Podcast #43 Show Notes: Merger Arbitrage with Peter Steinberg MD
This episode is all about merger arbitrage. Not exactly my recommended method for everybody but it is interesting to see all the different ways to invest and how many other options there are. It is fascinating to delve into the world of finance! Listen to the podcast here or it is available via the traditional podcast outlets, ITunes, Overcast, Acast, Stitcher, Google Play. Enjoy!
Podcast # 43 Sponsor
[00:00:20] This episode is sponsored by Bob Bhayani at Doctor Disability Quotes.com . They are a truly independent provider of disability insurance planning solutions to the medical community nationwide. Bob specializes in working with residents and fellows early in their careers to set up sound financial and insurance strategies. Contact Bob today by email at [email protected] or by calling 973-771-9100.
Quote of the Day
[00:01:14] “The true key to material happiness lays in a modest standard of living which could be achieved with little difficulty under almost all economic conditions.” – Benjamin Graham
[00:01:26] This episode has a special guest, Peter Steinberg M.D., a urologist out in Boston, who has a very interesting side hobby involving investing in a very specific type of investments, basically stocks that are merging with other companies. He does this together with his father, a financial adviser and it provides a great hobby for them as well as an interesting opportunity to try to make some outsized returns.
[00:04:34] Dr. Steinberg talks about his asset allocation.
[00:06:59] Dr. Steinberg defines arbitrage, an umbrella term that basically means exploiting a difference in prices. A couple of the specific types he gets involved in are merger arbitrage and stock buybacks or what is called tender offer arbitrage.
[00:08:22] WCI asks how does Dr. Steinberg personally go about participating in this? How much has he done and what kind of success has he seen?
[00:14:16] Dr. Steinberg describes technique used in stock buyback.
[00:23:20] WCI suggests some critics of merger arbitrage have said it has a limited upside and a huge downside. What is Dr. Steinberg's response to that?
[00:23:30] The upside is limited but you know what you can actually get for your shares. And you also know what the time period that the money will be occupied for happens to be. The upside is known although limited.
[00:24:37] The downside. 5% of the deals may fall apart.
[00:26:37] Dr. Steinberg talks about one of those deals that did not go through.
[00:29:58] Discussing the criticism of merger arbitrage, that the transaction costs eat up most of the profits.
[00:32:38] Discussing what else could go wrong with this strategy.
[00:39:42] Question: what is the point? Isn't a boring old index fund portfolio enough for a doctor to meet all of her financial goals? Why bother with all this hedge fund merger arbitrage?
[00:41:25] How much time do you spend doing this?
[00:44:06] If you are interested in learning more check out Warren Buffett's ex daughter in law Mary Buffett's book Warren Buffet and the Art of Stock Arbitrage
[00:45:09] WCI shares his opinion about merger arbitrage. Not exactly recommended for everybody but it is interesting to see all the different ways to invest and how many other options there are.
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Intro: [00:00:00] This is the White Coat Investor podcast where we help those who wear the white coat Get a fair shake on Wall Street. We've been helping doctors and other high income professionals stop doing dumb things with their money since 2011. Here's your host Dr. Jim Dahle.
WCI: [00:00:20] Welcome to podcast number 43, merger arbitrage with Peter Steinberg M.D. This episode is sponsored by Bob Bhayani a doctor disability quotes dot com. They are a truly independent provider of disability insurance planning solutions to the medical community nationwide. Bob specializes in working with residents and fellows early in their careers to set up sound financial and insurance strategies. Contact Bob today by email at info @ Dr. disability quotes dot com or by calling 9 7 3 7 7 1 9 1 0 0.
WCI: [00:00:49] Thank you for what you do. I spent the last week or so learning a new electronic medical record while trying to battle my way through flu season in the emergency department. Sometimes we minimize the stress of what we do on a daily basis because we've gotten used to it but it takes a special person to get into the physician training pipeline, much less get through it and then survive two to four decades of work in the field. I hope this podcast helps you to not only survive but also to thrive in your career.
WCI: [00:01:14] Our quote of the day today comes from Benjamin Graham who said the true key to material happiness lays in a modest standard of living which could be achieved with little difficulty Under almost all economic conditions.
WCI: [00:01:26] Today we have a special guest on the podcast Peter Steinberg M.D. is a urologist out in Boston who has an academic practice but has a very interesting side hobby involving investing in a very specific type of investments, Basically stocks that are merging with other companies.
WCI: [00:01:45] He does this together with his father, a financial adviser and it provides a great hobby for them as well as an interesting opportunity to try to make some outsized returns. So let's get into the interview with him.
WCI: [00:01:57] All right. Well welcome to the podcast Peter we're glad to have you here. Let's start out really at the beginning. Tell us a little bit about your upbringing. Before we get into the subject we're going to cover today.
