Stockpickr: Profit From Merger Arbitrage - TheStreet

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.

First up is petroleum products refiner

Giant Industries

(GI)

. The company is getting acquired by

Western Refining

(WNR)

for $77 per share. Let's work through the math on this one: Giant is currently trading around $75.72, or about 1.9% from the acquisition price. Shareholders are meeting on Feb. 27, and the deal will probably close shortly thereafter. So the annualized return is approximately 22%, at a fairly low-risk level.

The spread is probably as high as it is because Western Refining had previously offered $83 per share and then lowered its offer after fires at two of Giant's refineries. The merger arbitrage funds probably got burned, so to speak, and picked up their chips and went home. That leaves an unusually large spread, which we can take advantage of.

Two hedge funds that have played this trade and might still be in it are Gabelli ABC (Check here for

Gabelli's other arbitrage plays

) and Sowood Capital Management. Sowood was initially seeded by Harvard, and the fund participates in a lot of merger arbitrage and closed-end fund arbitrage plays. Check out

Sowood's current holdings.

What I like about Giant Industries is that even in a worst-case scenario (the shareholders don't approve the deal, regulators hold it up, etc.), the company trades for just seven times EBITDA and is a reasonable value here regardless. In other words, there's a margin of safety for a trade in this name.

Next up is

Delta and Pine Land

( DLP), which produces and markets cotton planting seed. In August,

Monsanto

(MON)

said it would pay $1.5 billion in cash ($42 per share) to buy Delta and Pine Land in a move to combine two of the world's largest seed companies.

Monsanto had first announced plans to buy Scott, Miss.-based Delta and Pine Land in 1998 but backed out, prompting a legal dispute that continued until the new agreement was reached. That first offer was withdrawn when the Department of Justice delayed its approval, citing monopoly reasons. However, the situation is different this time around due to the introduction of a competitor,

Bayer

( BAY), into the seed business.

Right now the spread between the current price of Delta and Pine Land (around $40.85) and $44 is 2.8%. If the deal closes within the next two months, the annualized spread is almost 17%. The deal may also close sooner than that, as stockholders have already approved it. That would be an annualized return that is significantly above the market returns of the past few years.

I'm not the only one who likes this play: Sowood is also in Delta and Pine Land. Deephaven Capital, which is owned by

Knight Capital

(NITE)

and specializes in all forms of arbitrage (but is particularly known for convertible arbitrage), has also accumulated a stake in Delta and Pine Land.

Click here

to see Deephaven's top holdings.

We update the top merger arbitrage situations, with spreads and analysis, every two weeks on Stockpickr.

Check out the portfolio

for the latest situations, and bookmark it with four stars to get email notification whenever we update our analysis.

Stockpickr tip of the day

: Market guru Peter Lynch's stock-picking advice is to go to the local mall and see what people are buying. Stockpickr member Tinley Park took it one step further. He has set up two portfolios on Stockpickr that are worth a look.

First is the

Orland Square Mall portfolio

, which is made up of public companies that have actual stores in the Orland Square Mall, near Chicago. This can almost be thought of as a retail index for boomers, since Orland Square seems somewhat upscale.

Second is the

Tinley Park portfolio

, which consists of all public companies in the Chicago suburb Tinley Park.

If you put up a portfolio of stocks related to a particular place or concept that's close to your heart, please

send me the URL

and I'll take a look at it.

At the time of publication, Altucher and/or his fund had no positions in stocks mentioned, although positions may change at any time.

James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of

Trade Like a Hedge Fund

and

Trade Like Warren Buffett

. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Altucher appreciates your feedback;

click here

to send him an email.

TheStreet.com has a revenue-sharing relationship with Trader's Library under which it receives a portion of the revenue from purchases by customers directed there from TheStreet.com.