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In part five of the series on special situations, I’ll briefly present the idea of risk (or merger) arbitrage.

This series is based on the book You can be a stock market genius! so for additional information, be sure to read it yourself.

New here? Catch up on the series.

Part 1: Odd Lot Tenders
Part 2: Book review on You can be a stock market genius!
Part 3: Spinoffs
Part 4: A Look at Dr Pepper Snapple

Quick Brush Up

There is no point in buying a stock speculating that the company will be taken over. Risk arbitrage, which I will just refer to as arbitrage, involves the purchase of a stock after the merger announcement.

The book quickly gets to the point and tells the reader to avoid arbitrage because of the high levels of uncertainty involved in the process. However, I would like to add that by waiting and choosing wisely, you will be able to make very good gains off low risk.

The basics and overview can be found in an earlier post here. It covers topics such as why you should consider arbitrage in your investing strategy, the types of homework you should do, what to look for and the risk involved.

Previous Arbitrage

So far, I’ve gone through three arbitrage opportunities in this blog. Aquila, Jazz Technologies and currently Puget Energy. I eeked out a tiny profit with Aquila and documented a vital mistake with this transaction, successfully did not partake in the Jazz merger due to the illiquidity and stock for stock condition, and would like to see the Pugest Energy merger close out soon.

Keep Things Simple

There are also different forms of arbitrage.

• Cash only transactions where stock is paid for in cash
• Stock for stock where the shareholders are given stock of the other company
• Partial stock where a percentage of the share is converted to stock and cash
• Purchase merger securities (the Greenblatt recommends looking into warrants)

Focus On This Checklist (source: fwallstreet.com)

Before you invest any cash, you should be able answer all the items below.

1. Due diligence by both parties
2. Financing and regulator approval
3. Get preliminary shareholder sentiment (or controlling shareholder approval)
4. Obtain regulator (SEC, FCC, any and all) approval
5. Get final shareholder approval at a meeting called for that purpose
6. Insiders continually vesting or buying shares

Risks to Think About

• Calculate the potential upside and downside vs time. In the PSD merger, I’ve given the chance of success 90% with a gain of around 25% within 1 month. This is excellent odds.

• Unpredictability: Anything can happen in mergers. Financing can break down at the last minute, the market can go crazy and take everyone with them, earthquakes could ruin the operation of the business  etc etc.

• Allocate assets accordingly depending on your odds.

• Taxes will have to be paid because this is a short term strategy. Consider this when you calculate gains.

But most of all, stick to investing in solid companies if you are unsure or feel uneasy with the whole notion.

Disclosure: Long PSD

[tags]arbitrage, special situation, PSD [/tags]

You may also be interested in:

1. Profit From Special Situations – Stock Tenders
2. Profit From Special Situations – Spinoffs
3. Update: Puget Energy (PSD) Arbitrage
4. A Look at Aquila (ILA) Arbitrage
5. Merger and Acquistion Arbitrage