Dr. Steinberg: [00:02:08] Sure Jim. So I was born in Washington D.C. and moved to Western New York Rochester New York when I was 5. My folks still live there so I grew up grew up there and then basically been in the Northeast ever since I went to college in Vermont. Med school in Philly did Residency in Dartmouth and then a fellowship in New York City. And I've been in practice about seven and a half years now. I started in Portland Maine for my first two years in practice and I've been in Boston for a little bit over five years now in an academic practice.
WCI: [00:02:43] OK. And I understand your your father was in finance is that right?
Dr. Steinberg: [00:02:48] No my father by training was an attorney. And I was born in D.C. because he was working in the Commerce Department. But when we moved to to New York when I was little he started in financial planning and accounting and he has been doing personal financial planning for 30 plus years at this point.
WCI: [00:03:10] But you ended up in medicine. How come you ended up in medicine that a following in the family trade?
Dr. Steinberg: [00:03:14] Well my brother is an attorney also so it is kind of kind of amazing. I have an uncle who is a gastroenterologist and sometime in elementary school I think he started providing a lot of guidance to me indirectly. I think he advised me not to become a physician but I didn't listen to him and I just watch what he was doing and he was he was my motivation for going into medicine.
WCI: [00:03:37] It's funny how everybody almost every doctor I know somebody tried to talk him out of going into medicine they wouldn't listen. Maybe there's some truth to the statement that if you can be talked out of it you should be talked out of it.
Dr. Steinberg: [00:03:48] That's probably true.
WCI: [00:03:50] Not that it's so bad but I think it just requires the sort of commitment that requires you know a willingness to go through just about anything to do it. And without that commitment you just won't make it through the long pipeline.
Dr. Steinberg: [00:04:02] Well exactly. And I think in reality he might have tried to dissuade me. But I think once I was actually training I think he really enjoyed having someone in the family he could talk shop with. Even though I'm a urologist and he does G.I. You know we've always found common ground to talk about interesting things.
WCI: [00:04:19] It's great. Now you are you working full time?
Dr. Steinberg: [00:04:23] Yes. Yeah I work. I work full time and in an academic practice so it's you know the schedule is a little bit different than a private practice. But but I would consider it fulltime.
WCI: [00:04:34] Well let's move a little more into the investing in finance kind of topics. Tell us about your asset allocation what are you what are you invested in? What's kind of the baseline from which we can go through the rest of this discussion?
Dr. Steinberg: [00:04:46] Sure. So I've got about 80 percent of my investable assets are in your typical tax deferred accounts 401k. I had a 457 in my old job. We have a very unique set up in my current job where they actually because we're in a large position group we actually have both a 401k and a 4O3b. I remember when I was interviewing I asked if it was illegal and they said well it is now but we've kept everything in line. And so I actually have most of my money in that. I have a decent chunk of my investable assets My father actually manages for me and he's pretty cheap so I've got him doing some of them and then the part of my investable money about 20 percent I've got in a taxable brokerage account where I do do the arbitrage type deals primarily.
WCI: [00:05:44] And you're investing in what typical stock bond reit index funds or most actively managed funds or what what are you invested in?
Dr. Steinberg: [00:05:53] So in my tax deferred accounts those are just your typical low cost index funds. I've got you know blue chip growth and a couple of things like that but are low cost primarily Fidelity manages our money in my current job and my old job I've still got some money in the 4O3b plan there which is primarily Vanguard and I've got a couple of America's funds in that. My father does a couple of different things he's got a mix of some low cost funds and then a couple of other more actively managed things which are designed to outperform in a bear market. Some of what that's in.
WCI: [00:06:33] Now that's that's fairly typical I think among our listeners but I didn't bring you on the show to talk about index funds today we're talking about something a little more interesting and maybe get out into the weeds a little bit when it comes to investments. I brought you on here to hear about this merger arbitrage that you're doing with a small portion of your investments. Can you describe what that term means for the readers?
Dr. Steinberg: [00:06:59] Sure. So arbitrage is the umbrella term that basically means exploiting a difference in prices. That's all it means and you can you can arbitrage anything. You know you can arbitrage you know Patriots t shirts in Philadelphia and selling them back in Boston r tax rates between states but arbitrage just means exploiting a price differential for something. So one of the classic types of arbitrage involves back in the old days before trading was electronic you could have a stock traded on two different exchanges in for a short period of time you might be able to buy it cheaper say in London and then sell it at a slightly higher price in New York and eventually the price differential will go away. But but arbitrage just refers to exploiting a price differential in a market.
Dr. Steinberg: [00:07:52] A couple of the specific types I get involved in, one type is merger arbitrage and then another type involves stock buybacks or what's called tender offer arbitrage. But merger arbitrage specifically deals with exploiting the price differential that exists when a company is going to merge with another company. The company that's being taken over usually there's a little bit of a difference in price between what they're going to be acquired for and what you can buy the stock for and exploiting that difference is merger arbitrage.
WCI: [00:08:22] This is a technique the hedge fund managers have been doing for a long time and with varying amounts of success. Like with any hedge fund. How do you personally go about doing this? How much of it have you done and what kind of success have you seen?
