old andraring to go. In the 1988 Berkshire Hathaway letter to investors, he discusses his first foray into arbitrage when he was working for Graham.Rockwood & Company was a modestly profitable maker of chocolate products that was sitting on an enormous supply of cocoa. In 1954 there was ashortage, and the price rocketed up. The company did not want to sell thecocoa outright because there would have been a tax consequence. A younginvestor by the name of Jay Pritzker helped Rockwood & Company to usethe 1954 tax code to its advantage. He pointed out a provision that said itcould distribute the cocoa to shareholders without incurring the almost 50percent tax liability if it were part of a restructuring that reduced the scopeof its cocoa business.The company then offered to repurchase its shares in exchange forcocoa (as opposed to dollars). Buffett would buy shares on the open market, sell the shares to the company in exchange for cocoa, and then sell thecocoa for a nice profit. His only risk was that the price of cocoa would fallbelow the level he was paying for the shares. Since he would attempt to dothese sales as simultaneously as possible, his risk was negligible.So, again, that was then and this is now. Clearly such spreads wouldn’texist right now, right? But then again, let’s look at the PALM-3Com example.March 2, 2000, only eight days before the Nasdaq’s all-time peak (as ofthis writing in January 2004), Palm went public. Initially scheduled to gopublic in a range of $14 to $16 per share, demand was so great that theshares priced at $38 per share. This translated to a huge cash bonanza forthe company. On the first day of trading the shares opened at $150, immediately traded as high as $165, before finally settling down and ending theday at $95.06. At this point only four percent of the company was availableto the trading public. 3Com (Nasdaq: COMS) still owned 95 percent of thecompany and was preparing to distribute 1.5 shares of PALM for every oneshare of COMS. If the only value of COMS had been its share of PALM, thatwould value each share of COMS at 1.5 × 95.06. In addition, COMS hadapproximately $10 per share in cash and it had zero debt, not to mentionthat COMS had an ongoing profitable business.So one would think that COMS now would be trading . . . where? Atleast $152 / share (the value of PALM plus the value of its cash). Or maybe$177 per share, since at least one analyst thought that its non-PALM assets
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EXHIBIT 6.2
Stub Value, 3Com
-May11
4May
r27
-Ap
r20
-Ap
r-Ap13
r6Ap
-Mar30
-Mar23
-Mar16
9Mar
2Mar
10
−
0
−10
Dollars per share
−203/20: 3 Com quarterly earnings, reorganization announced.Spin off to be completed by 9/1, earlier than planned.−303/16: Exchange tradedoptions introduced.−40
IRA approval announced, Palm shareswill be distributed 7/27. Expended stockrepurchases announced for 3 Com.
−50
−60
−70
Source: “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-outs.”by Owen A. Lamont and Richard H. Thaler (National Bureau of Economic Researchand University of Chicago), Journal of Political Economy, Volume III, Number 2,April 2003. Published by the University of Chicago.
were worth approximately $35. However, on the day of the IPO, COMSshares ended up at $81. This implied a spread of at least $60 between thevalue of the PALM shares and the value of the COMS shares, even if onevalued all of COMS’ other assets (cash in the bank plus a profitable business) at zero (see Exhibit 6.2).The stub value (the market-implied value of the 3Com assets minus itsPALM shares) converged to zero, and finally above zero, by September of2000 when 3Com finally spun out the shares to shareholders. This wouldhave been an immensely profitable arbitrage. The difficulty in implementing it would have been in finding shares of PALM to short. Recent IPOs areoften difficult to short.An example of such a trade where investors lost an immense amountof money occurred in early 2003 in Japan with the Eifuku fund. A similarsituation to the PALM/COMS spread occurred when Nippon Telephonebecame severely undervalued compared to its DoCoMo subsidiary. The
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Eifuku fund made a massive leveraged bet that the spread would close.Instead, the spread widened and within seven days the fund lost over 90percent of its value, closing down when Goldman Sachs took control andclosed all of its positions.A similar situation occurred with Long-Term Capital Management(LCTM) and Royal Dutch Shell. Royal Dutch, which traded on the NYSEand Shell, which traded on the London stock exchange, were actually thesame company, formed in 1907 by a merger between Royal Dutch and ShellTransport. The split between the two was 60/40 and should have tradedaccordingly (the value of Royal Dutch shares trading on the NYSE shouldbe 1.5 times the value of the Shell shares trading on the LSE. Instead, thedisparity is often much more.Richard Thaler provides Exhibit 6.3, which shows the disparity between the way the shares traded and the way they should have traded (the60/40 split).
