Hello friends, in today’s article, we see The Dhandho Investor Chapter 11 Summary. this chapter is all about fixating on Arbitrage. so let’s understand, how value investors can take benefit from this arbitrage.
Dhandho 302:- Fixate On arbitrage (Chapter 11)
In starting the author explain, what is the arbitrage, and how value investor take benefit from that
the author says, ” Arbitrage is a powerful construct and a fundamental tool in the arsenal of any value investor. with arbitrage, we get decent returns with virtually no risk.
The elimination of downside risk, even if the upside is limited, is awesome -& that is exactly what arbitrage gives us. With arbitrage, the appeal is ” Head, I win: Tails, I breakeven or win!”
Although many different forms of Arbitrage exist, compare these four:
1) Traditional Commodity Arbitrage:-The Dhandho Investor Chapter 11
in this, the author explains, Commodity Arbitrage
the author says, ” If gold is trading in London at $600 per ounce and is changing hands at $610 per ounce in new york city, an arbitrageur can buy in London and immediately sell in new york capturing the spread.
Over time, these trades will lead to the special being dramatically narrowed or eliminated.
2) Correlated Stock Arbitrage:-
In this arbitrage, the author gives the example of Berkshire Hathway
the author says, ” Berkshire Hathaway has two Classes of -BRK-A and BRK-B – which trade on the New York stock exchange ( NYSE). BRK-B is economically worth 1/30 of BRK of BRK-A.
One BRK-B share has 1/200 the voting rights of a BRK-A share. so it is slightly inferior as it has less than one-sixth of the voting power for the same dollar and invested, other than that, these two stocks are virtually identical. also, since Mr. Buffett, these close friends have large enough BRK-A Holdings. (The Dhandho Investor Chapter 11)
To control the company, these voting rights differences are mostly irrelevant. BRK-A shares can be converted into BRK-B shares at the discretion of the holder at any time however, the holder can not do the reverse.
Based on these facts, these two stocks should trade in lockstep with each other- or perhaps BRK-B ought to trade at a very slight discount due to its inferior voting rights and one-way conversion features.
However, the reality is different. As figure 11.1 shows, during a recent 3 month period. BRK-B traded mostly at a discount to BRK-A for a few weeks and then traded at a premium for a few weeks.
On some days, the two stocks, differed by up to 1 percent. Assuming minimal frictional costs an arbitrageur could endeavor to capture that spread.
This type of arbitrage exists in a variety of stocks, sometimes holding company stocks, trade at a discount to a sum of the parts even if the parts are individually publically traded.
sometimes the same stocks on different exchanges can have price differences. Closed-end-funds from time to time trade at significant discounts to their underlying assets, all are candidates for arbitrage plays.”
then author explains the merger arbitrage, between two companies
3) Merger Arbitrage:-
the author says ” Public company A announces it is to buy public company B for #15 a share, prior to the announcement B was trading at $10 a share; immediately after the announcement B goes to $14 a share.
if an investor buys B at $14 and holds the Stock until the deal closes; then the $1 spread can be captured for a tidy profit in a few months. (The Dhandho Investor Chapter 11)
However, there is always some risk that the deal does not close. In that case, Company B’s Stock price might head back down to $10 ( or lower). Unlike other forms of arbitrage discussed earlier, this is not risk-free. this is sometimes called risk arbitrage.
There are well-downside statistics on the percentage of announced mergers that never close. don’t get government approval, don’t get shareholder approval, or the like. if you understand the business and these dynamics, you can handicap the odds of the deal closing and decide to place a bet ( or not ) accordingly.”
then author explains, his famous Dhandho arbitrage
4) Dhandho Arbitrage:-
the author says, ” Virtually all startups engage in Dhandho arbitrage. An example of this is presented in chapter 5.
Our barber set up shop in town C and had a 17-mile arbitrage likely was reduced to a few blocks and the arbitrage mostly disappeared. However, while it lasted, he had Super-normal profits.
He got these profits by taking very little risk. It was low risk and high uncertainty that got him his bounty. the barber is a classic Dhandho arbitrageur.
Head, He wins, Tails, he doesn’t lose much!
the overwhelming majority of entrepreneurs are not risk-takers. they are Dhandho arbitrage players. one of the most vivid examples of this dhandho arbitrage. entrepreneurial journeys is the story of computing, documented by Amar Bhide in his wonderful book ” the origin and evolution of new businesses.”
then the author gives a detailed story,
the author says, ” In 1994, computing, was founded by two 20-year-olds- steve Shevlin and Robert Wilkin.
