The biotech space is hot with merger activity right now. Last night, Pharmacyclics (PCYC) agreed to be acquired by Abbvie (ABBV), and a few days ago the Salix / Valeant (VRX) deal was announced. Merger arbitrage, or speculating on mergers & acquisition activity, can be a high risk game. However a lower risk variation of merger arbitrage has been practiced by Warren Buffett, and of course it fits nicely in the value investor's framework.
Note: if you just want the merger arb tracking sheet, scroll to the bottom. If you want to learn about how Buffett does it, read on.
Not much has been written about Buffett's approach to merger arbitrage. However, I have found two books:
Warren Buffett and the Art of Stock Arbitrage cites this study and a Forbes article that state Buffett has produced annualized returns of 80% to 90% on his merger arb investments, or "work outs" as he likes to call them.
Buffett practices long-only merger arbitrage, taking long positions in the company to be acquired. This contrasts with traditional merger arbitrage, in which one goes long the acquired and shorts the buyer. This approach hedges out market risk and some other factors. However some criticize it as twice the risk for half the return.
Here is Warren Buffett in his 1988 letter writing about arbitrage:
Below is a summary of the investment criteria in Warren Buffett and the Art of Stock Arbitrage and Trade Like Warren Buffett.
With these factors in mind, Warren Buffett and the Art of Stock Arbitrage describes a model that incorporates these factors. One of my pet peeves is investment calculations in paragraph form. So I built the model below for you, and loaded it with my best estimates for PCYC and SLXP.
The entire sheet doesn't fit into this web page well, so you may just want to look at it here. I should mention this model is only good for all cash deals. If there is interest, I may build one for a mix of cash and stocks. My take away at time of publication: there is some opportunity in PCYC, but not much in SLXP.
This is the personal blog of Emory Redd.
This blog is not investment advice. This is not a solicitation to invest. Don't take candy from strangers.
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