One of the best aspects of writing online (as opposed to in print) is the immediate feedback from readers. Since starting this column last fall, I have received tons of email from readers. Frequently, people are looking for clarification of something I mentioned or want to ask a follow-up question. Sometimes it is just to call me an idiot.
By far the single most frequent email request I get is for recommendations of good books on the basics of risk arbitrage. So here is a bookshelf of essential reading for the aspiring risk arbitrager.
First, the basics. Risk arbitrage is, at its root, a form of value investing. The essence of classic Graham-and-Dodd value investing is to try to purchase stocks at 50 cents on the dollar of "intrinsic value." The underlying assumption, of course, is that over time the true value will surface and the investor will profit from the appreciation of the shares that were bought at a bargain.
Risk arbitrage takes that basic premise and gives it a subtle twist. We also try to buy assets at small discounts to some quantifiable future value, but we try to realize this appreciation over a short and definite period of time.
Whether or not you agree with
assessment that value-investing methodologies are currently irrelevant, these skills are the bedrock underlying risk-arbitrage analysis. Our study would begin with the masters: Benjamin Graham and David Dodd. Their
is a distillation of the methodology described at length in
, a dense tome.
While a bit dated, Dodd's and Graham's lessons on how to approach and understand value are still relevant and valid. Reading (or rereading) these books gives sobering perspective to the valuation methodologies in vogue today, particularly with regard to Internet companies.
Seth Klarman, a well-regarded value investor in the Graham-and-Dodd tradition, is the author of an excellent book called
Margin of Safety
. In the spirit of
, it is a readable and concise description of the value-investment process. Its chief merit is that it is contemporary, and discusses today's industries, companies and securities.
Klarman avoids the anachronisms of
, while making many of the same points -- namely, that investments should be made only when there is a sufficiently large return offered on a well-researched bargain purchase, with the downside protected by a comfortable margin for error in your assumptions. The trade-off between risk and reward is the basis for evaluating any arbitrage opportunity.
Without entering the
Dreman/Cramer fray, let me just say that I believe value investing will again become relevant sometime soon. Very relevant. Study up.
Moving closer to our ultimate goal of understanding risk arbitrage, I would recommend a book I enjoyed so much that I sent a copy to all of my investors:
You Can Be a Stock Market Genius
, by Joel Greenblatt. This book examines, in a
-like tone, many event-driven investment strategies.
Greenblatt discusses investing in spinoffs, defaulted securities and securities that are issued as merger currency. All of these strategies are on the periphery of risk arbitrage and will, I think, open your eyes to many of the investment opportunities that corporate restructuring and consolidation can produce.
While Greenblatt has generally negative things to say about risk arbitrage (he once lost money when a deal broke because a sinkhole opened up underneath a Florida theme park that was the subject of a merger -- a tough risk to hedge), many of the skills he discusses in other event-driven strategies are the same skills needed to be an effective arbitrager.
As for books specifically about risk arbitrage, until very recently the field was very thin. Believe it or not, until a year ago, the only book out there was
, by none other than
. If you didn't know any better, Boesky's book describes the risk-arbitrage process circa the mid-1980s in a clear and informative manner.
He discusses many transaction structures and how to profit from them. He explains how to research and analyze deals, how to trade the securities and how to hedge. He omitted the most important chapter however -- how to purchase illegal inside information in the middle of Central Park from dishonest investment bankers in exchange for sacks of cash. After Ivan got caught in 1986, the book disappeared from print. You can still find copies in used bookstores from time to time, however.
Just last year, Keith Moore wrote an excellent and comprehensive book simply titled
. Many 1990s-vintage transactions are used to illustrate the lessons on how to research and set up arbitrage spreads, as well as manage an arbitrage portfolio.
Moore is an experienced and well-regarded arbitrager, and his book is very thorough. It is denser and more technical than the other books, but if you have a serious interest in risk arbitrage, it is worth the work to get through it. The book would be suitable as a college textbook in a class on arbitrage.
And finally, I recently came across a book titled
Deals...Deals...and More Deals
by Regina Pitaro. Published in-house by high-profile fund manager
firm, it gives a good overview of the arbitrage process, with lots of specific examples gleaned from recent deals. Less technical than Moore's book, it is a very good primer on risk arbitrage for do-it-yourself investors who unexpectedly find themselves in the middle of a deal. The author is an experienced practitioner, with many war stories to tell.
This relatively brief list should put
readers on the road to a thorough understanding of merger arbitrage. Even if an investor never intends to become directly involved in arbitrage, I think he or she will benefit by understanding how and why stocks behave as they do during takeover battles.
Everyone eventually owns a stock that becomes a target. Too many people sell out the day the bid is announced, leaving easy additional money on the table. Understanding the deal process more deeply gives investors the knowledge and confidence to stay involved longer and reap bigger gains.
David Brail is the president and portfolio manager of Palestra Capital, a Manhattan-based hedge fund that focuses on risk arbitrage, and has been an investor in risk arbitrage and bankruptcy securities since 1987. At the time of publication, neither Brail nor Palestra held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brail appreciates your feedback at
TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.