Arbor Capital Management, Inc.
Special Situations Portfolio
RISK-REDUCING INVESTING
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Arbor Capital Management, Inc. Special Situations Portfolio |
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ENHANCING RETURNS WITH RISK-REDUCING INVESTING |
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What are “special situations”? Arbor Capital Management tries to exploit price discrepancies to obtain gains that greatly exceed return of the major indexes. In nearly all cases, we invest in situtations where the final return is already known. For example, a company that trades for $50 may announce that it intends to liquidate its assets for $55 per share. Buying the shares for $50 ensures a locked-in $5 profit. In another example, a stock may sell for $50 per share though the company may hold $55 per share in stock in other companies. A third opportunity arises when a company offers, say, $55 per share to buy another company, but the target company trades for just $50. In all three cases, an astute investor can lock in a short-term $5 gain, or 10%, by exploiting the price discrepancies. This technique is commonly referred to as “arbitrage.” The advantage of arbitrage comes from rolling over gains. Investors who can earn 10% on an investment over three months could earn 46% on their money if they can duplicate the returns over a full-year. We believe that by compiling a series of small, short-term gains, it’s possible to greatly outperform the general market. Legendary value investor Benjamin Graham mastered special situation investing during his 30 years managing money and obtained a 20% annual return doing so. His best student, billionaire Warren Buffett, has exploited price discrepancies hundreds of times since the 1950s to enhance returns in good markets and to maintain positive returns in weaker markets. Today, these techniques are practiced almost exclusively by hedge funds that resort to exotic strategies—futures, options, and other derivatives—to try to capitalize on expected movements in stock, bond, and currency markets. Arbor Capital Management is one of the few advisors practicing the conservative, yet successful arbitrage tactics of Graham and Buffett. Goals of the Account When applied prudently and conservatively, the use of arbitrage has shown to be an effective way to enhance returns while reducing overall portfolio risk. Arbor Capital Management believes that arbitrage can add several percentage points of yearly gains to accounts. When compounded over time, arbitrage can make a significant difference in the value of an account. We try to exploit price discrepancies that offer annualized returns in excess of 30%. For example, let’s say Company X offers to purchase Company Y for $20 per share in cash. Company Y’s stock trades for $18. Let’s further assume the deal will close in three months. Our potential arbitrage profit is 11% (a $2 profit on an $18 investment). The annualized return is an attractive 52%. Risk reduction is paramount in our arbitrage accounts. Each investment selected must offer a high annualized return, yet bear a minimum chance of loss. Since the beginning of 1998, the average U.S. stock has fallen in price, despite the much publicized performance of major indexes. As such, an individual has had more than a 50% chance of losing money on new stock purchases. Over the same time, it was possible to post annual returns in excess of 30% exploiting short-term price discrepancies. Investors who have used arbitrage over this period have been able to greatly increase their probabilities of gains and partly insulate their portfolios from the effects of market volatility. How Money is Managed Special situation investing takes many forms, from highly speculative derivatives spreads to simple “workouts.” Our research has shown that the most profitable form of price arbitrage involves buying stocks of companies involved in mergers. In the preponderance of cases, we will take positions in the target company after a merger has been announced in order to capture the “spread” between the market price of the target and the deal price. We typically hold the target’s stock until the deal closes. We continually monitor the progress of nearly every merger announced in the U.S. looking for price discrepancies that offer a high risk-adjusted return. When an opportunity presents itself, we will buy aggressively. Sell points are established at the time of purchase. A typical position is held less than 90 days. To manage risk, we strive to diversify portfolios across several mergers. In addition, we utilize internally developed models to assess risk so as to minimize the chances of loss. We are willing to pass up 99 deals until we find the 1 deal that fits our parameters. Arbor Capital Management also relies on its contacts in the industry — including other arbitrage specialists and investment bankers — to help assess new investment ideas.
The majority of special situation positions taken involve mergers and share four common characteristics: Examples Arbor Capital takes positions in arbitrage situations when the opportunities for short-term gains greatly exceed the risk. On any given day in the U.S., upwards of 20 mergers are announced, some of which eventually offer a high arbitrage return. As examples:
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