Dr. Steinberg: [00:08:36] Sure. So I've been doing this for about four years. This is the brainchild of my old man. So this is something that he was reading about and doing a lot of academic investigation for a long time. And as I got a little bit more into practice and had a little bit of extra money on my hands all of a sudden you know we were able to put together his book knowledge with a little bit of the capital that I had to start actually doing this so around 2015 we started doing this in earnest and the way I've gone about it I've done a fair amount of reading both of sort of economic papers and some books on this. But basically what we do is we find deals who are interested in investing in. And the majority of them will do this for mergers as with a Web site called Inside arbitrage dotcom where literally the gentleman running this site has a list of all the publicly announced mergers that exist and what the asking price is the current price of the stock how much you can expect to make FCC filings relate to that and I'll just look at that and figure out what type of annualized returns I'm interested in and then invest some of my taxable brokerage account into those deals. I'll also do like I mentioned some stock buyback deals which I frankly just search Google. I've got an automatic search that will pop up in my e-mail when new deals are announced and I look at them and decide which ones to go into in that same brokerage account.
Dr. Steinberg: [00:10:14] I would say that I was looking back through what I've been doing last couple of years in anticipation of talking to you. I'm doing somewhere between 10 and 20 arbitrage type positions per year. Some years it's been a little more some years it's a little less but somewhere in that range. And my overall track record with this the way you track this is you. You report what's called an annualized gain because that's the only way you can compare it to other investments because by definition these are relatively short time periods usually months where you're holding one of these stocks. So my annualized returns doing this are read around 30 percent since 2015 doing this.
WCI: [00:10:57] Obviously that's a great return I mean when you can make your money grow at 30 percent a year you've become very wealthy very quickly. Now you say you're basically buying the stock you're buying the stock that's being acquired or you're buying the company the stock of the company that's doing the acquiring or what are you buying and and how do you determine that.
Dr. Steinberg: [00:11:20] Sure. So the way we decided to do this and I can't tell you how many hours of father son bonding time has occurred you know talking about talking about this. What we decided to do would be a couple of things. So number one this is only with publicly announced deals where there is a actual intent of the two companies to merge and this is filed with the FCC.
Dr. Steinberg: [00:11:49] This is not you know dealing with rumors or speculate that these are actual deals that are announced. That's one thing. And when we decided to do when two companies merge they can either be acquired for cash stock or a combination and we decide I did that the best in most conservative way to do this is to deal only with the deals where the companies are being acquired for cash. I've done a few where there's a mix of stock or other conditions. But generally speaking we do that because you can just look and see who does the acquiring company have the cash on hand to buy the other company. And generally speaking if a company is going to buy something for cash usually they're positioned to consummate deal is better than some of these other situations. So we look for deals where it's a cash acquisition. I personally don't like to have the money tied up for more than a three months when I do this. My father's got a little more tolerance for stretching it out more like six or 12 months. But I'll look for deals that are closing usually within the quarter or around 90 days or so and I look to try to get an annualized return of at least 10 to 12 percent on the deals I'm going into because otherwise I just don't really find that it's worthwhile to be invested. Other people would take a lower annualized return but that's sort of the benchmark return that I've wanted. And that's what I've decided to go with.
Dr. Steinberg: [00:13:15] And all I do is purchase the company that's being acquired by stock usually watch what the stock is doing and I'll often buy in it a few different points in time. I generally don't commit more than about 5 sometimes 10 percent of my available funds and that account in any one deal so that I don't get too overweighted and I'll just buy the stock of the company that's being acquired. And I often will hold it.
Dr. Steinberg: [00:13:45] I usually don't hold it until the deal is consummated because a lot of times when the deal is about to close you've realized most of the gain that you're going to get. And I'll sell the stock back on the market at that point but sometimes I'll just hold it till deal consummation and that's generally how we do it.
WCI: [00:14:01] So of course those are those are pretty much all short term capital gains so you're fully taxed at your physician income on them. Even so your 30 percent returns that you've seen over the last four years that's a pre-tax return?
Dr. Steinberg: [00:14:15] That's correct.
WCI: [00:14:16] Okay. And tell us about the you mentioned the other techniques were used in the stock buyback technique. Tell us a little bit about your experience with that.
Dr. Steinberg: [00:14:23] Sure. So I personally like doing the stock buybacks more than merger's for a variety of reasons that are related to sort of some of the unique risks that exist. But I also like them because these are by definition a 30 day long period. So a stock buyback a lot of your listeners might have heard this come up recently in talks with the new tax bill one of the big complaints was what companies are going to repatriate money and buy their stock back and when I heard this I got excited. Other people don't really know what it means but stock buybacks are something a company can do with with money that they have literally sitting around. You know they can put it back in the company. They could buy another company or they can purchase their own stock back.
