Historically Warren has focused on seven classes of arbitrage and special situations. In the classic arbitrage category he invests in friendly mergers, hostile takeovers, and corporate tender offers for a company’s own stock. In the class of special situations he invests in liquidations, spin-offs, stubs, and reorganizations. Though we will go through each of these classes in great detail later on, it would serve us well to quickly touch on each of them before we delve into their finer points.
This is where two companies have agreed to merge with each other. An example would be Burlington Northern Santa Fe (BNSF) railway’s agreeing to being acquired by Berkshire for $100 a share. This presents an arbitrage opportunity in that BNSF’s stock price will trade slightly below Berkshire’s offering price, right up until the day the deal closes. These kinds of deals are plentiful and Warren has learned to make a fortune off of them.
This is where Company A wants to buy Company B, but the management of Company B doesn’t want to sell. So Company A decides to make a hostile bid for Company B. Which means that Company A is going to try to buy a controlling interest by taking its offer directly to Company B’s shareholders. An example of a hostile takeover would be Kraft Foods Inc.’s hostile takeover bid for Cadbury plc. This kind of corporate battle can get real ugly, but it can offer us lots of opportunity to make a fortune.
Sometimes companies will buy back their own shares by purchasing them in the stock market, and sometimes they do it by making a public tender offer directly to their shareholders. An example of this would be Maxgen’s tender offer for 6 million of its own shares. Warren has arbitraged a number of these self-tenders in the past and has found them both plentiful and bountiful.
This is where a company decides to sell its assets and pay out the proceeds to its shareholders. Sometimes an arbitrage opportunity arises when the price of the company’s shares are less than what the liquidated payout will be. An example of this would be when the real estate trust MGI Properties liquidated its portfolio of properties at a higher value than its shares were selling for. It’s hard to believe it happened, but it did, and Warren was there.
Conglomerates often own a collection of a lot of mediocre businesses mixed in with one or two great ones. The mediocre businesses dominate the stock market’s valuation of the business as a whole. To realize the true value of the great businesses, the company will sometimes spin them off directly to the shareholders. Warren has figured out that it is possible to buy a great business at a bargain price by buying the conglomerate’s shares before the spin-off, as when Dun & Bradstreet spun off Moody’s Investors Service.
Spin-offs come under the category of special situations.
Stubs are a special class of financial instrument that represent an interest in some asset of the company. They can also be a minority interest in a company that has been taken private. An arbitrage opportunity arises when the current stub price is lower than the asset value that the stub represents and there is some plan in place to realize the stub’s full value. Warren’s earliest arbitrage play involved buying shares in a cocoa producer, then trading the shares in for warehouse receipts for actual cocoa, which he then sold. The warehouse receipts were a kind of stub. Though they are known under many different names—minority interests, certificates of beneficial interests, certificates of participation, certificates of contingent interests, warehouse receipts, scrip, and liquidation certificates—they still present us with many wonderful opportunities to profit from them.
This is a huge area of special situations that offer some very interesting arbitrage-like opportunities. Warren has invested in a number of these over the years, the most notable being ServiceMaster’s conversion from a corporation to a master limited partnership and Tenneco Inc.’s conversion from a corporation into a royalty trust. We will examine his successful investments in both these reorganizations.
Now that we have briefly outlined some of the different kinds of arbitrage situations that Warren invests in, we need to spend a few pages going over some of the criteria that Warren uses to screen these opportunities for potential returns and probability of success.