August 6, 2019—President Trump Escalates U.S.-China Trade War With New Tariffs. What Happened Now?
Federal Reserve Cuts Rates by 0.25%. What Did The Market Think?
Beyond Meat Insiders Cash Out Of Stock In Droves. How Should Investors Interpret This?
London Stock Exchange Strikes Deal To Acquire Refinitiv. Why Did LSE’s Stock Price Rally By More Than 20%?
A Discussion On Merger Arbitrage: A Strategy For Consistent Profits In The Market
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.
Julian Klymochko: Welcome, ladies and gentlemen, to Episode 25 of The Absolute Return podcast. I am your host, Julian Klymochko.
Michael Kesslering: And I am Michael Kesslering.
Julian Klymochko: Today is Friday, August 2. A lot of really important market events to discuss this week, off the top.
- We will be chatting about President Trump, how he escalated the US China trade war with brand new tariffs. What did he do now?
- The Federal Reserve, as expected, it cut rates by 0.25%. We are going to chat about what the market did on that event.
- Beyond Meat, insiders cash out of stock in droves. How should investors interpret this dramatic insider selling?
- Some M&A news, London Stock Exchange strikes a deal to acquire Refinitiv. Why did LSE stock price rally by more than 20%?
- And lastly, we’re going to have a discussion on a recent blog posts just on Merger Arbitrage: A strategy for consistent profits in the market.
We got some escalation in the U.S. China trade war this week as President Trump announced on Twitter, of course, that the U.S. would be placing a 10% tariff on an additional 300 billion of Chinese goods. This extends tariffs to essentially all Chinese imports into the U.S. The new tariffs would take effect September 1 and cover 300 billion in Chinese goods, which includes smartphones, apparel, toys and other consumer products. Now, these come on top of 25% tariffs already imposed on two hundred and fifty billion of Chinese imports into the U.S. The tariffs would affect about 45 billion and cell phones. Thirty nine billion in laptops, tablets, and five point four billion in video game consoles. So some pretty big, potential effects on consumer prices of electronics.
The tariff plan threatens the maker of the iPhone. Apple, specifically the manufacturer, effectively all their products in China. They would either have to eat the cost of these tariffs, which they probably won’t do. So likely, those costs are going to be pushed on to the consumer, which would be substantial. There is estimates that these new tariffs would slap about 40-dollar cost on the price of an iPhone. Now, Trump suggested that negotiations, recent negotiations with China have gone poorly, with China failing to follow through on its pledges to buy more U.S. farm products, specifically soybeans. And also, they failed to restrict the flow of fentanyl into America. Trump claims that more and more Americans are dying from these drugs flowing from China to the U.S. However, this tariff fight was opposed by many in the administration. Including U.S. Trade Representative Robert Lighthizer, Treasury Secretary Stephen Mnuchin, White House Economic Adviser Larry Kudlow, and National Security Adviser John Bolton. So pretty much Trump kind of going kamikaze here, acting on his own on this, despite all the warnings from his inner circle. I just wanted to get into some of the background to review how this trade war between the U.S. and China has progressed thus far.
It started out last year with Trump slapping tariffs on Chinese imports of 50 billion of industrial products. He further added another 200 billion in tariffs in late 2018. Now, in May, after discussions, negotiations with China broke down, Trump increased the tariffs on that 200 billion from 10% to 25%. And then he also threatened to impose tariffs on the remaining 300 billion of Chinese imports that were not subject to terrorists. Now, on Thursday yesterday, Trump signalled that he would follow through on that threat to have tariffs on that remaining 300 billion. So effectively, it would cover all imports from China into the U.S. Now, Beijing, they are not happy. They issued a swift response with China’s commerce ministry vowing to retaliate with necessary countermeasures against the U.S. move, suggesting it was more likely to dig in in the face of Trump’s tariffs rather than make concession. And that’s really been the story of what’s happening here, and it really makes no sense because Trump continues to further ramp up more and more tariffs, and clearly, these threats aren’t working because China just goes out and retaliates. The effectively provided no concessions, and some speculate that this most recent temper tantrum from Trump was spurred on by a Wall Street Journal article this week that indicated that the slow progress in talks was partly the result of a new tactic from Beijing, which increasingly thinks that waiting may produce a more favourable agreement. So Trump getting the hint that perhaps China is dragging its feet on discussions and perhaps he thought that implementing this additional round of tariffs would spur some progress there, but ultimately thus far all these increasing tariff threats and even the implementation has really had no net effect on improving or getting any sort of concessions out of China. What are your thoughts on this increase in the escalating trade war with China here?
