Posts tagged Investment Strategy

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As a mathematical physicist and an actual arbitrageur (as opposed to armchair arbitrageur), I have a broader view of the arbitrage concept than many people. The original concept of arbitrage, its purest form, is simultaneous long buying and short selling of similar objects with no risk. For example, simultaneously, buy U.S. dollars with Euros, in London, and sell U.S. dollars for Euros, in Jakarta, for two slightly different prices to make a so-called spread, the difference between the prices in the two markets. Another type of currency arbitrage, which can be done in one market, is triangle arbitrage, using three currencies that are somehow out of alignment with one another.

As another example of arbitrage, we might conceive of buying convertible bonds and short selling the stock into which the bonds will convert. In that manner, you can create a virtually riskless position. It is a matter of looking at yield difference between the stock and the bond and creating an instantaneously riskless position. If you can earn a higher return than the riskless rate, you are ahead in the investment game. Moreover, because of the rules on securities holding for broker/dealers, you can also leverage such a position and put up only around 10 percent of the underlying long bond position, in this convertible arbitrage long-short position.

In merger arbitrage, there is risk: the risk that the merger will not go through. The arbitrage comes from an analogy for the special case of a share-for-share exchange merger. For example, XYZ Corporation might offer 2 shares for each share of ABC Corp., in a share exchange merger. That type of merger structure also has a tax advantage for shareholders, with the exchange not counting as a sale of shares. For the exchange ratio to be effective, the value of 2 XYZ shares must be greater than the price of ABC shares, trading in the market directly before the merger announcement. Then, if ABC’s shares had been trading at $30 before the announcement, and XYZ’s shares were trading at $25 per share, then, 2 shares of XYZ is $50. To set up a merger arbitrage position, in this case, the arbitrageur short sells 2 XYZ shares and buys 1 ABC share. In that manner, he locks in a definite spread, which will be earned, if the merger closes. Indeed, it does not matter if XYZ goes down after the position is taken on because ABC will follow. When the merger closes the arbitrageur will be given two shares of XYZ for every ABC share he owns, and the position, in his securities account will be short and long (called “short against the box”) and equal number of shares of XYZ.

In fact, the merger arbitrageur might also engage in capital gains tax arbitrage by “aging” his position and closing it out only after the gain has become long-term. Moreover, under capital requirements for broker-dealers, on a short against the box position, there is no capital requirement. Thus, the aging short against the box position is a zero investment riskless position with greater than a riskless return, at that point. As a result, a share exchange merger can become an arbitrage on top of an arbitrage.

We can look at brokers as doing a sort of riskless zero-capital arbitrage, in that they hook up a buy with a sell and get a riskless commission for so doing. Dealers and market makers are also engaging in a risky sort of arbitrage. They put up bids and offers on a security to earn the bid-ask spread, and, as long as they are able to trade flat every day, ending with no long or short position, they make the spread. There are arbitrages between commodities and their futures, as well as among stocks and their put and all options, and among the options. At the other end of the trading spectrum, a LBO firms are doing an arbitrage between the public market for corporate control and the private market for public control. A corporate raider is doing an arbitrage between a packaged public corporation and the private markets for its corporate parts. We recently did an article in buzzle.com that explained the Chinese export phenomenon as purchasing power arbitrage. We could go on with more examples and explanations of arbitrage, but we really should get to the point, so, we refer the reader, instead, to our website’s In Country Analysis page for further reading.

In the 1990’s, I took a dilapidated 18th century property, fixed it up, put my extensive collection of art and antiques in it, and turned it into an internationally recognized country inn. It was, in fact, just a double arbitrage. It took a collection of art and antiques and preformed private collection to public art viewing and retail markets arbitrage. I bought the art in the inter-dealer market, got an implicit rental for it, sold some at retail prices and sold the end of the collection with the property. I also did an arbitrage between mortgage payments on a residence and rental payments for overnight accommodations. Arbitrages are more numerous than people might first imagine.

The concept of Contrarian Investment Strategy was brought into the public awareness, in the late 1970’s by David Dreman. As any professional investor knows, one actually finds good investments in places where other people are not looking, either because of lack of general awareness, or lack of understanding. In that regard, the general mandate of contrarian investing is to invest, not willy nilly, in stocks of companies that are out of favor or that lack coverage by securities analysts, so that they are not in the public investment consciousness. In the end, those types of stocks are undervalued because of a lack of buying attention. That also means that they will have relatively low PE ratios, relative to other in-favor companies in their industry.

Normally, then, a contrarian investor does his own homework, mining these undervalued, low PE stocks and filtering out those that have low PE ratios, not because of any real financial problems, but because they have no investment following. The typical strategy, thereafter, involves going long the undervalued, low PE stocks. In so doing, the investor is, in another light, engaging in a sort of PE arbitrage, buying the low PE versus the industry standard PE, which he is implicitly, though not actually, short. This strategy has given wrought good investment returns, most of the time, but it is an unhedged, pure long strategy and, therefore, is still left open to the vagaries of the markets. That is a lesson that even the father of this strategy, David Dreman, has learned, this year. The idea that there is implicit protection lies in the fallacy that the stocks have already been beaten so low, that a down market should not hurt the naked long positions, too much.

A better way to implement this PE arbitrage, would be to also find those stocks, within the industries of the chosen long low PE stocks, with relatively high PE’s. Then, the contrarian PE arbitrage strategy would be to build a portfolio of long, low PE stocks and short an equal dollar value of high PE sticks, paired with the longs. In that manner, not only will the portfolio be a hedged portfolio but, also, to take full advantage of the PE arbitrage opportunity, earning a PE spread as both stocks, high and low PE pairs, gravitate to the norm. Moreover, even if the market goes up or the market goes down, the long-short pairs will counterbalance one another.

In the end, value investing is investing, not arbitrage. Value is defined in many ways, but it usually focuses on psychology. Another method that has been tried, involving this general psychological value focus, does take a two sided arbitrage approach, for example. A phenomenon observed by researchers [Victor Bernard & JacobThomas, "Post-Earnings Announcement Drift: Delayed Price Response or Risk Premium?" Journal of Accounting Research 27 (1989)] is called post earnings announcement drift. It has to do with a market inefficiency that information is not immediately correctly processed by real human beings. If the stock market is efficient, either expected earnings should already be reflected in stock prices, and an earnings surprise, one that is better or worse than the forecast expectation, should be rapidly assimilated into market prices. However, the reaction is actually stretched out for a whole fiscal quarter (60 trading days), in other words, until the next earnings announcement. There is some anticipation before the announcement, but abnormal returns continue even after the news has been announced. The phenomenon has been in the markets for decades. A strategy of going long a portfolio of the highest decile stocks with so-called standardized unexpected earnings, and short a portfolio of the lowest decile, those with bad earnings surprises, produced an average CAR, cumulative abnormal profits, of 4.2 percent over the sixty day period after announcement, or about 18% annualized. In addition, the effect is more pronounced for small firms, which are less covered by analysts and less followed by the investment community, resulting in a zero-investment strategy CAR of 5.3 percent, or over 21 percent annualized. Although the effect does last, on average, past the 60 day limit, it does seem to finally disappear by the end of a 180 day, or three quarter, period.

In the end, the only type of investment that will not be upset by an unexpected market crash is some sort of arbitrage strategy. We just use a broader definition of the term and the strategy.