Great article, with some very good input from your readers here.

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@ Richard,
Thanks for the comment and the link.

@ AJ,
Good point about PFE deal.

@ Ken,
Will have to try and get a copy of that book. I’ve got 6 books I have to finish first though. The current one I’m reading is a complete loser.. don’t know why I’m still trying to read it.

@ All,
I still intend to participate in mergers but am now much more willing to sell and lock in profits rather than go for the whole prize. Profit is only a profit if it’s locked in.

Ken’s last blog post..Risk Arbitrage & EMAG Post Mortem

First, our minds shy away from tough questions and latch on to quantifying things that we can grasp (50% upside). This perhaps is the reason we look at reward first … Quantifying risk IS the HARDEST thing to in any purchase, not least because it implies a thorough understand of the company, the situation, and the potential pitfalls. Nonetheless, this is exactly the moat we build to protect principal (Graham’s numero uno rule!). I personally feel that by not striving to measure risk rigorously we turn, as per Klarman’s definition, from investors into speculators.

Second, on arb situations specifically – they are inherently risky, and if you read WEB’s partnership letters he says so repeatedly. What is great about them is their value in forcing you to be disciplined – because you might lose 50% on a given date, your brain will be scared into running the risk scenarios properly, losses will be keenly felt (e.g. Jae’s EMAG), and lessons will be learned more swiftly.

Moreover, arb situations can serve as a wonderful training tool to improve our recognition patterns of uncertainty and risk and their separation, which is what Pabrai correctly tells us to do. In EMAG’s case, uncertainty and risk were intimately tied – we all figured that if the deal fell through, EMAG’s survival was questionable. However, the proposed Pfizer/Wyeth deal still provides great uncertainty (e.g. time, egos and antitrust), but the risk is much smaller – first, Wyeth is currently trading at $43, while before the deal’s announcement it traded at about $39, so conceivably downside is 10%; second, Wyeth is a strong company – 2008 Operating Cash Flow was $5.9 billion and they have a good pipeline – so the stock might rebound from any drop (should the merger fall through) swiftly or not drop at all (assuming the market agrees that it incorrectly valued Wyeth before…).

Now to your point – should we be in these arbs? My answer is – if you find a high uncertainty, low risk arb with enough upside, bet big. If not, walk away having developed more discipline – this is Pabrai’s “Tails I win, heads I don’t lose much”. Even in such a situation I urge you to remain dynamic in your analysis of the arb situation – if the share has gone up 90% of what it can (the target price), the upside, downside and odds are now different – then I say sell all of it – I would rather have 90% of the gain for sure than 100% of the gain with a 90% probability …

Richard Beddard’s last blog post..The UK’s riskiest big companies

Thanks for the offer as well!

In all seriousness – I have learned a lot from you and your blog, so I am more than happy to share!

In this market though, where stocks will sell off 50% or more when a deal falls through (BCE, EMAG, perhaps ROH?), the implication of your schema seems to be that risk arbitrage shouldn’t be used at all. If the reward is 10%, but the downside could be 40%-50%, you need to have VERY HIGH odds that the deal will close to justify the risk. If we concentrate on risk in this market, merger arbitrage may not make sense. If so, have we gotten too fearful? Or perhaps just smarter?

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