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I hope you've enjoyed the last two newsletters. So far, we've looked at strategies involving rights issues and distressed assets.
This week, we're using one of the most popular and profitable strategies used by the hedge fund community: classic risk arbitrage.
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In a nutshell, this strategy looks for events that will happen with near certainty in the near future, such as mergers and acquisitions. It then simply tries to exploit the market inefficiencies that arise around such a situation.
This type of strategy usually involves buying one stock, and selling another at the same time. This means that the portfolio is "hedged" or "market neutral". By market neutral, I mean that it doesn't matter whether the overall market goes up or down that won't affect your return either way.
The strategy
This strategy involves two US pharmaceutical giants Pfizer (US: PFE) and Wyeth (US: WYE). On January 26th they announced a $68bn merger. This will create one of the largest companies in the sector, and is expected to yield synergies estimated at $4bn. The merger is a friendly deal (in other words, both parties agreed to it) and is expected to close in October or November. It's also subject to approval by the competition authorities, but this isn't expected to be a problem.
The terms of the merger
Pfizer will pay $33 in cash, plus 0.985 Pfizer shares, for each Wyeth share outstanding. The deal is expected to close in five to six months, during which time Pfizer will pay $0.16 in quarterly dividends while Wyeth pays $0.30.
As of Friday's close, the shares trade as follows:
Pfizer (US: PFE) - $14.96; Wyeth (US: WYE) - $44.14
Here's what you do. Buy 1,000 Wyeth shares, and short-sell 985 shares of Pfizer (or multiples or fractions of this if you buy 2,000 Wyeth shares, you sell 1,970 Pfizer shares; if you buy 500 Wyeth, you should sell 493 Pfizer). You then hold onto these positions until the merger closes in October / November. Make sure that whatever quantity you buy, you keep the ratio constant at 1,000/985. This ensures that your portfolio is market neutral. If you get your sums wrong, any moves (up or down) in the wider market may affect the profitability of your strategy.
What sort of return can you expect? Well, let's say you buy 1,000 shares of Wyeth now for $44,140. By the time the merger closes (in six months or so), you'll have received two quarterly dividends from Wyeth, worth $600 (1,000 x $0.30).
Then when the merger goes through, you'll get 985 shares in Pfizer (1,000 x 0.985), plus $33,000 in cash ($33 x 1,000) in exchange for your Wyeth shares. Taking the current price, the Pfizer shares are worth $14,735.60 ($14.96 x 985). You'll have to subtract two quarters of dividends from Pfizer, because you've shorted them, so you have to repay the dividends (although this is factored in to the spread when you are spreadbetting). That comes to $315.20 (157.6 x 2).
So for an outlay of $44,140, you get $600 + $33,000 + $14,735.60 - $315.20 = $48,020.40. That's a profit of $3,880.40. That equates to a return (excluding commission) of 8.8% on a six-month period. On an annualized basis, that's 17.6%. If you allow 1% commission for trading, financing and spreads (although this will depend on your broker), then the return becomes 7.8%, or 15.6% on an annualized basis.
Mathematical details
Let's get into the technical details (if you'd rather not look at the equations, then you can skip this bit). The merger terms can be expressed by the following mathematical formula expressed in US dollars.
$33 + ((Pfizer Pfizer dividends)*0.985) - (Wyeth + Wyeth dividends) = profit
Let's start by taking a simplified formula, using Friday's closing prices and without the dividends:
$33 + ($14.96*0.985) $44.14 = $3.60 per share profit
If we include dividends, which are $0.16 a quarter for Pfizer and $0.30 a quarter for Wyeth, we get the revised formula (the quarterly payments of $0.16 and $0.30 are multiplied by two because the deal will take six months to complete).
$33 + (($14.96 ($0.16*2))*0.985) ($44.14 + $0.3*2) = $3.88 per share profit
In this example, the profit increases when you include dividends, because the ratio of Pfizer shares to Wyeth shares is close to 1:1, and you are holding the stock which pays the larger dividend.
As said before, the deal is subject to competition authority (antitrust) approval which should not pose a significant problem. I reckon the deal has a 90-95% chance of going through (perhaps even higher). The spread between the stocks is likely to close as we approach completion date and the chances of the deal going through become ever more certain.
How to make the trade
This strategy can be implemented via any major online broker. Here is a step-by-step guide on how to do it.
1) Buy Wyeth shares. The easiest way is to just purchase the shares normally through your broker. I wouldn't recommend using spread betting to get exposure to Wyeth, because the financing costs could add significantly to your purchase price and might reduce the profit of the position.
