In this Newsletter
- Thank You
- The End of an Era?
- Portfolio Performance
- Portfolio Readjustment
- Merger Arbitrage
- Printer Friendly Version
SINLetter – March 2009
Welcome to edition 43 of Suria Investment Newsletter (SINLetter), a free monthly investment newsletter. The objective of this newsletter is to provide you with unbiased initial research and basic facts about individual stocks and other financial instruments so that you can research them further before deciding to add them to your portfolio or not. If you are reading this and are not a subscriber, you can subscribe by going to http://www.sinletter.com/?page_id=3 and you will start receiving this newsletter from next month. I have provided relevant links throughout this newsletter, but if you have any questions or comments, feel free to write to me.
I picked one of the worst months in the history of the Dow Jones Industrial Average to launch a new subscription service in the form of SINLetter Special Reports and the response from subscribers thus far has more than exceeded my expectations. I want to thank you for showing your support in such a difficult period, where with the exception of gold and cash, there are few places to hide. The Special Reports Portfolio has gotten off to a good start and I hope that the merger arbitrage opportunity discussed below will be a good addition to the special reports portfolio until the next report is published. The 50% introductory discount for special reports is set to expire on March 10, 2009. If you would like to subscribe, you can do so by clicking on this subscribe link.
The End of an Era?
In his annual letter to shareholders, Warren Buffett’s recently stated,
“During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt. I will tell you more about these later. Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.”
With the February declines in the Dow and the S&P 500, we are now looking in the face of a secular bear that started in early 2000 and is yet to find a bottom. After hibernating through the nearly 20 year secular bull market that started in 1982 and culminated in the 2000 dot com crash, the bear has come back with a vengeance and has caused many veterans of the previous bull market like Bill Miller, Warren Buffett and even Ken Fisher to stumble. How long this bear market is going to last is anyone’s guess. It took 2 years and 10 months after the crash of 1929 for the Dow Jones Industrial Average to find a bottom. In contrast after nearly 19 years following the peak of the Japanese Nikkei 225 index on December 29, 1989, the Nikkei is still in a secular bear market.
In this period of uncertainty it is hard to make a case for buying stocks but it is even harder for me to short stocks, especially after a 50% plus decline. In this environment it is worth repeating that during the great depression, the market bottomed in 1932, a full 7 years before the end of the depression.
It is also important to remember the impact of dividends and deflation on investment returns. If you invested at the peak of the market in 1929, it took more than 25 years for the Dow to reach the high it established in 1929 and for you to break even. However during the great depression dividend yields almost reached double digits and the Consumer Price Index declined 27% from 1929 to 1933 as discussed in this article by Mark Hulbert of Marketwatch.com. Taking dividends into account, “the inflation-adjusted total return index of the U.S. stock market was higher by 1936 or 1937 than its pre-crash peak in 1929″.
Given the current market environment, a market neutral strategy like merger arbitrage as discussed below, can make a lot of sense.
If experiencing a month in which the Dow posted the worst January ever in its 113-year history was not punishment enough for most investors, the Dow followed it with the worst February since 1933, delivering a loss of 11.72% for the month and a year-to-date loss of 19.52%. The SINLetter model portfolio turned in a loss of 8.21% in February and a year-to-date loss of 7.69% thanks to a small gain in January. With the exception of Activision Blizzard (ATVI) and Teva Pharmaceutical (TEVA), pretty much every other stock in the portfolio declined in February.
|Performance Metric||Dow||S&P 500||Nasdaq||SINLetter|
|Since Inception (Aug 2005)||-33.51%||-40.5%||-37.24%||22.81%|
Israeli drug manufacturer Teva Pharmaceutical (TEVA) actually managed to post a gain in February in the face of a declining market after reporting better than expected fourth quarter results and receiving an outperform rating by Credit Suisse. Excluding one-time items, the company reported a quarterly profit of $634 million or 76 cents per share, 3 cents better than analyst expectations. It was interesting to note that by the end of 2009, Teva expects the leverage of its balance sheet to fall to levels before its $7.46 billion acquisition of Barr Laboratories. Excluding special items, the company expects to earn between $3.20 and $3.40 per share in 2009 giving it a forward P/E of 13.51.
We have held Teva in the SINLetter model portfolio since September 2006 and while I do not get a chance to post an update about Teva often, I have been happy with the performance of the stock and the company. For a company that expects earnings to grow 30 to 35% in 2010, it is very attractively valued right now and I concur with S&P’s strong buy rating for the stock.