Dr. Steinberg: [00:15:11] There are two ways of doing this. Most commonly this is just done on the open market where a company will say we're going to buyback you know a billion dollars of our stock over the next year or two. But there's something a company can do which is called a tender offer where they will again registered with the FCC and there's specific laws and regulations that apply to this. They will make a public announcement saying we're going to buyback a certain amount of our stock. It's either a fixed dollar amount or a certain number of shares they want to acquire and they either name the price they're going to buy which is what's called a cash tender offer or they have a range of prices they'll bide in which is something a little more complex called the Dutch auction. This is actually how Treasuries are actually sold. It's the opposite of a normal auction, a normal auction the highest price wins in a Dutch auction the lowest price wins. It's a little bit confusing but nonetheless the company will say we're going to buyback a certain number of shares of stock at a certain price for a set period of time.
Dr. Steinberg: [00:16:12] And what I'll do then is acquire the shares and you utilize your broker to actually execute a more complex trade To do that and what will happen is people will put their shares back into this buyback and if the number of shares the company has coming back in is less than the offer all of your shares will be bought back and if it exceeds the number you'll get a prorated number of your shares purchased back. I've personally had better success with this because I think I understand the mechanics of this a little better. I mean I always learn new things each time but I get the mechanics of that a little bit more than the mechanics of mergers which are subject to a lot of different factors. So so I do a fair amount of that there hasn't been as much of that lately. There was a lot of it a couple of years ago when the market was quite high and a lot of companies didn't know what to do with cash.
WCI: [00:17:05] Now I'm still trying to sort out on this stock buyback why there is a difference there why there's money to be made there. It seems a Little odd to me that it's not a little bit more efficient than that that the price they're buying it back is basically the price you bought it out. Why. Why is there a difference there or room there for you to make a profit?
Dr. Steinberg: [00:17:25] Well there isn't always so you know not every buyback that is put out there offers a good arbitrage opportunity. So there are a couple of things that come up. So number one when you're dealing with many of these companies a lot of times you're dealing with fairly small companies as far as their market cap goes. I mean remember the first one of these I did in 2015 was a very small virtual currency company in Seattle whose total market cap was about ten million dollars. And you know that's a company where they've got a small number of shareholders probably a lot of family members and insiders. So you're not dealing with hedge funds and private equity firms competing with that. There have been some other big ones I've done like Wendy's and HR block. But you're dealing with a lot of times relatively small companies with stocks that are not trading a lot of shares each day. And so there's not a huge market for this and you're dealing with a lot of people who are holding their shares and not really parting with them. So a lot of times you'll get an opportunity there because a lot of times it's just how the market will work. Sometimes when you're dealing with a bigger company or a more liquid stock where there's more trading or more institutional involvement where there are more shares being moved around oftentimes the fluctuation of the stock price during that buyback interval will give you an opportunity to have an arbitrage profit there.
Dr. Steinberg: [00:19:02] So the movement of a lot of stock in and out a lot of say big investors selling once this is announced to realize a profit will often give you an opportunity to exploit this.
WCI: [00:19:13] Now like any individual stock investing you know if you're making a profit there somebody who's taken a loss. So you're really competing against the other people that are buying or selling that stock aren't you in these situations?
Dr. Steinberg: [00:19:25] Well it's a little bit different than that because there are a couple of different rules that govern buybacks. So you know number one with some of these companies there are people who want nothing to do with the buyback. These are people who are holding this stock for a long period of time perhaps they're insiders. Maybe it's someone who just has a few shares and the stock doesn't even know this is happening or forgot he owned them. And sometimes you're dealing with institutions that are trying to say acquire some of the shares of stock. So there are a lot of different dynamics that come into play. One of the things that does happen during these and one of the reasons why a lot of companies do this is to flush out a lot of small investors. There are rules that actually prevent you if you have 99 shares of the stock or fewer and you put into the offer from being prorated. So any small investor who puts his shares back into the buyback gets all of them bought back. So there are a couple of different dynamics here at play. The other thing is a lot of times management will do this to just remove shares from circulation. So if you're a company and you're retiring 25 percent of your shares you know the company is getting more control there. And it's a little bit different than the rest of the market where you know everybody wins and loses you know your shares are being retired permanently.
Dr. Steinberg: [00:20:45] So the dynamics are a little bit different than sort of just buying and selling on the market which are also dealing with a fixed price that the company will pay you for your shares within that month which is different than the market the rest of the time they're you're dealing with what people think it's worth you know how things are going to be in the future or what not. Here the company saying look we're going to give you this 30 days from now. Do you want to participate or not? So it is a little bit different than your typical open market trading.
WCI: [00:21:14] I guess I would the I would think about it would be if the company has said we'll pay you 30 dollars a share at some point the next month. I would expect the stock price to just lock in to 30 dollars a share for the next month. Why is it that it fluctuates?