Michael Kesslering: Yeah, I think the public is a little bit desensitised to the view of more tariffs. It seems like every month there is new tariffs being implemented by Trump. The effects just seem to be having a less and less of an effect on the negotiations. And after this, he had indicated that he could move the tariffs from 10% all the way up to above 25%. I really don’t know, I would agree with you. I really don’t think that this is having the effect that he would hope. One other industry you mentioned Apple, the other industry that is affected by this would be the toy industry as they source 85% of their products from China. That would affect Hasbro and Mattel. In this situation went to Apple, you mentioned that they have the choice of whether to cover the costs of the tariffs, to eat the costs themselves or pass them along to their consumers. Well, with the toy industry, they do have a little bit of a struggle in passing along these prices as toy prices for the holiday season, which is rapidly approaching, have already been negotiated, and these are set with the retailers already. That could be a situation to watch for the toy industry, but my last comment on that would just be that you really don’t tariff your way to prosperity. And that seems to be the way that Trump is trying to appeal to his base. I really don’t think that’s a sound economic strategy.
Julian Klymochko: Yeah, he really seems to have a primitive understanding of basic economics. Ultimately, the U.S. consumer pays for these tariffs, right. Nonetheless, I mean, the U.S. economy is still holding up quite well. Got a jobs report this week, Hundred sixty four thousand jobs which were in line with expectations and still a great number. Unemployment at 3.7% near an all-time low. The U.S. economy really know doing well here. GDP growth north of 2% and you see, conversely to that, the Chinese economic figures, economic growth, they are hitting, I believe, 27 year lows and the numbers are increasingly looking poor out of China. Nonetheless, they seem to want to be digging in their heels here. Less concern about economic impact and more so it seems like an ego thing that President Xi does not want us to show any weakness, and I believe the Chinese people are behind that attitude.
We want to get into some numbers. Obviously, the market did not like this right after the tweet of additional tariffs. The Dow Jones plummeting 550 points, so that is about a 2% drop just from this news. The yield on the 10-year treasury and now remember yields move inversely to prices. The yield fell to its lowest level since 2016. There is a flight to safety here, people bidding up bonds and Treasury bond prices increasing.
Michael Kesslering: With your comment with regards to China’s slow moving and being willing to play the long game is another thing to keep in mind is that they don’t have to worry about an election next year where Trump is very worried about his next campaign.
Julian Klymochko: And who knows? Perhaps Trump is playing 3-D chess here and we don’t even know it, and it could be some re-election move that ultimately works, but that is yet to be seen, and we’ll closely follow the situation.
On to the Fed, and this really dovetails nicely with the economic discussion and the escalation in U.S. China trade war. Because what the Fed did, is this week they cut interest rates for the first time since 2008. The Central Bank cut its benchmark overnight lending rate by 0.25% or 25 basis points, and this was really expected by the market. One of the reasons the market expected this rate cut is to offset any potential economic weakness from the ongoing trade war.
Now, the Fed stated that this rate cut was driven by global developments for the economic outlook along with muted inflation pressures. Ultimately, it seems like it is a pre-emptive strike to cushion the economy from a global slowdown. Number one caused by this trade war, number two, you know, there are challenges in Europe. You are seeing poor economic data there, Brexit, but the Fed said that it will ultimately continue to monitor how incoming information will affect the economy, adding that it will continue to act as appropriate to sustain this record long U.S. economic expansion.
