Book Notes: Trade Like Warren Buffett

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For whatever reason self-help guru James Altucher has disavowed his older trading/investing books, including one of my favorite Buffett books: [easyazon_link identifier=”0471655848″ locale=”US” tag=”valueinvesand-20″]Trade Like Warren Buffett[/easyazon_link].

In a sea of bland-same-old-conservative-value-Buffett-books, Altucher’s evaluates the out of the ordinary strategies Buffett pursued and ends the book with interviews of two of my favorites hedge fund managers: Mohnish Pabrai and Zeke Ashton.

I have devoured this book at least seven separate times and much of it led to the techniques I wrote about in my first book.

The strategies Altucher describes include: Merger Arbitrage, Relative Value arbitrage, Junk Bonds, Closed-end fund arbitrage, PE ratios and market timing and disasters.  My notes on each will follow.

Merger Arb

Merger arbitrage is the technique of purchasing the stock of a to-be-acquired security when it trades for lower than the price of the announced merger, while shorting the acquirer to hedge, to gain the difference.

Risks involved in the arbitrage include:

  • Due Diligence risk – risk that the acquirer will back out of the deal when it finds something bad during the due diligence phase.
  • Regulatory risk – risk that governments will block the deal.
  • Another acquirer showing up – this would kill the short hedge.
  • Interest rate risk – risk that the amount of time it takes for the deal to close will push the return below the risk-free rate.

To calculate the potential return in the deal, use the formula: V = P((D-T)/T); where v = the value of the deal; p = the probability of the deal completing; d = the deal price; t = the price we pay for the target stock.

Relative Value Arb

In relative value arbitrage investors find a company where the sum-of-the-parts value is great than the current market value of the company, purchase the company and then short the parts.

For example, if Price Industries had holdings worth $150mm in Kelsey Farm Corp, $100mm in Packers Are Just Alright, Inc and $50mm in Not as Interesting of a name, LLC the sum of the parts valuation would be $350mm.

If the market value of Price Industries was $300mm there is an obvious gap to be arbitraged away through investors purchasing shares in Price.

Of course, it is also possible the value of the holdings could fall, therefore arbitrageurs short the holdings and then hold both positions simultaneously until the gap is closed.

Junk Bonds

Junk bonds, or distressed debt, is the publicly traded debt of companies given a poor rating by credit rating agencies.  Because the agency gives the company a material chance of bankruptcy before the debt can be repaid, the interest rate of the debt is higher than typical corporate debt to attract investors willing to take on the risk.

Per Altucher, in junk bond situations Buffett does not go through the typical rigmarole of evaluating the quality of the business or is sustainable competitive advantages; he simply evaluates the business’s ability to pay back the debt.

With distressed debt, it is important to keep in mind that the day-to-day, even year-to-year, volatility of the debt is, in the end, irrelevant.  The debt will do one of two things: make its payments and pay back lenders or default.

Closed-End Fund Arbitrage

Find the site’s closed-end fund strategy here.

Market Timing

Despite Buffett’s constant statements that he does not attempt to time the market he had, at the time of this book’s publishing, made market calls in 1969, 1974, 1979, 1986, 1992, 1999 and 2001.

Altucher tries to tie these market calls to value ratios like P/E and P/Book and to the so-called Fed Model where investors buy stocks when the earnings yield (E/P) is higher than bond yields, but fails to establish a successful trading system using either.

It seems Buffett’s market calls are valuation based but are more based on his personal feel than on a direct ratio.

[easyazon_link identifier=”1539313190″ locale=”US” tag=”valueinvesand-20″]If you’re interested in learning about market timing, I devoted the final chapter in my most recent book to various value based indicators.[/easyazon_link]

Disaster

Every time some sort of disaster happens (e.g. 9/11 or the housing crisis) Buffett is on TV soon after declaring the stock market will return.

Altucher finds that, for the most part, when there is a disaster and the market panics in the short-term it bounces back fairly strongly over the next month and six months.

Altucher even shows a trading system where traders purchase any stock that falls 10% in a day and it outperforms buy and hold by a factor of over 5.

[easyazon_link identifier=”0471655848″ locale=”US” tag=”valueinvesand-20″]You can buy the book here.[/easyazon_link]