Arbitrage and Market Turmoil

Seth Klarman and Joel Greenblatt have made careers correctly monetizing on the dislocations in the capital markets. They look for forced sellers where the stock price is depressed not because of the fundamentals but because of the stakeholders who are selling in bulk for one reason or the other. In spinoffs it could be the the holder do not want to or cannot hold on spinco, in additions and deletions from indexes there is opportunity for the astute investor. I am finding now there are opportunities where a deal does not go through and most of the float is held by the arbitragers.

Now suppose a stock is to be taken out at $30/share and was trading at $25/share, which seems to be its intrinsic value as determined by the market. The stock will trade close to $30 and most of the investors holding the shares would have sold their shares to the arbs in the $29 range. Now further suppose that this merger falls apart, for whatever reason (other than a material change in the business suppressing the intrinsic value). Ideally, the stock should go down to around $25/share (in a normal market), but the opportunity arises because it usually does not! The arbs are not in the business of buy and hold, they are in the business of 'buy at 58 sell at 60'. So they will sell their holdings, and because they are levered (to juice the returns) they will sell fast. The stock will have undue downward pressure in these situations and will come way below its $25 intrinsic value. The more it comes down the better it is for investor looking to scoop up a company for cheap. To be sure the window of opportunity here is narrow, the investor would need to do his HW before.

Let me give you an example, after Genesco terminated the merger with Finish Line the stock came down to around $2/share (while the merger was around $15). The price had come down to a fraction of book value for a profitable retailer, and this is mainly because of the forced sales by the arbs. An opportunistic investor could have loaded up and 6 months later sold the position at around $10/share for a 5x return!!

Another example could be the Cerberus-United Rentals buyout. The company went to court but the judge ruled in favor of Cerberus, there was no buyout but Cerberus agreed to pay $100 million termination fee. The buyout was at around $35/share and and URI shares fell to as low as $16/share in the following weeks. Again a opportunistic investor could see that this is way undervaluing the company. The company itself realized that its share price was too low and initiated a tender offer between $22-$25/share for around 20% of its float! The shares traded around $22/share in the ensuing weeks a which seemed to be its value prior to the buyout news.