EXHIBIT 6.3
Royal Dutch Shell Pricing DisparityPricing of Royal Dutch Relative to Shell(Deviation from parity)
20%15%
Deviation
10%5%0%−5%−10%
Source: “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-outs.”by Owen A. Lamont and Richard H. Thaler (National Bureau of Economic Researchand University of Chicago), Journal of Political Economy, Volume III, Number 2,April 2003. Published by the University of Chicago.
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In August 1998 this disparity reached an all-time high, precisely whenLong-Term Capital Management was hanging on by a thread to this position as well as many other arbitrage positions that were experiencing asimilar widening.It is interesting that at this time, when LTCM was on the brink of losingits $3 billion fund, Buffett offered to pay approximately $100 million to takecharge of its portfolio. They turned him down, but Buffett was definitelysniffing around for a good cause.Are we wasting our time, then? Do these situations happen on a regular basis and, if they do happen, is it unusual for the results to pay off? MarkMitchell, Todd Pulvino, and Erik Stafford1 examine every situation between1985 and 2000 in which the market capitalization of a company traded forless than the sum of its parts.They note that there are two types of risk in this strategy. The first isfundamental risk, the risk that the shares of the two securities might neverconverge. The parent company, for instance, can go bankrupt, having usedthe value of shares in the spin-off as collateral before finally collapsing. Theother type of risk to the arbitrageur is financial risk, the risk that the securities might converge, but first they might diverge in such a way that substantial losses by the arbitrageur are incurred, as happened in the LTCMand Eifuku cases above.Mitchell, Pulvino, and Stafford walk through the example of CreativeComputers and Ubid. Ubid was an eBay-like auction site started by Creative Computers. Creative spun out 20 percent of Ubid to the public onDecember 4, 1998. Like all good dot-com stocks at that time, Ubid sharesbegan trading in a frenzy and at the end of the first day of trading after theIPO, UBID shares were trading at a market capitalization of $439 million,making the 80 percent that Creative Computers still held in UBID worthapproximately $80 million more than the entire market capitalization ofCreative. The authors go on to assume that an arbitrageur would havewaited four days before trying to play the spread due to the lack of short-
1
“Limited Arbitrage in Equity Markets,” by Mark Mitchell, Todd Pulvino, and ErikStafford, Journal of Finance, April 2001.
Relative Value Arbitrage
EXHIBIT 6.4
127
Creative Computers/UBID Arbitrage
Source: Mark Mitchell, Todd Pulvino, and Erik Stafford, “Limited Arbitrage inEquity Markets,” Journal of Finance 57, Issue 2, April 2002, Figure I, pp. 568.Reprinted by permission from Blackwell Publishers Journal Rights, Email:JournalRights@oxon.blackwellpublishing.com.
able shares in Ubid immediately after the IPO. On the fourth day, the valueof the stub value had increased from −$80 million to −$28 million.Attempting to capitalize on this spread, an arbitrageur would haveshorted 0.72 shares of UBID for every one share of Creative Computers.Assuming that Creative was going to spin out the shares to shareholderswithin six months of the IPO, the return to the arbitrageur would have beenapproximately 45 percent.However, within a few weeks the value of the stub would havedecreased from −$28 million to less than −$700 million. The losses sustained by an arbitrageur would have been close to 100 percent assuming thearbitrageur met all of the margin calls, as detailed in Exhibit 6.4. Althoughthe prices eventually did converge, the roller coaster was too painful forany investor to handle.The authors assume that all margin calls are met, they assume transaction costs and they also limit the initial investment in any one deal to 20percent of total equity. Additionally, they assume short rebates of three
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EXHIBIT 6.5Year
Pure Negative StubValue Portfolio
198619871988198919901991199219931994199519961997199819992000
9.5%44.4%17.5%–0.3%29.3%17.6%6.4%55.6%2.5%2.1%41.1%20.5%–14.2%15.7%77.4%
MeanStdSharpe Ratio
22.0%24.8%0.676
Source: Mark Mitchell, Todd Pulvino, and Erik Stafford, “Limited Arbitrage inEquity Markets,” Journal of Finance 57, Issue 2, April 2002, Figure VI, pp. 575.Reprinted by permission from Blackwell Publishers Journal Rights, Email:JournalRights@oxon.blackwellpublishing.com.