Dr. Steinberg: [00:21:31] So so once these deals are announced and this goes for mergers or buybacks let's say your stock is plunging along at a particular price once the deal is announced the stock prices invariably with rare exception will shoot up and get close to what the deal prices so often with a stock buyback The company's doing it because they think their stock is the market price is undervalued. So let's use your 30 dollar buyback price so let's say the stock is trading for 20 bucks and the company thinks it's worth 30. They'll announce the buyback. The price will shoot up because that's what people will think it will be worth. But then all of a sudden you're going to get a lot of people who are going to say you know what I just made 50 percent of my money. I'm selling my shares. And that will drive the price down. So that's often what will happen is you will get some initial movement. But it just doesn't stay there because you've got some people are selling their shares to realize a gain. And there can be other dynamics going on. Like I said the companies might be trying to get control of shares of stock so insiders might be buying. You might have institutions that hold large positions who are doing things. So there are a lot of different dynamics that will usually give you a little bit of a spread not a big spread but a little bit of a spread. Frankly I just did one of these recently where for some reason the market price was 10 percent below the asking price.
Dr. Steinberg: [00:22:54] I can't explain why that was the case. But it was a great arbitrage opportunity. And as someone who just wants to exploit this for a short period of time I don't really care if the stock is trading for what the company says it's worth I just want that arbitrage spread. So in some deals there isn't much of a spread. You know you really had some deals you can't make a reasonable profit and those are deals you just avoid.
WCI: [00:23:20] Now some critics of merger arbitrage have said it has a limited upside and a huge downside. What's your response to that?
Dr. Steinberg: [00:23:30] Well I think in many ways they're right. But I think there are a couple of caveats. So let's talk about the upside. First the upside is limited. Absolutely. Let's say your company is being bought for ten dollars a share. That's a limit. You know it's not going to be 20 unless the deal gets renegotiated. But you know that someone's going to pay you ten dollars for the stock and you know that that deal is going to close in three months six months whatever with the rest of the market You neither know what it's going to be worth in the future nor do you know what the dollars you've got now are going to be worth. So yes the upside is limited but you actually know what you can actually get for your shares. And you also know what the time period that the money will be occupied for happens to be and is compared to say indexing you know 30 years from now you're going to get 10 percent a year and your S&P index fund but you don't know six months from now what you're going to get. So that is the difference. The upside is known although limited.
Dr. Steinberg: [00:24:37] I would say on the downside. I don't think huge is exactly the way I would would describe it. Sometimes the downside is huge. But the fact of the matter is when you're dealing with mergers I've just ran some numbers for just the last couple of years. You're dealing with in excess of 90 percent of mergers in the last three years closing after their publicly announced in 2017. So last year 95 percent of the publicly announced mergers that existed closed. So you're dealing with 95 percent of the time the deal is going to be consummated in the 5 percent of deals that fall apart. Sometimes they do so spectacularly. But when you're dealing with a deal that doesn't work or with the downside here it doesn't usually mean that the company you bought went to zero or went to bankrupt. Often it just means it went back to what it was trading for before the merger was announced.
Dr. Steinberg: [00:25:31] And another factor the spread between what the market is paying for the stock right now what the market price of the stock in the deal price happens to be the wider that number is the lower the probability of the deal being consummated. So it's not like you're dealing with deals that are likely to close where you're very close in value to what they're going to buy the company for And then those deals fall apart. That's very unusual and usually there's not much money to be made on those deals. The deals where there's a bigger spread there's a lower risk of those coming together. But the stock usually doesn't have as fall as far to fall. If those deals fall apart. So there certainly is a downside but it's not like every single deal is likely to fall apart. So that's really what the advantage is is is compared to the rest of the market. You basically know with high probability what the security is worth. And over what time period as opposed to with the rest of the market in a very long time period you've got a good idea. But in a short time period you don't.
WCI: [00:26:37] Now have you had have you had one of these deals that didn't go through or the merger didn't happen?
Dr. Steinberg: [00:26:42] Oh yeah I had one that was a disaster which was the worst single one I've had was the Rite Aid Walgreens merger which got delayed for an exceedingly long period of time and fell hard. And just before we came on Walgreen's was talking about merging with AmerisourceBergen and I started shaking my head. I was having flashbacks. But that that is one of the deals that I've been in that has that has come apart. That's probably the single worst one that I've been involved in.
WCI: [00:27:14] And what happened to your investment on that one?
Dr. Steinberg: [00:27:17] So what happened there, I held the shares as the stock price kind of, They renegotiated the terms a couple of times and then the deal basically went caput. So I held onto that stock for quite a while waiting to see if someone else would come along and buy them and then ultimately I decided to take the loss on it to do some tax loss harvesting.
WCI: [00:27:40] And do you remember about what your loss was on it?
Dr. Steinberg: [00:27:43] In terms of the dollar value of that?
WCI: [00:27:45] Mostly the percentage.
Dr. Steinberg: [00:27:47] It's hard to to pull it out that way because the tricky thing is is you're sort of recycling money to do this. So I can't tell you my total account last X amount of value of that. But I can tell you it is not my gains down substantially for that year from where they would have been otherwise I would say it probably dropped my annualized gain in that year by 50 percent.
WCI: [00:28:17] And that's with many other deals going on during the year. This one had a large effect on at least that portion of your portfolio you were doing this with.
