Monday, April 30, 2007

Value investing is arbitrage

The other day, I talked about the reverse-split arbitrage I've been been engaged in for the past year. Thinking about the methods I use to evaluate the opportunities, I started to wonder if they could be applied to other investments. Certainly the concept of arbitrage can be extended to other realms such as sports betting. The key element is that there must be multiple markets for the arbitrageur to exploit. In the case of a reverse-split, the two markets are the open market where one normally purchases the shares, and the company market where the company buys the shares. The reason this arbitrage is profitable is that the second market is only available to those who hold a small number of shares. In mergers and tender offers open to unlimited amounts, the market adjusts almost immediately to the offered price.

Value investors do something similar when we attempt to profit on discrepancies between the price and the value of a stock. Of course, the value market is a theoretical one, at least in the short term. But the purpose of buying an "undervalued" company is the hope that eventually the market will change in such a way to properly value the position.

Let's take a look at Berkshire Hathaway, the classic value stock. First, we need an estimate of the payout if a bet on Berkshire is successful. The Berkshire Hathaway Intrisivaluator is as good a place to start as any. Currently, the "Cost of Capital" estimate puts BRK.B shares at $4754. This estimate assumes a healthy growth rate discounted at Berkshire's cost of capital. For an estimate of the minimum value, we'll use the "Liquidation" scenario of $3114 a share. Here the assumption is Berkshire sells off all its assets, settles all its debts, and distributes what's left to shareholders. There are other choices offered by the model, but for the sake of argument, let's assume that these are the payouts for success and failure.

The market values BRK.B at $3628 as of today's close. Using the method I described last week, that implies the market thinks there is roughly a 45% chance Berkshire will perform well enough in the future for "B" shares to be worth $4754 today. By elimination, that means there's a 55% chance Berkshire will stall out and only pay out $3114. Obviously any rational view of a company's future will be more nuanced and complicated than a simply success/failure trial. But it does provide a dead-simple method of calculating the odds of a stock investment. In this case, the market seems to think Berkshire doesn't have much gas left in the tank.

One issue with thinking this way for ordinary stocks is that there is no finite termination date. It's as if the coin keeps spinning and never comes down—or maybe the coin is flipped over and over again as shares are traded. But that's not a bad thing from a practical standpoint, since the company's value doesn't stop moving either. Each quarter there is new input into the value calculation, which often makes a good deal look even better. If you flip back in the Intrinsivaluator to 1981 ("B" shares, if they existed, were valued at $40), the value keeps climbing as you step through the years. Even in 1995, when Berkshire seemed most overvalued, a long-term investor would probably regret selling.

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