Now, the main issue here, Chairman Jay Powell did have a conference after the announcement of this rate cut, which brought the benchmark rate between 2% and 2.25%. Chairman Powell stated that this was, quote, “a mid-cycle adjustment.” Now, the market really had a lot of trouble with this, because that indication that this is just a mid-cycle adjustment, many interpreted that as being a one and done type scenario where they just cut rates once instead of going into a brand new rate cutting cycle, which would see interest rates drop significantly lower after a number of consecutive rate cuts. Got a quote here from Scott Minerd, the CIO at Guggenheim Partners. He stated, quote, “Powell increased uncertainty around the direction of policy. The discussion about the future path of interest rates was ham handed and probably undid a lot of the benefit of the rate cut today.” Interesting quote from Trump. He went on Twitter and stated, quote, “what the market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate cutting cycle. As usual, Powell let us down.” So that really sums up nicely what the market was thinking, because equity markets went down pretty significantly after he announced that in his conference that this was really that mid cycle adjustment and those were his thoughts there. Another interesting fact was the decision to cut rates also drew dissents from two Fed members. Those Boston Fed President Eric Rosengren and Kansas City Fed President Esther George. They argued for leaving rates unchanged. So they are against rate cuts, as at this moment. Both have raised doubts about a rate cut in the face of the current expansion. As we discuss unemployment rate at near all-time lows, along with robust household spending.
But what this rate cut did is it effectively reversed the Fed’s December rate increase, which came during a period in which it believed interest rates were still low enough to spur growth and inflation, but since then, I mean, the inflation numbers have come in. Ever since 2009, we really have not had a sustained period with inflation north of 2%. That is ultimately one of the Fed’s mandates is to get inflation. You know, they call it stable pricing, but they ultimately want to see inflation around that 2% level. Currently core CPI at 1.6%, as we discuss unemployment rate that is their other mandate, near all-time lows at 3.7% in June. Then the US economy expanding at 2.1% last quarter, which is also a very good number. The argument against rate cuts here certainly makes sense. However, the Fed really needs to take into account what the market is expecting, and as we discussed on last week’s episode, the market was pricing at a 100% chance of a rate cut. There ultimately was not going to be 25 basis points or 50 basis points, and the market was expecting, I believe, 83% chance of 0.25% cut, which in fact they did get. Now, this rate cut marks just the fifth time in the past 25 years that the Fed switched from raising rates to lowering rates in the four prior cases. The Fed never cut rates just once, so I think here, despite what Powell says and we have discussed many times that you should ultimately watch for what Powell does. Not what he says, because he has been known to flip flop, to do 180-degree turns and effectively, you know, negate the previous language that he has given to the market on these decisions here. Nonetheless, the market is pricing in a 94% chance of a rate cut next month in September. What are your thoughts on the recent Fed cut and all this consternation in the market about, Powell, quote, mid-cycle adjustment language?
Michael Kesslering: Yeah. With regards to the mid cycle adjustment language, it is helpful. You did mention the four previous times that the Fed cut rates and it really looks like what happened in 1995 and 1998 where the Fed made a few believe it was two or three small cuts and the economy did avoid a recession. That is what it really seems like he means by a mid-cycle adjustment. That could just be the commenters not really understanding, having a historical context for what he is saying, or it could just be. Powell just really struggles with communication as we have discussed before.
Julian Klymochko: Yeah, That has been the case thus far, in his term.
Michael Kesslering: Absolutely, and as well, while we are on the note of history, I did want to put this into context. The last time that the Fed was cutting rates was in 2008 after the global financial crisis. In comparison to that, the benchmark rate at that time was more than double where it is at today, and the Fed asset portfolio today is 18% of GDP vs 5% at that time. If you look at those two like from where it’s starting from, those are very different scenarios, which is quite interesting. Like you mentioned, with the jobs data, the inflation numbers that are below the 2%, but there not one point six range. This is not an economy that’s, you know, very weak. So, you know, if it was my guess, it would be that, yes, there is a couple of rate cuts this year. Then, you know, ideally that would avoid any sort of recession barring any sort of global events. But I think that’s the way that Powell is looking at it. It is just remains to be seen and your comment from Trump’s quote, when he talked about, you know, disappointing us. I think you could just substitute us for me, from Trump’s point of view, where really it was what he was looking for, and Powell just continues to disappoint him, but Trump does have political motives.