Dr. Steinberg: [00:28:25] Yes and it was also partially because I put a lot more into that deal than others because I thought this was surely going to close in a whole bunch of other things and so I overweighted that one in the portfolio and that was part of why it did it hurts so much when it fell apart.
WCI: [00:28:40] Now I understand hostile deals have a much higher break rate than the less hostile mergers. do you avoid hostile deals because of that. Why or why not?
Dr. Steinberg: [00:28:50] Yes I entirely avoid any any deals like that. So a hostile takeover. You'll see this in the news periodically and one of the classic guys who does this is Carl Icahn who runs this big investment house. He will basically solicit shares of a particular company that he wants to acquire control of and he'll put a notice out his own tender offer if you will for shares of particular companies and the management of the companies will say you know we suggest you reject this etc. etc. So that's a deal where the parties have not agreed to merge but where someone is trying to take the company over through acquiring that stock. that is very different than where two companies have agreed to merge. The documents are in place. Often the boards of the companies have voted for it are going to vote for the board of directors approves that. So I completely avoid those. The upside is much much higher but the downside is very high there and you just don't have that high probability of those deals coming together so I completely avoid hostile takeovers entirely.
WCI: [00:29:58] Now another criticism of merger arbitrage is that the transaction costs eat up most all the profits. What's your response to that criticism?
Dr. Steinberg: [00:30:07] For me I've got a Merrill Edge account that I do these trades in. And I have no transaction costs for them. I get 100 trades a month because it's affiliated with my Bank of America accounts. So there's no costs. I would say when I do the actual tender offers the actual buybacks those are broker assisted trades. We actually need to call a person with the company I work with Merrill. And you need to give them instructions to go into the offer and that costs 30 dollars. So that's a little bit pricey but you know you factor it into how many shares you want to buy and how you're going to handle them.
Dr. Steinberg: [00:30:48] And you know frankly given how well those types of deals work out I think it's a very reasonable cost especially when you're trapped you know you're trading something where your profits going to be hundreds or maybe even thousands of dollars. Thirty boxes is not a big deal. But for the other transactions I don't have any costs so I don't think that's a that's a problem. And if you have a low cost brokerage you know you're not talking about lots and lots of trades here. You know you're talking about a handful a month. So I think the cost can stay pretty low.
WCI: [00:31:20] Now even even when you're not paying commissions you've at least got to be paying bid ask spreads on some of these you mentioned they weren't very liquid. Do you find those bid ask spreads that add up too much?
Dr. Steinberg: [00:31:31] So that can be a bit of an issue and I had some I mean I could spend an hour telling you about every bad experience I had Doing this with each type of deal that I mean I learn something new every time. But I had a couple of issues early on where I got what's called whipsawed by a relatively illiquid stock. So if you're dealing with a stock it's relatively illiquid and by that I would say if you're dealing with a stock that doesn't trade tens of thousands of shares a day once you're up in the 20 25 50 thousand shares a day range you can generally just sell it at the market price and you're not going to have an issue. But stocks that trade hundreds or thousands of shares a day you've got to be very careful about how you put your orders into your your brokerage software. And if you're doing it yourself you often need to become familiar with something called the limit order where you either want to buy something at a certain price or sell it at a certain price. Otherwise you can get what's known as whipsawed where you know you think you're selling it for four bucks and you sell it for 250 or something so you have to you have to be very careful about that.
WCI: [00:32:38] So what else could go wrong with the strategy?
Dr. Steinberg: [00:32:42] Lots of things. So I think the way I think about what can go wrong I break it into mergers and tender offers because they have unique risks.
Dr. Steinberg: [00:32:53] So when you're talking about mergers one of the most interesting problems that I ran into was what I would call antitrust risk or governmental risk I think is the bigger umbrella. And by that I mean when President Obama was in office the Federal Trade Commission took a in my opinion a somewhat anti merger attitude and the ratio of deals that went through was about the same as we're seeing now. But a lot of deals got extended by the Obama Federal Trade Commission. And when you're looking for annualized returns if you're thinking you're going to be invested for 90 days and it gets stretched out to 180 days your annualized return just drop by half. So that was a big risk that that I became aware of.
Dr. Steinberg: [00:33:43] And now with the Trump administration I think that everyone would agree they've got a little more pro business pro merger deal but that's a very big anti China bias. And there have been some mergers that have fallen apart. A lot of these made the news. One of them was called Lattice Semiconductor where it was a computer chip company that was going to be bought by a Chinese company. They blocked that deal and it fell apart. So there's governmental risk to these deals antitrust risks and other things.
Dr. Steinberg: [00:34:12] One of the other issues you can run into with mergers is just the underlying nature of the health of the company that's being acquired. Earnings can affect this. They can have a bad quarter there can be some other issues other things can come out during the merger period where the probability of the deal coming together goes down.