percent a year, where the cash they make from selling the shares they borrow yields interest. Exhibit 6.5 demonstrates their results.The strategy of playing the spread between a parent and subsidiaryresulted in an average return of 22 percent per year between 1986 and 2000.
CHAPTER 7
PIPEs andHigh Yield
bviously, not every technique that Buffett has used to trade can beused by the average investor or trader. Some of the techniqueshe used in the 1960s and 1950s, like driving around putting up signsfor people to sell him shares in specific “cigar-butt” companies, do notapply to today’s Internet-driven world. What is important is to identify thecommon thread that drives each of his investment decisions: the quest fora margin of safety in each trading strategy. Again, this is not “margin ofsafety” in the Graham-Dodd sense of buying a company at two-thirds itsliquidation value, but the idea of making a trade or investment where youhave multiple reasons, hopefully uncorrelated reasons, to believe that theinvestment will not lose money.For example, in Chapter 5 I discussed the Arcata deal where KKR hadan offer to buy the company. Buffett was buying shares of Arcata becausehe believed the deal would be consummated. However, the key is that Buffett also went through the exercise of asking, “If this deal never happens,can I get out of these shares with a profit?” At that point, he also analyzedthe liquidation value of the company and determined that the exit, whileprobably slightly longer off, would still result in a profitable trade for him.In other words, he had an “out,” a back door exit available to him just incase the front door exit he had planned for did not work. It is this thatsums up Buffett’s margin of safety in every case.
O
129
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The use of private investments in public equities (PIPES) is a techniquethat Buffett often exploits to get his hoped-for margin of safety, but this isnot necessarily a technique available to the average investor.A public company typically goes the PIPE route when other avenuesfor raising capital are closed off. Normally, a public company that needs toraise money either does a secondary offering or a debt offering. In otherwords, the company can hire an investment bank like Goldman Sachs orMorgan Stanley. They put together an offering memorandum explaining therisks and the possible benefits in investing in their company, and then theygo on the road, meeting investors who might be interested in their offering.Typically, a secondary offering is at a slight discount to wherever the stockis then trading, in order to give the secondary investors an added advantageto purchasing the secondary instead of simply buying the shares on theopen market.Additionally, the common stock of a company usually suffers in botha secondary stock offering and a debt offering. When there is a secondary,current shareholders of the company know that they are about to bediluted and that each stock is therefore worth less. Both Dalia Marciukaityte1and Mikkelson and Partch2 conclude that immediately after a secondaryoffering, the stock price tends to decline. Perhaps shareholders are worried about the effects of dilution. Or perhaps shareholders wonder whymanagement chose this time to sell off common stock. In other words, didmanagement view the stock as overvalued, so, like any investor withenormous information about a company’s prospects, it made an investment decision?Similarly, after a debt offering, common stock tends to sell off, as wellas many of the recipients of the new debt now hedge their bets by shortingthe stock.Additionally, the costs of a secondary are not trivial. The bank takes itsfees, which could be as high as six or seven percent. In addition, the SECrequires various filings to register the shares in advance (which also
1
“Investor Behavior and the Timing of Secondary Equity Offerings,” Dalia Marciukaityte, Louisiana Tech University working paper, 2002.2“Study Price Effects of Secondary Distribution,” Mikkelson & Partch (JFE, 1985).