Julian Klymochko: Right, because Trump wants to see GDP growth of at least 3% and he wants to see the stock market hitting new all-time highs. That is really his main goals with criticizing the Fed, and he wants ultra-low, ultra-loose monetary policy. Now, commenting on, you know, you touched on historical monetary policy and I think ultimately here. As for the previous rate hiking cycle, the one that effectively just ended, I think they are looking to return rates to the 3 to 4 percent rate range. Ultimately, prior to the cut, they only got 2.25 to 2.5%. So not quite there previously viewed neutral rate in addition to that, the size of the balance sheet. They wanted to get it down to about one point five to 2.5 trillion. However, you know, it is currently at three point eight trillion and now looks like it is going to stay there because they ultimately halted the un-wind of the balance sheet there.
Michael Kesslering: And it will actually grow because the interest payments will be reinvested, so it will actually continue to grow.
Julian Klymochko: Touching on some market action now, the U.S. dollar. This was bullish for the U.S. dollar. It actually touched its highest value in more than two years, and the U.S. markets were down 1.2% on the news, largely that power language regarding the mid cycle adjustment, but interesting development there will obviously closely cover any sort of developments, especially the next Fed decision come September.
Getting to some news on everyone’s favourite alternative meat companies. What happened this week was, Beyond Meat sold nearly half a billion worth of stock at one hundred sixty dollars per share, and this was at a stunning 18.6% discount to its closing price. Now that 500 million worth of stock was all insiders selling. Insider is cashing out of their stakes in the alternative meat company. Now, this share sale came amidst a nearly 10-fold increase in the price since Beyond Meat recent IPO. As you remember, this IPO came into the market at twenty-five dollars per share just in May, and the stock has rallied nearly 10 fold. It peaked at two hundred and thirty dollars per share. Ultimately, they are selling shares here at 160. So certainly a large increase since the twenty-five dollar IPO, not the peak of the market at two point thirty dollars, but relatively close.
Now, the biggest beneficiaries of this secondary offering, they call it a secondary because the company is receiving no capital from the three million shares sold in this offering. The main beneficiaries will be Venture Capitalists who bet on Beyond when it was a private company. There is Kleiner Perkins, which are selling over 600,000 shares, and this will net them, I believe, almost 100 million dollars. They have access to more, they could sell, I believe, an additional 100,000 shares. The CEO is selling six million; the CFO is selling nine million dollars’ worth. So those guys getting a good chunk of change there, but I’d like to note that none of them are cashing out completely. They are just sort of taking a little bit off the table. An interesting aspect here is that there was a six month, 180 day lockup on the IPO, which would have prevented IPO or private company or holders those before the IPO from selling prior to October 29, but they managed to get under that lockup. Do you want to chat about how that happened here?
Michael Kesslering: Yes. So the important thing that investors need to understand that this 180 day lockup is agreement between the company and the IPO underwriters. This is not a regulatory lockup or an agreement, for that matter, with current shareholders. It is really up to the underwriters to allow them to break this lock up and sell shares into another offering. I guess the question would be why would the IPO underwriters agree to this as they had just sold a number of shares in the IPO to their clients? And the simple reason for that is that the initial IPO was done at twenty five dollars a share and the share price before this announcement was to over two hundred and thirty dollars per share, so those initial IPO investors had to have over a 10 X.
Julian Klymochko: Right and a lot of this is a supply demand dynamics because as we have seen a lot of recent IPO, as we call it, a low float IPO. I believe there is 60 million shares in the IPO. They offered, you know, maybe 12 million.
Michael Kesslering: 12 million.
Julian Klymochko: Yeah, so that was only about 20% of the float. And so there is a lot of demand from a lot of millennial speculators, but not too much supply. What the underwriters want to do is increase supply of shares such that they are not so volatile so they can get those supply demand dynamics more in check. But I’m considering, calling them out on this one. I am calling it beyond ridiculous, and I really want to warn investors here, we did see a recent precedent or something very, very similar happened in Tilray. As you remember, Tilray is a cannabis producer. Now they are a heavily hyped new growth industry that had a low float IPO and their stock also rallied significantly since their IPO, and I believe they allowed insiders to cash out before the lockup. And when the CEO was asked if he was selling it and he started laughing on CNBC and really ploughed out his shares at a highly inflated price, and I believe since then, Tilray stock is down roughly 80%. I think that is interesting precedent for Beyond Meat investors to observe, because getting to valuation here, their market cap is currently 10 billion dollars. They reported quarterly losses of about 10 million on revenue of about 67 million. They are expected to produce annual revenue of about two hundred million. You look at that valuation, they are trading at 50 times sales. Meanwhile, their peers trade at one-time sales. Beyond Meat, has a valuation 50 fold higher than their competitors, and this is going to be an extremely competitive space. You see a lot of the traditional food producers getting into this market and investing a lot to bring some serious competition to Beyond Meat.