Dr. Steinberg: [00:34:32] There can be other regulatory issues and regulatory approvals that can impact these. And then one of the other issues that can impact these is the funding of these deals. You know there's always a risk that the company says it's got the money or it's going to take a loan from Deutsche Bank to buy it or whatever and they don't really have the funding. So those are all possible risks with mergers that are that are sort of unique and things you wouldn't think of immediately you know the deal not consummating is one of them but but these other factors really do really do play in and I will say that the the spread between the deal price and what the stock is trading for it does reflect that risk. So if the deal is if the market doesn't think the deal is going to go through that number widens you know the discrepancy between those those gets bigger and your chance for arbitrage profits goes up but the chance of the deal not closing also does as well.
Dr. Steinberg: [00:35:26] With tender offers. It's a little bit of a different risk because the company that's buying back the shares means to tell you and the FCC how they're going to fund the buyback. So they can't really do a switcheroo on you and say we're going to buyback half a billion dollars of stock and then not have the money that's that securities fraud.
Dr. Steinberg: [00:35:48] So the real issues there the the single biggest issue is getting your shares prorated so that means that the deal is oversubscribed let's say the company is going to buy back a million shares of stock and five million shares are offered for buyback and all of a sudden you're holding 80 percent of the shares you bought. So that's a unique risk to that. And one of the best ways to tell if that's likely or not is to look at the volume that the stock is trading. Well the deals announced during that month relative to the number of shares they're buying back when there are institutions involved in this then you're going to trade hundreds of percentages of the deal size. So if the deal sizes a million shares and there's 5 million shares that trade hands in the first week that's got a high risk proration because institutional players are involved if they're buying back a million shares or 100000 shares trade hands in the first week. That's where smaller players are involved in prorations less of a risk.
Dr. Steinberg: [00:36:51] You've also got just general risks of the market collapsing. Well one of these deals is going on although it during any single 30 day period the risk is low but some of these can be called off because of that or other catastrophic events like wars and things of that nature although that's that's just a general risk with everything else. And the only other thing with tender offers that's an issue is when the shares are bought back for this Dutch auction process you need to name a price you're willing to pay for the stock. It's if you put in a bid that's higher than the price they buy the shares back for none of your shares get bought back. So you've got to be strategic about those deals and be very careful about how you deal with those auctions or else none of your shares will get will get bought back.
Dr. Steinberg: [00:37:35] So but really I would boil it down to the merger risk is the deal not closing were being delayed which is probably really a bigger risk frankly and with the tender offers it's being prorated by institutional investors overwhelming the deal.
WCI: [00:37:50] Now it sounds like you and at least together with your father are doing this yourselves now. Why bother doing that instead of hiring a hedge fund manager some sort of professional to be doing this for you.
Dr. Steinberg: [00:38:02] Sure. So there are a couple of things. There are actually merger arbitrage mutual funds that exist. The problem is they can't really be selective about the deals that they go into. You know they're required to invest the money they have so they end up spreading the money around a variety of deals some with low risk of success in some with almost no spread. So the returns you get when you're going into that many deals are not quite the same as when you can be selective.
Dr. Steinberg: [00:38:36] As far as a hedge fund manager goes I mean the reality is I don't know about you but I don't have enough investable assets to go to a hedge fund and say well you know play my money for me. So so that's really the issue there and the other issue is you know when you're dealing with the black box of a hedge fund you don't really know exactly what strategy they're using and are they going to get into, Are they using options and doing all these other crazy things. So that's really why why neither of those things that appeal to us. But the biggest thing being with the mutual funds you know they need to go into so many deals it dilutes the returns frankly just by virtue of the way those are structured so so I think those are the big reasons why I wouldn't do that plus the lack of money to have my money managed by a hedge fund I think is that it's another big reason why why I would avoid that and frankly I mean this stuff sounds complicated.
Dr. Steinberg: [00:39:31] It's actually not that complex when you when you start doing it and read about it a little bit it's really not that complicated. You can make it very complicated but it's really not that complex.
WCI: [00:39:42] All right let's ask some of the tough questions now. First first one what's what's the point? I mean it isn't a boring old index fund portfolio enough for a doctor to meet all of her financial goals? Why bother with all this hedge fund merger arbitrage garbage?
Dr. Steinberg: [00:39:56] But I think if you want to get the market which don't get me wrong I mean as you know and your show is espoused in many fine publications and a lot of brilliant minds on this just say hey you know get a low cost index fund that's great. If you do index fund investing and that's where you're putting your investable assets you will do really really well. But you will get the market return. And I think that as with all investing the goal is to make money. And I'm not saying I'm doing this but doing something like this gives you a chance to get returns in excess of what the market returns. And since the goal of investing activities is to try to make money. I think that's one of the reasons to try to do something like this to try to get better than market returns. And that the real ammo I would say and don't get me wrong I don't think I'm Warren Buffett but Warren Buffett and Charlie Munger have done a time of arbitrage not so much now because they can't because they're so big. But back in the 60s and 70s and in the early days of Berkshire Hathaway they did a lot of this and I figure if that's one of the ways these guys were making money and it's a big chunk of their excess returns it seemed like a strategy was worth trying to trying to learn more about and try to implement.