2) Sell Pfizer shares. Most brokers will not allow you to short sell a share for a long period of time. So you are better off using spread betting for this part of the trade. But please do check the following details as they can have a major impact on the profitability of the trade:
a) Commission rates.
b) Costs for shorting Pfizer for six months (assuming the deal goes through according to schedule, which may not happen see the risks section below) via a spread bet (financing, rollover and so on).
c) How much of the Pfizer dividend you will be required to pay to the lender (when you short a stock, you borrow it from another holder). This is a technicality that stems from the fiscal treatment of the dividends. Normally you'd expect to pay 100% of the dividend. But sometimes, because of the tax credit carried by dividends, the lender might want to be paid more than the dividend itself in order to be compensated for the loss of the tax credit. So before your profit is reduced you are better off asking! (I spoke to my broker and I was quoted 100% dividend (which would be included in the spread); plus Libor (a key interbank lending rate) less 2.5% in interest paid on your short position - so 0%, as Libor is below 2.5%; plus $0.06 a quarter for rollover of the position).
d) Margin. How much margin will you be asked to put up in your spread betting account? Be prepared to top it up. If the shares of both companies move higher in line with the market, say, you will have an unrealized profit on the long in Wyeth, but a realized loss on the short in Pfizer and you will have to put up additional capital.
Also bear in mind that you are using leverage here, so to get exposure to say, 985 shares of Pfizer, you will only need to put down a fraction of the money you would need to buy the actual shares. Just make sure that you get your proportions right when doing so. For every 1,000 Wyeth shares you buy, you need to sell Pfizer at $9.85 a point.
3) Once the merger is completed in October or November and you have received the Pfizer shares, you can then sell them with your broker account, and close the Pfizer short trade in your spread betting account.
This strategy works best if you already have dollar funds, because you won't have any currency risk. However, if you are a pound investor there are ways to hedge your currency risk, which I'll explain later on.
What are the risks?
This strategy carries is what is known as an 'asymmetric risk / reward' strategy. This can be defined as an event which has a large probability of happening, and a small positive reward associated with it; and conversely a small probability of failing, but a large negative reward. An example would be a game where you can win £1 with a 90% probability, or lose £4 with a 10% probability.
In this case, I reckon the merger has a 90-95% chance of happening. Friendly deals of these sizes are generally discussed with authorities in advance.
But clearly, one risk associated with the strategy is that the merger falls apart and you'll be left with a long position in Wyeth shares and the short in Pfizer. In this case I believe you can expect to lose around 15-20% of the capital you have invested. You can estimate this figure by comparing where the two stocks where trading prior to the merger announcement. In this case the two stocks were not very volatile, so even if the merger were to fall through, I would not expect significant moves in prices of 20% or more.
So all in all, at a rough estimate, you have a 90-95% chance of making 7.8%; and a 5-10% of losing 20%.
Bear in mind that if you decide to use leverage then your risk profile will increase depending on the amount of borrowing you take on, and you might even lose all your capital and be wiped out!
Another risk involved is that the merger does not close at the expected dates because the competition review takes longer, or because Pfizer (rated AAA, under negative review, by the credit ratings agencies) is unable to raise sufficient debt financing. In this case a delay would only reduce your annualized return. You should still make roughly 7.8%, but it might take nine months rather than six, and you might have to add an extra quarter of dividends.
With risk arbitrage strategies you also run the positive risk (ie the 'risk' that you could make more than you expect, rather than less) of the merger terms being improved for Wyeth shareholders, or even that another bidder might come in with a higher offer. However in this case, the probability of such a positive outcome is close to 0%.
You might also worry that you are exposed to operational risk in the company. If the company issues a profit warning, for example, won't you lose money as the shares fall? The answer is no, not if the merger goes through - you do not have to worry about the performance of the company, simply because if the share price falls, then what you lose in the long position in Wyeth you'll make up in your short on Pfizer, as the two shares trade according to the terms of the merger. So for example, you don't have to worry about the fact that Pfizer will lose patent protection for its blockbuster drug Lipitor in 2011.
Remember however what I said earlier about the short on Pfizer being done with spread betting. In this case, if the shares move higher, you will show a paper profit in the long position in Wyeth, which you won't be able to realize until the merger closes. But you will show an actual loss in Pfizer, which will mean you have to post extra funds in your spread betting account to cover it in order to keep the bet open.
Another risk in this trade is the basis risk, or the danger that after you set up the position the spread, or the gap, between the two stocks widens (for example, if a large order is placed on only one stock). In this case, don't worry too much, as the spread is likely to reduce as we move closer to the closing date of the deal.
The final risk is currency risk, which in my opinion is the biggest risk of the trade if you are a UK investor. If you are investing in dollars this does not apply to you as your return will be around 7.8% in dollar terms. However, if you are trading in pounds then the main risk is that the pound appreciates against the dollar in the next six months.