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131
telegraphs to the public at large that a secondary is looming, causing perhaps an initial selloff in shares).For these reasons, many companies opt to go immediately into thePIPE route, selling shares directly to private investors without having totake the secondary route. In many cases this avoids the costs associatedwith hiring an investment bank to manage a secondary offering. Also,smaller companies or companies deeply in distress may not be able to hirean investment bank to take them through the ropes of a secondary.The typical PIPE comes in one of two flavors: common stock (with awarrants kicker) or debt (usually convertible).A common stock PIPE might work as follows: Company XYZ is tradingat $10 a share and needs to raise $4 million. It sells 500,000 shares at $8 ashare (a 20 percent discount) and for every 10 shares of stock an investorbuys, he or she also receives four warrants with a strike price of $12 a share(40 percent warrant coverage at a 20 percent premium strike price). Typically, the shares cannot be sold immediately, but only after a waitingperiod, usually anywhere from three months to one year. The investor insuch a PIPE can justify his margin of safety in two primary ways:1. The 20 percent discount. If not specified in the agreement, a PIPE
investor can hedge his shares by immediately shorting at $10, locking inthe $2 spread (since he owns at $8). However, usually the PIPE agreement will specifically state that no hedging is allowed. Also, the sharesmight not be liquid enough for such a hedge.2. With luck, the share purchaser was attracted to other aspects of
the deal beyond the 20 percent discount. If the company is a legitimate investment, then the buyer of the PIPE shares just received agreat bargain compared to the common stock holder. If the stock goesup, not only does the PIPE investor benefit from the 20 percent discount, but also the warrants.From January 1, 2004 to May 1, 2004, there were 436 examples of PIPEdeals involving common stock, according to PrivateRaise.com. These dealsadded up to $5.1 billion in investments. Most (298) of these deals were oncompanies with a market capitalization less than $100 million. So they weremostly micro-cap companies.
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TRADE LIKE WARREN BUFFETT
For example, on April 29, 2004, Capital Title Group (NasdaqSC: CTGI)announced it raised $10.1 million at an average price of $3.60 a share. Theday before, the stock had closed at $4.20. Additionally, the purchasers ofthe $2.8 million shares at $3.60 were granted warrants that gave them theright to buy at any point over the next five years 889,252 shares of commonstock at an exercise price of $4.00 per share.The other type of PIPE deal is a private offering of debt that later converts to equity. This can take a wide variety of forms, but it usually involvesa fairly high interest rate and an attractive conversion price that is somewhere near where the stock is currently trading. If the debt-holder neverconverts, then he or she benefits from the high yield. If the stock goes up,the debt-holder can benefit by converting to common stock at a muchlower stock price and reaping the benefits of the capital gain.Convertible PIPEs became notorious in the late 1990s when manytechnology companies, desperate for cash as the bubble began to burst,offered what became known as “death spiral convertibles” or “toxic convertibles.” These were debt offerings that converted whenever the debtholder wanted, at whatever the stock happened to be trading at, no matterhow low. The result was that many investors in these PIPEs would immediately begin shorting the stock as soon as they took hold of the convertible, in order to drive down the price of the stock as low as possible. Whilethis was usually a rare and unpleasant form of PIPE, which ultimatelyresulted in bankruptcies and lawsuits, this practice gave the PIPE offeringa bad name.Although Buffett has never engaged in these death-spiral convertiblesor anything remotely close, he has been an active investor in distressedcompanies through the use of PIPES. In some cases, as with Salomon andChampion, Buffett has been approached by management to be a “whiteknight” so that the company could avoid the grasp of an unwelcome suitor.Such knighthood carried its cost for the company and Buffett was oftengranted favorable terms through the use of a PIPE.In other cases, Buffett has been an investor in distressed companies,usually securing generous terms with companies in dire straits. In additionto the terms of the offering, Buffett would often achieve his margin ofsafety by having the offering backed up by significant assets, as in the caseof Williams Co., which we will examine later.