WCI: [00:41:25] So how much time do you spend doing this?
Dr. Steinberg: [00:41:29] That's a pretty good question. I would say and again you know when you're when you're talking to your father on the phone about the stock market I mean I don't really hate it. That's usually pretty fun if you ask me. But I would say I probably at this point devote a few hours a week to this. I'd say probably spend maybe four hours a week. At this point when I started out it took me a lot longer to analyze deals. Look at the underlying companies figured out was a deal I wanted to do or not figure out how to track my returns. I would say I spent a few hours a week on this.
WCI: [00:42:05] Do you think one you subtract the value of your time I mean your urologist your time's worth a lot once you subtract out the value of your time and once you subtract out the fact that your pain short term capital gains rate on your gains. Do you think this is still worth it or do you think you're doing this just because it's something you really enjoy?
Dr. Steinberg: [00:42:23] I think it's both. I mean I think I think the reality is this is for me this is entertainment and this is you know frankly having a hobby with my father is really what this boils down to. So I think that that's I mean I derive a lot of enjoyment just from seeing what's going on out there talking about different spreads and the risks and just for me that's fun. I think when I compared to when I first started doing this I was spending a sizable amount of time you know reading underlining books and articles about how this is done and trying to back calculate returns and things. I spent a lot of time on this and you know it's easy to say now that maybe that wasn't the best use of my time. But I think it's worthwhile and I think that now you know it's pretty easy for me each time a deal comes along to sort of roll this through and I extrapolate in the future if this is something I'm going to keep doing when I've got more investable assets. I think in a few years you know this this might actually pay off financially in some ways. You know really you know what this amounts to is this is really almost like a cash substitute in your portfolio. You know the idea is you'll get a small return annualized it's a little bit bigger but if interest rates were normal you'd plunk your money into the government bonds or something at 5 percent.
Dr. Steinberg: [00:43:45] But since they're not this is sort of a way to tweak some cash you've got sitting around and get more than nothing on it.
WCI: [00:43:52] OK so Dr. walks up to you in the doctor's lounge maybe not a very financially sophisticated Doc maybe this doc doesn't know the difference when a Roth IRA and a traditional IRA. And he heard you talking about merger arbitrage in the OR. He wants to get into it. What do you tell him?
Dr. Steinberg: [00:44:06] So I would tell him and I've done this for a couple of doctors I work with where I've actually bought them this book Warren Buffett's ex daughter in law Mary Buffett has written a number of books about her former father in law.
Dr. Steinberg: [00:44:18] But there is a great book. It's about 120 pages long. It'll take you literally an hour to read called Warren Buffett and the art of stock arbitrage. The chapters are about four pages long each and the type is big and you can read it and in about an hour I would get that book off of Amazon flip through it see if it's something that interests you and if it does I think you could be off to the races pretty quickly. And if you read it and you think this sounds ridiculous then that's not for you.
WCI: [00:44:49] All right. Well I sure appreciate you coming on the show today and wanted to thank you for that and for enlightening our listeners to a little bit a different way to invest and some of the risks and opportunities available there. I appreciate your time this evening.
Dr. Steinberg: [00:45:03] Absolutely Jim it's been great listening to your show and I wish you nothing but continued success.
WCI: [00:45:07] Thank you very much, Same to you.
WCI: [00:45:09] Well we've got Dr. Steinberg off the phone now although I'm sure you'll listen to this podcast later. That was an interesting dive into one of the ways in which you can do individual stock investing. Long term listeners and readers know I'm not a huge fan of individual stock investing whether you're doing it for merger arbitrage or stock buybacks or whatever your strategy is in picking stocks. The main problem with picking individual stocks is you're running uncompensated risk and perhaps you're really good at it and maybe this is something that you know you really enjoy and you're willing to spend 20 hours a month on. But I think for the typical physician who's just wants to get a fair return on their investments and who's really focused on spending their time on their practice and their family and their hobbies I'm not sure I'd recommend diving into an investing strategy that's going to require you know 15 or 20 hours a month in order to be successful. And even then not know if you're going to be successful. So not exactly my recommended method for everybody but it's interesting to see all the different ways to invest and how many other options there are and just how interesting it can be to delve into the world of finance.
WCI: [00:46:22] This episode was sponsored by Bob Bhayani at doctor disability quotes dotcom an independent provider of own occupation disability insurance for medical professionals. He has leveraged decades worth of relationships with top insurance companies to deliver discounts to all eligible applicants. If you do not yet have disability insurance or just need a review of your existing coverage contact Bob by email at info at Dr. Disability quotes dotcom that's DR disability quotes dot com or by calling 9 7 3 7 7 1 9 1 0 0.
WCI: [00:46:52] Thank you for a leaving a great rating for this podcast. That really does help us get the word out to those who need it most. Head up shoulders back. You've got this will help you but you'll have to do some of the work. Don't worry it's much easier than what you do on a daily basis and you're not going to have to learn how to do merger arbitrage.