Monday, October 20, 2008 1 comments ++[ CLICK TO COMMENT ]++

An example of high probability, low return, risk arbitrage: Fording Canadian Coal Trust (FDG; TSX: FDG.UN)

A reader e-mailed me and asked about taking a position in the Fording Canadian Coal Trust (FDG; TSX: FDG.UN) takeover. I never took a position for various reasons (I describe this takeover below) but what I want to do is to point out how there are two types of risk arbitrage deals: the high probability, low return ones; and the low probability, high return ones. The thinking behind each is quite different.

Anyone following this blog would notice that, with the few I have dealt with, I tend to take seemingly high risk arbitrage positions. You know, deals that the market doesn't think will close easily. I'm just a newbie and still trying to figure out what works for me, but so far I like the low probability, high return deals. I usually look at deals with wide spreads (preferably 10% total, or say 20% to 40% annualized.) Such wide spreads essentially means that the market doesn't think the deal will be likely to close.

Although one may view such deals as risky from an arbitrage point of view (since they are less likely to close) I tend to favour them because it is actually safer from an investment point of view! What I mean by that is the following. If a high probability deal collapses, the loss tends to be massive. The share price will fall significantly (of course, this depends on takeover premium built into the stock and a few other details.) In contrast, low probability deals have lower losses. If i was satisfied with the merits of a business, holding a position with a small loss is acceptable to me. (do keep in mind that one shouldn't blindly look at spreads since higher spreads may actually be a far worse situation. It's kind of like junk bonds. Most junk bonds are junk, as Buffett would say, but a junk investor tries to pick a good junk bond, not just the highest yielding one.)

I don't know how good my strategy will end up being but I'm sticking with it for the time being. My thinking goes against what a typical risk arbitrage fund undertakes. A typical risk arbitrage fund generally undertakes high probability, low return positions and uses leverage to magnify that. A typical arbitrage fund also sells out of their position at the outcome of the deal (if you can hedge then everyone should exit the deal regardless but I'm talking about cases where you can't hedge.) I'm not saying all funds are like that but that's the typical modus operandi.

In contrast to a risk arbitrage fund, I don't use leverage and I am willing to hold a stock if the deal fails. The latter point of being able to hold a stock is probably what gives me an advantage over a pure risk arbitrage fund and allows me to consider these lower probability events. This also means that I place quite a bit of emphasis on whether I would want to hold a stock.

I don't think there is anything wrong with pursuing high probability, low return positions. For some investors, this will work out nicely. Do note that this strategy involves competing against the risk arbitrage funds. Whatever you pursue, make sure you are clear on what your strategy is.

A High Probability, Low Return Deal

Teck Caminco is buying out Fording Canadian Coal Trust (FDG; TSX: FDG.UN). This used to a higher return play a few weeks ago but it is presently a high probability, low return deal. I didn't calculate the numbers today but when I looked at them late last week, the potential return was around 6% to 7% with almost certain success within the month.

Although I would take a position if the return was around 10%, this is the type of deal I don't like. Although a failure is extremely slim, if it does fail, you are talking about a massive loss. I can see the stock dropping 50% (Fording is one of the top performers this year and is up around 100% this year--in a nasty bear market where almost every commodity stock has been slaughtered.) Unless you were a commodity bull and a fan of coal or steel (which is what it is used for,) it would be difficult to recoup such a big loss. It's also not clear if you can adquately hedge this position.

There are also a few other issues with this deal. One is the fact that the payout is in fixed US$ (plus some shares of Teck Caminco) so Canadians are exposed to currency risk. Given the way currencies have been moving lately, half the 6% or whatever you earn might be wiped out by currency changes (assuming you don't hedge--generally expensive or difficult for small investors.) The other wrinkle with this deal is that the deal is structured as a sale and distribution to shareholders, which is taxed as regular income (rather than the lower taxed dividends or capital gains.) So anyone holding the shares of Fording until closing will pay regular income taxes (but if you sell before the deal closes, or if this is in a tax-sheltered retirement account, it's not an issue.) Anyway, I would still take a position in Fording at a good price (say 10% return or very close to close).

The key point I wanted to make in this post is to point out the high probability deals from the low probability ones. Don't assume that the high probability, low return ones are not worth it (after all, Buffett took a risk arbitrage position in Dow Jones last year--I thought the deal would fail.) Both can work but I think the strategy is somewhat different for each.

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1 Response to An example of high probability, low return, risk arbitrage: Fording Canadian Coal Trust (FDG; TSX: FDG.UN)

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