PIPEs and High Yield
133
GILLETTE, JULY 1989There has been a lot of analysis of Buffett’s core holdings in companiessuch as Gillette and Coca-Cola. These are great brands, they have consistent earnings, and their stock prices have gone up enormously since Buffettbought them. In hindsight they seem like no-brainers. Why didn’t everyonebuy these stocks?Things were definitely not so simple in the late 1980s when Buffettdecided to purchase a stake in Gillette. The company, founded in 1923 byKing Gillette, was being stalked by disposable blade inventor Bic. Gillettewas surprised by the strength of public demand for the low-margin disposable razors, which quickly grabbed up to 50 percent of the razor market.Although return on equity was incredibly stable and the company was stillgrowing, Gillette was no longer achieving a growth rate attractive enoughfor institutions. In addition, the stock price was faltering. Sales were growing at a meager one percent a year. In addition, the company had to increaseits debt load to fight off four different takeover attempts. This is not normally thought of as the typical Buffett investment.In July 1989, Buffett contacted the CEO, Colman Mockler, and workedout an arrangement whereby he received $600 million in convertible preferredstock yielding 8.75 percent a year for ten years and convertible into commonstock at a conversion price of $50 a share. The stock was then trading at $40,but had been rising pretty steadily in the 1980s until about a year or so earlier,when it had flattened out along with its sales and margins (see Exhibit 7.1).In February 1991, Buffett was able to convert into common stock whenGillette was trading at $73 per share, for a 45 percent profit on his originalinvestment, not counting dividends. Much has been written on Gillette’svalue to Buffett as an equity investment over the years, but it is interestingto note that it did not start that way. However, the PIPE that Buffett didenabled him to essentially have a free ride on Gillette. The one thing that Buffett knew, based on the company’s 60-year earnings history, was that Gillettewould not go out of business. In other words, he was going to get his 8.75 percent yield no matter how badly margins got squeezed by disposable razors.He also knew that given the strong brand of Gillette, it would take a lot longerthan ten years, the life of the bond, for anyone to knock Gillette off itspedestal, even if it were attacked on all sides.
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EXHIBIT 7.1
TRADE LIKE WARREN BUFFETT
Gillette: 1982–2004
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
In other words, Buffett had a free ticket to watch the show in the cutthroat razor-blade business while getting his 8.75 percent coupon no matterwhat. He could simply wait for the right moment, should it come, to convertat an enormous profit. He did exactly that. For a detailed analysis of Gilletteas an equity investment at the time that Buffett did his conversion, I highlyrecommend Hagstrom’s book, The Warren Buffett Way.
SALOMON INCORPORATEDSalomon is another company that definitely did not fit Buffett’s style.Investment banks are subject to the whims of their times, and very fewbanks achieve the type of moat status that Buffett covets. Also, investment banks go in and out of favor depending on the market. If the marketis down, mergers and acquisitions (M&A) are less frequent; alternately,IPOs are less frequent, and investment banks earn less money in fees. During those periods, investment banks are dependent on their proprietary
PIPEs and High Yield
135
trading, which Salomon at that time was well known for—particularlytheir bond trading group as made famous by Michael Lewis in his classicbook, Liar’s Poker.3However, despite Salomon’s acumen as a money-raiser or as a tradingoperation, these were not revenues or earnings that could be consideredpredictable. Nevertheless, Buffett had worked with John Gutfreund, theCEO of Salomon, in the past (most particularly when Buffett took overGeico in 1976). When corporate raider Ron Perelman was stalking thecompany, Gutfreund called Buffett and made a deal.In 1987, Buffett bought $700 million worth of convertible preferredstock paying a nine percent annual dividend. The preferred would beredeemed over a five-year period beginning in October 1995. Meanwhile,the preferred stock could also be converted into common stock at a priceof $38 per share, with the common at that moment trading at $33. If thestock went up from $33, Buffett would be very happy because he would getthe full appreciation of any price move above $38.However, the market crashed a month after Buffett did the PIPE, causing Salomon stock to sink to $16. Was Buffett worried? Not at all. As far ashe was concerned, at that point he had a very solid bond paying nine percent per annum. In other words, he had a free ride on the company.The story would have a pleasant ending if that was all there was to it.However, the Salomon preferred stock almost became Buffett’s most costlymistake ever: On August 16, 1991, Salomon announced, with the stock justpennies from Buffett’s $38 strike price, that the company had violated U.S.Treasury rules involving the government bond auctions and that all of thetop officers were resigning.What happened afterward has been written about in numerous places.Lowenstein4 and Hagstrom5 document the incident thoroughly. Buffettbasically took control of the company and cleaned house. He fired everyone involved with the scandal, pleaded successfully with the government
3
Liar’s Poker, Michael Lewis, Penguin Books, 1990.Buffett: The Making of an American Capitalist, Roger Lowenstein, RandomHouse, 1995.5The Warren Buffett Way, by Robert G. Hagstrom, John Wiley & Sons, 1994.4
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to be mild in any penal suspensions of trading activity, and guided the company back on course.Suffice it to say, Buffett made money on his investment, both in hissteady nine percent annual return on the dividend, and from the eventualconversion of portions of his preferred stock into common once Salomoneventually traded above the conversion price of $38 in 1993. Again, this isan example where if it were not for the PIPE investment, it is unlikely thatBuffett would have been a buyer of common stock shares of Salomon in1987. But the PIPE allowed him to get a free ride while at the same time getting a very respectable dividend. This provided a considerable margin ofsafety, making up for the fact that the economics of the business might nothave fit Buffett’s sweet spot.