Michael Kesslering: Absolutely, and in terms of the competition, what Beyond Meat plans to spend in Capex this year, I believe is something around 40 million dollars. That’s not a lot in the grand scheme of things, especially when you have a competitors like Tyson who, you know, if they just take it as, you know, a percentage of revenue, that could be easily in the billions that they would be investing into the business
Julian Klymochko: And I saw that Maple Leaf Foods expects to have north of 200 million in alternative meat sales in the next few years.
Michael Kesslering: Absolutely, and the other aspect is you had mentioned the low float of this of this particular stock. You had mentioned it was about 20% of shares outstanding was their float. So now, they are increasing that, effectively increasing it to 24%, which is increasing that float by 20%. That may not sound like a big deal, but in terms of this, like you mentioned, the supply and demand, that just means that there will be more shares available to short and at reasonable borrow rates. It could become a more normal hazed valuation.
Julian Klymochko: Right and those borrow rates are in the triple digits well north of 100%, and could be one reason on the buying pressures is a massive short squeeze. I think this is beyond ridiculous for a couple reasons. Number one, you know, we have never been a fan of these low float, heavily hyped IPO. They usually end in investor heartbreak with the shares declining precipitously, but the insiders ploughing out here. I mean, I don’t blame them, they’re taking advantage of Mr. Market, giving them a ridiculous price, but still, you know, it’s not the best look when we believe that the shares are kind of manipulated here given those low float dynamics. Number two, I am not a big fan of VC, Venture Capitalists ploughing out garbage to the public markets. It just seems like a really low quality IPO with respect to the valuation and the competitive dynamics. You know, nothing to say on the products, but it really is disappointing to see that Venture Capitalists view public markets as just a dumping ground to get rid of the stuff that they no longer want. Looking to capitalize on retail investors, pensions, mutual funds, and I think it is a shame.
Onto some M&A, interesting event in the mergers and acquisition space with the London Stock Exchange. LSE announced an agreement to acquire financial data provider Refinitiv in a twenty seven billion dollar deal. This acquisition will expand LSE’s trading business beyond just shares and derivatives and into currencies. In addition, it will make the combined company into a strong rival for Bloomberg. Now Bloomberg is the dominant distributor of financial market data. You find it on effectively every trading desk. Refinitiv offers competing terminal called Eikon, which is not nearly as successful, but they are really trying to take market share away from Bloomberg, who has been the number one market player for decades. Now the LSE specializes, they really specialize in the plumbing of financial markets with assets such as provider FTSE Russell, obviously, these, you know, manage the FSTE and Russell indices, as you know, Russell pretty big in these small and mid-cap space. Also have clearinghouse as well obviously as its namesake stock exchange, The London Stock Exchange. Refinitiv in addition for its Eikon Icahn portals. Also just financial data, you know, everything from stock prices, bond prices, commodity prices, basically everything any sort of financial manager could rely on. Ownership Refinitiv, it is really interesting because it’s currently owned by a consortium of investors led by Blackstone, Thomson Reuters and including CPP, the Canada Pension Plan. All Canadians really benefiting from this deal to the London Stock Exchange. Now, this merger of Refinitiv with the LSE is just coming 10 months after Blackstone bought the majority stake in the unit from Thomson Reuters in a deal that closed just last October, saw a quick flip for the LBO purveyors here. Basically Blackstone, CPP, Thomson Reuters maintained a stake, after that they divested this subsidiary in the deal just 10 months ago. However, I should note that the private equity consortium here, they are only getting shares and they are going to be major shareholders in LSE. They are not really cashing out, they are monetizing it, but ultimately they are just receiving paper for this deal. Fun fact here, the deal’s origins actually date way back to 2013 when the CEO running Thomson Reuters Financial and Risk Division, which they did rename Refinitiv. He was actually introduced to Blackstone’s head of private equity at the Chelsea Flower Show. So you never know what certain networking events or social events can get you, but clearly that back in 2013, they kind of structured this deal to Blackstone involved and then perhaps flip it to a financial player, which is clearly what’s happening here. Now, the strategic rationale for LSE is they hope that the Refinitiv deal will help it transform into a major global market data and infrastructure player. What they are going to see from this deal is they are going to see some major earnings accretion, meaning that earnings per share will rise by more than 30% in the first full year after this deal, which the market really liked. LSE stock was up over 20% on the news. What are your thoughts on this large, twenty seven billion dollar M&A transaction?
