Below is the second clip from my 2007 letter to partners. The first post was a case study of Tribune Co., an arbitrage situation we participated in last year.

“Give a man a fish and he eats for a day. Teach him to arbitrage, and he will eat for a lifetime.” —Warren Buffett

Risk arbitrage (also called merger arbitrage) is where an investor buys stock in a company that’s expecting to be taken over. The investor’s goal is to profit from the difference in current market price and eventual buyout price. Here’s a simple example: Company A announces that it will acquire Company B for $20 per share. Immediately after the announcement, the share price moves from $15 to $19 per share. The arbitrageur then purchases the stock, hoping to make a $1 profit once the deal is complete.

Why doesn’t Company B just move straight to $20 after the announcement? Why the $1 difference? There are a number of reasons. First, since the merger usually takes some time to complete, part of the $1 represents the “time value” of not receiving the $20 right away. But most of the discrepancy usually represents the market’s uncertainty about the final outcome. The deal may fall through for multiple reasons, such as financing problems, regulatory roadblocks, or the acquirer simply changing their mind. So the risk arbitrageur has two questions to answer: will the deal go through – and if so, how long will it take?

Merger arbitrage is like a simpler, time-constrained version of value investing. When screening for candidates, there’s no need to do valuation work because the value of the company has already been announced. Both arbitrage and value investing involve handicapping the odds and buying assets for less than they are worth. With that in mind, below are some important things to consider when making any arbitrage investment.

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The following is a section from my 2007 letter to partners. It examines the buyout of the Tribune Company, an arbitrage situation we took part in last year. Tomorrow I will post another section that discusses risk arbitrage. (Please note that I have removed some of the non-public information that was included the actual letter). Enjoy!

On April 2, 2007 Tribune Co. announced that Sam Zell prevailed in his bid for the struggling newspaper company. The final $34 per share offer was chosen over another eleventh-hour bid from Los Angeles billionaires Eli Broad and Ron Burkle. Sam “The Grave Dancer” Zell—contrarian real estate magnate—had just completed the sale of Equity Office Properties, his real estate holding company. With the cash he received from the sale (the largest leveraged buyout in history), Zell jumped back into business with his offer for Tribune. The company owns coveted newspapers such as the Chicago Tribune and the Los Angeles Times. Other assets include a string of TV stations and the Chicago Cubs baseball team.

Under the terms of the agreement, each share of Tribune would eventually be exchanged for $34 in cash. The deal would be subject to shareholder approval and regulatory clearance from the FCC. Sounds simple, right? The end result of the transaction was easy to understand, but the mechanics of the deal were anything but. It was especially unique because the shares would initially be owned not by Zell, but by an Employee Stock Ownership Plan (ESOP) where Tribune employees would share in the company’s upside.

Immediately after the announcement, the ESOP would purchase $250 million of newly issued stock for $28 a share. Zell’s initial investment consisted of a $200 million promissory note and $50 million in new stock. In May, Tribune would borrow $4.2 billion to finance the purchase of about half of the company from public shareholders.

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I find it useful to know as much as possible about any potential investment, especially if it may become a large position down the road. Why is Company X where it’s at today? Knowing their history, philosophy, and information about current/past management teams can help you solve that question. In turn, it will help when you estimate where they’ll be 10 years from now.

Sometimes I like to take the activist investor approach: For large long-term holdings, you’re ultimate goal should be to know the company better than the management team running it. Nine months ago, there was a story on activist investor Nelson Peltz in Fortune magazine. Commenting on his research methods, the author wrote: “Peltz prides himself on knowing businesses so intimately, from factory floor to supermarket shelf, that he can systematically break down any management’s rationale for mediocre results.”

Below are 6 useful sources for researching individual companies.

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Guy Kawasaki points readers to a list of videos from the Consumer Electronics Show last week. The feed includes the keynote speeches and more specific sessions by CES presenters. Below are the links to my favorite presentations. The Bill Gates keynote (very funny) link on the feed is broken, so below is the link to a segment of it on YouTube.

Bill Gates keynote
International Retail Power Panel / Retailers talk about retail trends and technologies (includes heads of Best Buy, Circuit City, and Target)
Chip Heath keynote / One of the authors of Made to Stick explains the concepts of the book.
Michael Dell keynote
Top 10 Technologies You’ve Never Heard Of

ValueVision Media (VVTV) - $5.58

Although I planned on writing up my entire thesis for VVTV, things got a little busy and I never ended up finishing it. Thankfully, someone over at Value Investors Club has done my job for me. Click here to see david101’s writeup on ValueVision (available via a 45-day delay).

I would also reiterate that under $6 per share this is a very “heads I win, tails I don’t lose much” type of investment. There is uncertainty surrounding a few different aspects of the investment (like cable distribution costs, the transition to digital, new internet ventures) but little to no downside based on hard assets and cash. If a few things go right ValueVision could be worth 2-3x its current price. In addition to the information provided in the above writeup, I’ll add a few of my thoughts below:

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