Shevlin was the main driver of the business. A college dropout, Shevlin, entered the army where he trained and worked as an electronic technician. (The Dhandho Investor Chapter 11)
he didn’t care too much for the military’s uptight attitude. After a brief stint, he left the army. Shevlin was unemployed and without much money. He lived in a tiny studio apartment in Florida.
it was the very early days of the personal computer business, and Shevlin being a hacker type, had a computer and a printer in his studio.
The Ideal setup required the printer to be placed away from the PC and he needed a 20-foot cable to connect them. he went to a shop that sold printer cables and computer accessories and asked if they had the long cable he needed.
at that time, when PCs were very few the interfaces for all these cables were not Universal or standard as they are today. there was a hodgepodge of different cabling and socket standards.
The retailer said he had the cable but it was only seven feet long. he suggested daisy-chaining three cables and adding some special connectors to make it all work.
Shevlin was not happy with the total price or nature of the proposed solution. He went back to his studio and thought about the situation. he come back to the retailer and said that he adds been a tech in the army and knew how to make PC cables.
he offered to make and sell cables in a variety of lengths to the retailer. the retailer said that he was used to getting all sorts of requests for cables of different lengths that he did not have the ability to procure or provide. Nonetheless, the retailer was hesitant about taking inventory risk on unbranded cables as some of the different lengths that he did not have the ability to produce or provide.
Nonetheless, the retailer was hesitant about taking inventory risks and unbranded cables as some of the inventory might become obsolete quickly.
Shevlin offered to give it to him on consignment the retailer said that on a consignment basis, he’d stock anything.
so Shevlin was in business with the first customer lined up. Shevlin and Wilkin carefully noted all the missing cable lengths and connections that people might want. (The Dhandho Investor Chapter 11)
They bought 300 free cables and all the hardware to make the various connectors and want to work.
they made various odd-length cables and delivered them to the retailer who was elated. these cables cost about two to three dollars apiece which was very competitive with the other shorter lengths.
the retailer put them for sale at over $30. everyone was happy with the healthy margins.
They started to get more retailers to carry their cables and sales grew significantly over the next few months. then sales started falling.
The retailer put them for sale at over $30. everyone was happy with the healthy margins.
they started to get more retailers to carry their cables and sale grew significantly over the next few months. then sales started falling. the retailers said that they no longer needed the CompuLink cables as their primary vendor had come up with these lengths, and the incumbent had a better brand and packaging.
Shevlin was very disappointed and spent some time thinking. he realized that PC and printer manufacturers are continuously coming up with new models of printers and new models of computers and other devices that need to be connected.
Every few months, CompuLing changed large portions of this product line as competitors entered the fray. Shevlin was always running about three to six months ahead of his big competitors in intraday cables because he was nimble and focused. the competitors were slower because they were larger companies, and it took time to roll out new products.
Shevlin would get the new cables into distributor channels, scoop, in all the super-normal profits as a monopolist, milk it for three to six months, and then be told that he was either being replaced by the mainstream vendor or had to drop prices.
They did exceptionally well with their lowly Dhandho arbitrage and become an Inc.500 company in 1989- one of the fastest-growing businesses in the United States.
They literally were the Ultimate business arbitrage model- one where supernormal profits were totally free but lasted just a few months.
They were good at dealing with uncertainty, low-risk high uncertainty and arbitrage are the core fundamentals of how good entrepreneurs operate. (The Dhandho Investor Chapter 11)
As computer interfaces began to get standardized computing original arbitrage spread all but vanished. it continued to evolve and always looked to exploit on offering gap.
It did find such a gap in complex cable installation today, CompuLink has 600 employees doing mostly cable installation services.
This spread, too, has narrowed, but in the meanwhile, it has built brand and reputation. it’s likely CompuLink Will continue to strive -at least for several more years before this gap closes.
Due to technology changes or more intense competition. ”
then the author gives the examples of GEICO Insurance, the arbitrage spread is its focus on selling auto insurance policies without agents or a branch office Network.
so this is a summary of chapter 11, from the book ” The Dhandho Investor” written by Mohnish Pabrai