Michael Kesslering: Yeah, so, number one, you had mentioned the accretion to EPS. One thing that this deal is also going to add for the LSC is a very leveraged capital structure as Refinitiv, had about 12 billion dollars’ worth of debt, so that does add some balance sheet risk to them. The other thing that I would like to mention was you had mention the Blackstone Consortium and that deal in October 2018. That was valuing the company at 20 billion, whereas this deal is valuing the company in its debt at 27 billion. A nice little increase for Blackstone, and I believe because that Blackstone had put on some debt to the company that this actually results in them doubling their initial investment. Over her over 10 months, that is a great investment return and as you mentioned, that is for all our fellow Canadians as well.
Julian Klymochko: 100% gain.
Michael Kesslering: Absolutely, and the other thing that I would like to point out is that Refinitiv actually is growing at a substantially lower rate than the LSD core business, as they’re just growing revenue at a currency adjusted rate of 3%. After a few years of declines, so I don’t know if that growth is sustainable, whereas their rival FactSet is another rival to both Refinitiv and Bloomberg is growing their revenue at effectively double that in the 6% range. I wanted to point that out as well in terms that competitive dynamics.
Julian Klymochko: Right, so certainly not quickly growing asset here. More like a steady, low growth financial data business. However, the market really liking it, which to me presents a very interesting dynamic because we cover mergers and acquisitions a lot on this podcast. Typically what we have seen are the acquired stock really tanking once they announce any M&A in this environment. Specifically, we saw it on the Oxy Anadarko deal, and we can name countless deals in which the acquirers stock declined by double-digit percent on any sort of large M&A. However, on this one interesting contrast, you are seeing LSE shares rise by over 20% and I think, caused by two things. Number one is so they are buying a private asset, so a merger arbitrage can’t come in and arb this deal and how that will work is typically you buy the target and you short the acquirer. LSE is seeing no selling pressure, no hedging pressure from merger arbs on their stock. So that is one dynamic that typically causes the acquirer stock to decline in public market M&A transaction. Number two, people quoting the earnings accretion, so if you maintain the same earnings per share multiple and earnings per share rises by 30% while then the share price should rise by 30%, but nonetheless, the market will discount. Well, typically the dramatic increase in leverage here, because as you indicated, that does increase the default risk of the pro forma entity, so some really interesting dynamics on this deal. But looking like quite the homerun for the private equity backers of Refinitiv.
Put out a blog post this weekend titled Merger Arbitrage: A Strategy for Consistent Profits in the Market. And what we detail is really how this strategy works and why it would be a benefit to a diversified portfolio. Number one, it really is the tried and true hedge fund strategy that has been successful has a long track record of success in the market of really low volatility, absolute return, providing that, you know, really consistent return profile at low volatility for investors. You got some charts in here since 2005, the arbitrage index has provided a 4.6% annualized return, so nearly 5%, which was 50 basis points or 0.5% higher than the Bloomberg Barclays U.S. AGG Index, which is the broad based bond index, and it was during a basis points or 3% higher than short term treasuries. That is really how merger arbitrage works; we will get into a simple example. I talked about Red Hat, which was a recent acquisition of IBM. Now, after the Red Hat deal was initially announced at one hundred and ninety dollars per share. The stock traded at a pretty significant discount to that price of about 12%, and that deal closed in seven months giving merger arbitrage investors, who did provide liquidity step into the market, allow long term redhead investors to exit at a discount to the merger price. But merger arbs, the investors that invest in these deals and earn that merger spread, they need to take on the risk of a deal breaker, which in the Red Hat deal, it closed successfully in seven months, providing a an attractive annualized return of north of 17% annualized. Now you put together a portfolio of those attractive risk reward arbitrage trades and you can generate some pretty good results. As we indicated, the arbitrage index over the past 15 years averaging almost 5% and that was at a volatility level of annualized around 4%, which is a bit higher than bonds, but a fraction of equity market volatility, which is typically in the 15-16% range. So arbitrage about one fourth the volatility and it really is one of the best performing hedge fund strategies out there, on a risk reward basis and retouch on this further in the blog post on just, some strategies around merger arbitrage. How you run a merger arbitrage strategy, how you handicap the deals and ultimately how you want to structure the portfolio. I encourage you to read it, there’s a lot of interesting details of our experience running a merger arbitrage strategies and how we view the risk management framework behind those strategies.