CHAMPION INTERNATIONALAnother similar PIPE deal was Buffett’s 1989 arrangement with ChampionInternational; he bought $300 million worth of convertible preferreds paying a 9.25 percent interest rate and convertible into common stock at $38per share when it was trading at $30.The company had almost nothing going for it. Return on equity was ameager seven percent. The company had a very erratic earnings historyand no real growth to speak of. That said, there were several million acresof timber on the books that nobody knew how to value. Buffett knew thatduring the 10-year holding period of the bonds he would get his 9.25 percentinterest rate. In the worst-case scenario, the company could just sell offmore timber to pay the coupon. On top of that, timber was a useful hedgeagainst inflation. And, finally, if the company had a turnaround or was ableto liquidate the timber, then the shares would substantially appreciate. Buffett was able to cash out his converted shares at a profit within five years.All of these PIPE deals from the late 1980s were interesting in that theyare often used (particularly Gillette) to describe the features Buffett looks forin an equity investment. It is true that they each became equity investmentsonce Buffett converted his shares, but he essentially got a “free look”—or a“lottery ticket” as Roger Lowenstein describes it in his biography of Buffett.Buffett was able to enjoy the benefits of the bond, which required a different
PIPEs and High Yield
137
level of due diligence than doing an equity investment, and then ride the capital gains later as the stocks all went up—even though in the case of Salomon,he became perilously close to losing his investment. In the October 1997 edition of Fortune, Buffett said about the Salomon investment, “I’d say we hit ascratch single, but not before the count got to 0 and 2.”At the time of these transactions Buffett and the companies involvedwere criticized; the complaint was that Buffett was getting a sweetheartdeal at the time unavailable to other investors. This criticism is true and theaction is hard to defend. However, the rationale was that Buffett’s playingthe role of “white knight” saved the shareholders from whatever horrorwould have resulted had the company been taken over by hostile raiders orincapable management. And Buffett’s abilities in a clutch situation werecertainly demonstrated when he saved Salomon from almost certain bankruptcy during its 1991 troubles.In the post-bubble downturn of 2000–2002, Buffett again engaged inseveral PIPE transactions.
LEVEL THREE COMMUNICATIONSLevel Three Communications (Figure 7.2) was a surprise investment. Justas an aside, it reminded me of the Fischer-Spassky chess match in 1972.Bobby Fischer was a rather eccentric chess grandmaster who became thefirst post-war American to challenge the Russians in the world championship. He also was notorious for only liking one first move: moving hisking pawn two squares. Anyone who prepared for Fischer only needed tostudy this move, because he had stated repeatedly that this is the only firstmove worth playing. Hence, it came as an unbelievable shock when heplayed his queen pawn as the opening move in the middle of the match.Buffett pulled a similar maneuver in July of 2002 when he made a private investment in Level Three Communications, a provider of broadbandservices. Level Three was a bubble stock founded by Buffett’s good friendand Berkshire director, Walter Scott. In early 2000, Level Three shares wereworth over $100 per share.It was around this time that Buffett was getting the most criticism fornot investing in technology. He was getting grief on two levels:
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EXHIBIT 7.2
TRADE LIKE WARREN BUFFETT
Level 3 Communications Inc
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
1. Many investors were patting themselves on the backs for beating out
the “world’s greatest investor” when they loaded up the boat on techstocks in 1999 and 