MERGER ARBITRAGE AS A SAFE HAVEN
16 MAY 2022
Does it make sense to do merger arbitrage when the market is turbulent or in a downfall? The idea is to buy a company before, or even after an acquisition is announced and camp out until the acquisition is completed or it’s opportunistic to invest in the market again.
Warren Buffett’s recent purchase of Activision Blizzard is an endorsement of “merger arbitrage as a safe haven.” Analyzing his thought process will give us a better understanding of the strategy.
Microsoft buys Activision Blizzard (background)
Activision Blizzard is a gaming company. Microsoft owns Xbox and develops exclusive games themselves. A merger between the two makes sense.
In January 2022, news broke out that Microsoft would acquire Activision for USD 95/share. Activision was trading around USD 65 prior to the announcement.
Buffett’s story with Activision actually takes place before the deal was announced. An investor at Berkshire bought a USD 1 billion stake in Activision back in October of 2021. Buffett says he never knew about the possibility of a merger, though that’s debatable since people at his level always know more than they let on.
Nevertheless, it doesn’t affect the execution of the arbitrage since Buffett himself admitted to taking the position up to USD 5.6 billion post-announcement. This would give him a roughly 9% stake in Activision. And since there’s a large spread of around 20%, Berkshire seeks to profit by around USD 1.1 billion.
For anyone who’s studied Buffett (especially in his post-cigar butt decades), it’s known he doesn’t participate in short-term speculation and arbitrage opportunities often. Instead, he aims to buy great businesses that can compound his wealth over a decade or more. So, Activision is a rather unique case.
Microsoft buys Activision Blizzard (arbitrage safe haven)
Buffett knows the market is overvalued based on many metrics. Buffett knows the Fed printed too much money, which artificially boosted asset prices. Buffett knows inflation is inordinately high and the Fed has to fix the problem, which means raising rates and destroying demand to bring down prices. And Buffett knows that the stock market will be negatively impacted as long as the Fed holds an anti-inflationary agenda.
All of this is rather obvious in hindsight since the Nasdaq is down 25% YTD.
Finally, Buffett knows he can’t stay in cash too long; otherwise he’ll bleed 8% a year (CPI inflation). So he has to find something to invest in. In the past, he would just invest in short-term treasuries, but with inflation vastly higher than yields, that’s no longer an option.
Indeed, Berkshire spent USD 52 billion in Q1 on stocks (a lot of oil) to avoid inflation. 10% of that obviously went to Activision.
His thinking was probably something like:
- Inflation is like having a -8% carry on cash and the market can easily go down 20–50%, so I have to move my money out of cash, but I can’t just buy any stock out there and there aren’t many great deals around.
- There’s currently a 20% spread from where Activision will be acquired, so my upside is 20%.
- The risk is I end up owning Activision if the deal falls through. Am I okay with holding Activision if that happens?
- Well, I’m getting a 0.6% dividend yield. The PE is average. And I’m going to get an earnings yield of 8+% (the last number I made up, but I’m sure Buffett and his team thought something similar). There were people willing to own Activision up to USD 100 even when many tech stocks were falling in 2021.
- Activision is a decent business at a fair price. If the deal falls through, I’ll own a business that will weather the storm.
- Let’s buy and hold to completion. Meanwhile, I have a temporary safe haven from inflation and a slipping market because Microsoft set a floor on Activision’s share price.
So far, Buffett appears to be flat, while the Nasdaq is down -25% – merger arbitrage as a safe haven appears to be working as intended.
ATVI in blue. Nasdaq in orange.
A merger (not-so arbitrage) safe haven of our own
Our very own Vidler Water recently decided to merge with homebuilder D.R. Horton on April 14, 2021. The offer price was USD 15.75, and it’s been trading there ever since.
We’ve owned Vidler since it was USD 12. Usually, it’s worth selling when a buyout is announced, not only to cash in but also to erase the risk of the deal falling through and having the stock lose its premium. However, in this case, I thought holding was the better move since:
- A bidding war may happen because water scarcity is a growing issue in the Southwest.
- It’s better to hide out in Vidler than in cash or another falling stock.
So far, Vidler is treating us well and acting as a safe haven as intended. For details, you can read my updates.
A couple of examples should convince you that merger arbitrage is a valid strategy for alpha and can even act as a safe haven in turbulent markets. As an investor, the trick is to find businesses that you are willing to own even if the deal falls through. As long as you do that, if the deal falls through, you can always hold or average down, and leverage time to see your investment pay off.