This is because there is a large cash component in the offer , so the main risk is that the $33,000 you receive in six months' time (assuming you buy 1,000 Wyeth shares) could be worth less when converted back into sterling than when you first set up the trade. As the exchange rate has moved quite dramatically in the last year, this is a definite possibility to keep in consideration. With this trade you could break even or end up losing money if the pound has gained 7.8% against the dollar (giving an exchange rate of around $1.71) in six months' time. The reverse is also true if the pound falls you will end up make more than the planned 7.8%.
How to hedge your currency risk
The easiest and simplest way to hedge your currency risk is to sell dollars forward (or sell dollars at a fixed exchange rate today, for delivery when the merger closes). This might sound complicated but it is in fact something that even your high street bank can do for you - basically you are just fixing your exchange rate at close to today's prices. It means that if the pound goes up against the dollar, you won't lose out, but equally, if the pound weakens against the dollar, you won't bank any extra profit.
Generally the exchange rate for a forward transaction depends on the interest rate differential between the two currencies, but because today interest rates for dollars and pounds are 0% or close to 0%, for six-month periods your forward exchange rate should not be very different from the spot exchange rate. This type of transaction is widely used in trade finance more than in investment banking, as this is a vital component of currency management for companies that import and export goods or services.
Because interest rates are very low you could also consider selling forward dollars for an extra two or three months after the expected date of the merger closing. This means that even if the merger is delayed you will still be hedged against currency risk. The downside to this is that you will have to wait for a longer time to reconvert your currency.
To implement the currency hedge you can first speak with your broker or otherwise you can always check with your high street bank. Either of them should be able to arrange this transaction for you.
Alternatively, because with this strategy your risk is that the pound appreciates against the dollar, wiping out your profit, there is another way you could protect yourself while leaving intact the potential extra return that might happen if the pound falls against the dollar. You could buy a call option on the dollar at around $1.63. In this case, if the pound appreciates your profit is safe because you can exercise the option and buy the dollars at a predetermined exchange rate, while if the pound falls against the dollar then your profit will be enhanced by the currency moving in your favour.
However, this options strategy has two main limits. The first is that it costs money to buy the call option (the premium), so this will reduce your potential profit. The second is that options have a minimum trading size, so you will need around $100,000 in this position to effectively be able to trade it (although do check with your broker/bank for options sizes).
Why is this trade possible at all?
If you are wondering why you can earn 7.8% in six months, or why no one else is doing it, then here's a simple answer. There is not a lot of capital around. Most of it is in safe assets like T-bonds. Also, hedge funds have suffered very high losses and withdrawals in the last year or so, and they are also not allowed to use leverage to the same extent as in 2007 (when the return on this type of strategy would have been much lower).
Wyeth is a $68bn company, so there are lots and lots of shares around (in fact, if you make a back of the envelope calculation, you'll find that Wyeth's market cap represents around 5% of the total assets under management in hedge funds). Institutional investors do not play these strategies. Once the bid is out, they consider the target stock dead and tend to reinvest the money in other stocks where they think they can outperform the market.
These strategies were very popular throughout the 1990s and early 2000s. They disappeared between 2004 and 2007 simply because too much leverage led to such ridiculously low spreads that they were not worth playing. People started to see offer prices as floors and bet instead that the offer terms could be improved. It was just yet another part of the irrational exuberance fuelled by the credit bubble and we all know now how it all ended.
As usual if you would like to discuss this idea or have any questions please e-mail me at eventstrader@f-s-p.co.uk. And before we go...
An update on our first trade
Our first stock Snam Rete Gas (Milan: SRG) which I suggested two weeks ago has fallen to our first buy limit of €3.10.
However, my concern is that in the past two weeks the market has looked toppy. I fear that there could be a correction once people realize that even if the worst of the recession is over it does not mean that the recovery is around the corner. So if you have bought it, I would just wait for a couple more weeks and then get out. My target price is in the €3.3-€3.4 region, so if it hits that area before then, then sell.
If you didn't buy it, don't worry and let's move on to the next trade there will be plenty more rights issues in the future.
Your capital is at risk when you invest in shares, never risk more than you can afford to lose. The share recommended is denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Spread betting is not suitable for everyone - ensure you fully understand the risks involved and never risk more than you can afford to lose. Prices can move rapidly against you and resulting losses may be more than your original stake or deposit. Please seek independent personal advice if necessary.
Figures are calculated using the closing mid-prices on the date on which shares are first recommended. All gains are gross, and returns will be affected by dividend payments, dealing costs and taxes. Past performance and forecasts are not reliable indicators of future results.
Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors or contributors may have an interest in shares recommended.
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