Michael Kesslering: Yeah, so just a couple of questions here. I guess really surrounding the risk management framework. Could you just describe how you would structure a trade where you viewed there was a high probability of a bidding war?
Julian Klymochko: Yes, so the bidding war is the best possible news that could happen to an arbitrage. What you are dealing with, every trade you get into. You want the deal to close successfully, but inevitably, some of them break. I find basically one or two deals in your portfolio per year will break. A deal or break is about as costly as 10 successful deals are, so you’re basically typically losing 10 fold of what you expect to gain from the successful closing vs. a deal break. You mentioned the concept of a bidding war, which is just catnip to arbs because that offers substantial upside multiples of what you expected on the typical standard merger arbitrage gain and these bidding wars ultimately offset the pain and the losses that go with the deal break. If a bidding war occurs, I mean, number one rule is you always want to hold the stock and I always want to hold it and see it through the end of the bidding war. You may not top tick it, but you will be around to really, reap the rewards. As you know the original buyer and the interloper go back and forth and increasing prices. If there is shared consideration involved, you don’t ultimately know who’s going to successfully close the deal, so in my opinion, in that type situation, you just want to be outright long the target. I call it riding the lightning where you are unhedged, but ultimately, if it is a target and it is in the bidding war, more often than not, that stock is heading higher.
Michael Kesslering: And so another aspect to do with risk management is that if it is a shared deal and the acquire has to issue a certain amount of shares, there would be a buy side vote, and so why would you want to avoid a buy side vote?
Julian Klymochko: Right, and by buy side vote, you mean that they deal requires shareholder approval from the acquiror in the transaction. Now, why that is so risky to arbitrage in a scenario in which the acquire is issuing sufficient shares to require from a regulatory standpoint for them to get approval for that share issuance. Now what that does is it effectively puts them in play, meaning that anyone who is interested in buying the acquiror, they basically have the ability to do so in that situation. The way that works, the way that dynamic works is if an acquiror makes a play for the target and they require a vote, and if an interloper steps in and then makes a play for the acquiror. Well, how are they acquire as shareholder is going to vote? Are they going to vote for an acquisition which likely cause the share price to go down or are they going to vote to sell the company at a large premium? Ultimately, well, obviously, they are going to vote to sell the company at a large premium. That buy side vote is really just inviting an interloper to come with an unsolicited or hostile offer for the acquire in that situation. As an arbitrage or you never, ever, ever want to be short an arb trade long the target, short the acquiror, when that acquiror requires a shareholder vote. Unless you have the situation where there is a controlling shareholder and an interloper cannot buy the company under any circumstances or if the company is what I call unacquirable where they are so big that no one can buy them, say Exxon Mobil, Google or Apple. In those situations, you can put on those trades where you along in the target and short the acquiror. But if the acquiror presents a bite sized acquisition to a competitor and they require a vote, stay far away. Because in the situation where an interloper does come over the top and offer to buy the acquiror for a large premium, now you are short the acquiror’s stock, so not only will your target fall because that deal will fall apart, so you will face large losses on your long target position, making the matters much, much worse, you are short the acquiror’s stock, which is now subject to a hostile bid, and so you are going to get your face ripped off on your short position. You are losing on both ends and you can lose well over 100% on that position because, your long position is tanking, your short position is ripping. Ultimately, in my opinion, it is never worth the risk of putting on a merger arbitrate where the buyer ultimately requires a buy side vote, a vote of the acquirers shareholders to allow them to take over the target. So just a warning, stay far away from that type of merger arbitrage trade.
That about wraps it up for episode 25 of The Absolute Return Podcast. We hope you have a great week and we will chat with you soon, cheers.
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