.911.110.5
$217.45$193.18$177.30$156.55$144.91$157.35$117.37$121.25$107.61$101.08
11.611.813.69.216.526.323.816.716.115.1
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
77
Current Holdings
WELLS FARGOSymbol: WFC (NYSE)Date Purchased: 1990Wells Fargo is another case study excellently covered in Hagstrom’s books(and others’) on Buffett. Suffice it to say, Buffett was a buyer when the market was cruelly punishing bank stocks and particularly California banks inthe fallout of the Savings & Loan crisis.
EXHIBIT 4.20
WFC
Year
Revenues
Net Income
Margin
Book/Share
ROE
3-Dec2-Dec1-DecDec-00Dec-99Dec-98Dec-97Dec-96Dec-95Dec-94
3180028473268912756821795204829659.78882.97582.36032
62025710342340263747195013511153.9956800.4
19.520.112.714.617.29.5141312.613.3
$20.17$17.97$16.01$15.29$13.44$12.35$9.01$7.97$7.10$5.39
18.118.812.615.417.19.619.819.619.124
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
CHAPTER 5
MergerArbitrage LikeWarren Buffett
Give a man a fish and he eats for a day. Teachhim to arbitrage, and he will eat for a lifetime.—Warren BuffettWe sometimes enter the arbitrage field when wehave more money than ideas.—Warren Buffett,1985 Berkshire Hathaway annual report
uffett went from a trader of Berkshire Hathaway’s shares to a longterm investor as the result of an arbitrage gone bad. The companyitself was trading for almost half its book value and was regularlybuying back its shares through tender offers. Buffett would buy its stock,wait for the tender offer, and then sell the shares. This was almost a risklessarbitrage. He was buying stock for less than its liquidation value and thecompany was regularly offering to buy back shares at higher prices. It isthis double-edged margin of safety (more than one possible exit strategyfrom the trade) that is the hallmark of a Buffett trade. In any case, it wasthis “out” that afforded Buffett the luxury of building a company worthmore than $100 billion; the company CEO at that time, Jack Stanton, asked
B
79
80
TRADE LIKE WARREN BUFFETT
Buffett at what price he would tender his shares. Buffett said 113⁄8 andthen the company went ahead and tried to lowball him with a tender offerat 111⁄4. “Don’t mess with Warren Buffett” is not necessarily a phrase whispered in the halls of Buffett’s companies, and yet someone should havedefinitely advised Stanton against testing the great trader. Buffett ended uprejecting the tender offer, buying more shares, and outing Stanton—ultimately taking the CEO and chairmanship role for himself. We can only hopeStanton held onto any shares he might have had!Early in his initial partnership, Buffett divided his investment activitiesinto three buckets: generals, workouts, and controls. Generals were longterm value plays determined primarily by their discount to book value,although some qualitative standards were used as well (for example, whenBuffett put much of his fund in American Express stock after the Salad OilScandal in 1964). Controls were usually “promoted” (or demoted, depending on your point of view) to Generals, where Buffett bought so much stockhe ended up controlling the company. Usually, in the case of a “cigar-butt”stock, a stock that was so undervalued Buffett was able to buy shares at asignificant discount to book value, Buffett didn’t mind taking ownership inthe company so he could control the liquidation in order to secure his ability to make money on the investment. He called these cigar-butt stocksbecause if you find a cigar-butt on the ground, it might be good for onemore puff, but that’s about it.And, finally, there were the workouts. The following is from Buffett’sletter to investors in 1963:These are the securities with a timetable. They arise from corporateactivity—sell-outs, mergers, reorganizations, spin-offs, etc. In thiscategory we are not talking about rumors or “inside information”pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper. The riskpertains not primarily to general market behavior (although that issometimes tied in to a degree), but instead to something upsetting theapplecart so that the expected development does not materialize. Suchkilljoys could include anti-trust or other negative government action,stockholder disapproval, withholding of tax rulings, etc. The grossprofits in many workouts appear quite small. A friend refers to this
Merger Arbitrage Like Warren Buffett
81
as getting the last nickel after the other fellow has made the firstninety-five cents. However, the predictability coupled with a shortholding period produces quite decent annual rates of return. Thiscategory produces more steady absolute profits from year to yearthan generals do.During any given year, 50 percent or more of Buffett’s profits on theyear could come from workout situations. Over the course of his 50 yearsof investing, Buffett has engaged in many forms of arbitrage, includingmerger arbitrage, relative value arbitrage, convertible arbitrage, fixedincome arbitrage, and other special situations that involved short-term trading unrelated to his usual bread and butter of stock picking. Does he stillpractice every form of arbitrage there is? No. In some cases, the sheer sizeof the amount of money Berkshire needs to put to work in a deal makes itinappropriate to attempt forms of investing where the capacity of the strategy is much smaller.Later in this chapter we will examine Buffett’s use of arbitrage andinterview a “Buffett-like” manager who does merger arbitrage, John Orricoof The Arbitrage Fund.What does it mean to be “Buffett-like”? In many cases, it is a comparison of apples and oranges. For instance, Warren Buffett seldom (if ever)engages in merger arbitrage these days. Nor is Berkshire Hathaway goingaround buying companies that are trading for less than their book value(usually these companies, if they exist, are too small for him). That said,there are many managers out there who have successfully applied Buffett’sapproach to investing in their own methods. This approach primarilyconsists of an obsession with “margin of safety.” Buffett once said, “Inthe last chapter of The Intelligent Investor, [Graham] said the threemost important words of investing: ‘margin of safety.’ I think those ideas,100 years from now, will still be regarded as the three cornerstones ofsound investing.”So what does “margin of safety” mean? In the basic Graham-Doddanalysis for a stock, it means “buying a stock that is trading at two-thirds ofits liquidation value.” However, even Buffett quickly moved beyond thatunderstanding of the phrase in the early 1960s when he began focusing onmore qualitative aspects of a stock such as brand value, earnings growth,
82
TRADE LIKE WARREN BUFFETT
and so on. It is probably easier to figure out what “margin of safety” is notwhen it comes to investing. It is not:• Buying a stock because it closed above its 200-day moving average.• Shorting a stock because “a 200 P/E is ridiculous!”• Buying calls in a stock on takeover rumors.In other words, the margin of safety will help prevent you from getting intoa situation where the risk cannot be quantified or understood in terms ofthe size of the potential loss.
MERGER ARBITRAGE: WHAT IS IT?The classic arbitrage took place frequently in the early 1900s. Securitiesand London might, for more than a few microseconds, trade at one price onthe London Stock Exchange and then a different price on the New YorkStock Exchange simply because information did not flow as quickly betweenthe two exchanges as they do today. The complete lack of information flowseverely disrupted the plans of an efficient market god. Computers and nowthe Internet have replaced the telegraph as the bridge toward bringing abouta global marketplace, where severe information disconnects like the onesBaruch exploited no longer exists. When an arbitrage exists between anytwo assets, computer models often immediately pinpoint the spread and billions of dollars instantly go to work toward making that spread converge.The question now is, Do opportunities continue to exist? In the BerkshireHathaway 1999 annual meeting, Buffett stated that techniques like arbitragewould still enable an investor to make more than 50 percent a year.The first example of arbitrage to examine is risk arbitrage, which wewill more accurately call merger arbitrage. The reason it is often called riskarbitrage is that the word “arbitrage” often implies there is no risk. How canthere be risk if you are selling gold for $401 in London and buying it backfor $400 in New York simultaneously? But with merger arbitrage enoughrisks exist such that a spread is created between the two assets involvedthat supposedly anticipate and define that risk.A potential merger arbitrage situation is created when any merger isannounced in which the target is a public company. Often the target com-
Merger Arbitrage Like Warren Buffett
83
pany trades for less than the amount offered for that company. A tradeexists where you can buy the target company shares and sell them whenthey reach the price specified in the deal. For instance, if company XYZannounces it is acquiring company ABC for $15/share in cash and companyABC is trading at $14, then you can buy shares in ABC with the idea thatthose same shares will be sold to XYZ when the deal closes at $15/share.Why would there be risks to a merger? Why wouldn’t the target company trade immediately at the price at which it was being acquired? Thereare at least four types of “deal risks” that can prevent a deal from closing:1. Due diligence risk. After the deal is agreed upon there is usually a due
diligence “out,” meaning the acquirer can back out of a deal (usuallyafter paying a breakup fee).2. Regulatory risk. For instance, the GE/Honeywell merger was blocked
by antitrust concerns from European regulators.3. Another acquirer can step in. Particularly in a hostile takeover
situation, a “white knight” might become involved. This would mostlikely be great for those who are long the target’s shares, but in a stockdeal, arbitrageurs who are short the acquirer’s shares as a hedge willlose money.4. Interest rate risk. If a deal is going to take a year to close and the
spread between the target company and its acquisition price is fourpercent and interest rates are five, then an arbitrageur would rather sittight in bonds unless the spread of the deal got wider.Typically when a potential merger is announced, the stock of the targetruns up, settling down near the level of the deal price. The spread betweenthe price it trades at and the eventual deal price is dependent on the risksdescribed above and how much the market, particularly the group of arbitrageurs who are stepping in to make money on the spread, value thoserisks. In an all-stock deal, the stock of the acquirer will also most likelycome down as arbitrageurs short the stock to hedge their risk. The amountof risk an arbitrageur takes in the deal is usually related to the amount thestock ran up the day the deal was announced. If news of the deal had beenleaked in the days prior to the deal being announced, then