Stockpickr: Profit From Merger Arbitrage

In 1997, Warren Buffett said that if he had just $1 million to invest he could make returns of 50% per year. He was referring to arbitrage, a technique he used in his smaller, more nimble hedge fund days.

At Stockpickr, we keep track of current merger arbitrage situations that we believe have attractive-enough spreads to make them worthwhile low-risk trades.

I can best explain merger arbitrage with an example. Let's say company ABC is trading at $9. Company XYZ says, "We'll pay $10.50 a share in cash for company ABC," and company ABC jumps to $10 on the news. Now there is a 5% spread in the price (the difference between $10.50 and $10).

Let's say the transaction is supposed to close in three months. You can buy the stock at $10 and in three months sell it for $10.50 if the deal goes through. That gives you a 5% return.

The "annualized spread" equals 20% (three months times four equals one year, so you multiply the spread by four). Now you have to determine if 20% annualized spread is a good enough return for you (it definitely should be) and what risks there are to the deal.

The risks are what determine the size of the spread. If there are regulatory issues, if there are other bidders, if shareholders oppose the deal, if the deal is going to be slow to close, if there are financing problems, etc. -- all of these factors influence the spread and must be analyzed.

So let's take a look at some current arbitrage situations that I believe are attractive.