Standard & Poor’s announced in February that Diamond Offshore Drilling (DO) will be added to the S&P 500 index at a yet to be determined date. Although the stock did not appreciate much after the announcement, it held up well and also benefited from a rise in oil prices towards the end of February. When compared to its peer Transocean (RIG), Diamond Offshore has a much stronger balance sheet and better operating margins, providing an interesting way to get exposure to oil without investing in the actual commodity.
Lionsgate Films reported disappointing results for the fiscal third quarter of 2009 with a $93.4 million loss or 81 cents/share after stumbling with movies like Transporter 3 (as much as I like Jason Statham, he needs to break out of the genre), unusually high DVD returns from retailers and missing the boat on a slew of independent movies like multi-Oscar winner Slumdog Millionaire even after original distributor Warner Independent Pictures dropped it in 2007. Lionsgate posted the loss despite an 8% increase in quarterly revenue to $324 million from $299 million last year. The company does expect to post “significant” positive EBITDA (earnings before interest, taxes, depreciation and amortization) next fiscal year, which begins in April 2009. Activist investor Carl Icahn has continued to increase his stake in Lionsgate as discussed in this BusinessWeek article titled How Icahn Would Attack Lionsgate. While I do not plan to add to my Lionsgate position, it will be good to see some pressure on management to return to the basic formula that has worked so well for them in the past and move away from acquisitions such as the recent $255 million acquisition of the TV Guide Network.
Gold increased for a fourth month in a row with a gain of $12.5 or 1.35% to close the month of February at $939.60 per troy ounce.
Merger Arbitrage and the Pfizer – Wyeth Deal (WYE) $40.82
If you are familiar with merger arbitrage, please feel free to skip straight down to the deal metrics section below. Merger arbitrage is a process akin to picking up a few pennies and nickels along the way while panning the river for the big prize, gold. You are basically trying to pick up a few short-term and hopefully low risk dollars in your journey to your long-term investment goals. To explain merger arbitrage, I am going to borrow from a blog entry I wrote on January 11, 2007 titled A Merger Arbitrage Opportunity, where I wrote,
2006 proved to be a banner year for global mergers & acquisitions with $3.79 trillion worth of deals, which even surpassed the deals made during the height of the dot com boom in 2000. As you may have noticed, when a merger or acquisition is announced, the stock of the company getting acquired usually jumps up and closes the day at a price very close to the acquisition price but often a little lower. For example when private equity firm Genstar Capital announced the acquisition of International Aluminum Corp yesterday, the stock jumped up more than 4% to close the day at $52.08. This is almost a dollar less than the acquisition price of $53 per share in cash that Genstar is offering. Here are a few reasons why this occurs.
- Unless there is a possibility of a rival bid, the stock of the company getting acquired will stay stagnant and tie up capital until the acquisition is completed.
- The acquisition may not go through due to antitrust issues or breach of conditions mentioned in the deal.
- The deal may be an all stock or stock plus cash deal and there is a risk that the stock of the acquisitor may drop in value before the acquisition is complete.
- If it is a very large deal, there is a risk that the acquisitor may not be able to raise the required capital to complete the deal.
Investors can profit from mergers and acquisition in a variety of ways. One of these methods is called merger arbitrage where investors purchase the stock of the company getting acquired while simultaneously shorting the stock of the acquisitor (I like this word and have already used it thrice since it saves me from typing “the company making the acquisition” or something to that effect). This is best done as soon as the news of the merger or acquisition is released but is often the hardest to achieve in this era of universal and instant access to news. Another method to benefit from mergers is called risk arbitrage and is described in detail in this excellent FocusInvestor.com article called Introduction To Risk Arbitrage: Rainy Day Returns? (PDF).
In case you are wondering, risk arbitrage is not just for hedge fund managers and as mentioned in the article above, has been used by both Warren Buffett of Berkshire Hathaway (BRK-A) and his guru Benjamin Graham.
On Monday January 26, 2009, Pfizer (PFE) made a definitive announcement to acquire Wyeth (WYE) in a deal estimated at nearly $68 billion or $50.19/share at the time of announcement. Since Dow Jones had already reported on the deal the previous Friday, the stock appreciated from Thursday’s close of $38.83 to $43.74 on Friday, January 23, 2009. Hence I am going to use $38.83 as a pre-deal price.
Pfizer is offering $33 in cash plus 0.985 of a Pfizer share in exchange for each share of Wyeth. With the 0.985 share of Pfizer working out to $17.19 at the time of announcement, the cash component of the deal worked out to $44.7 billion. Pfizer ended 2008 with nearly $24 billion in cash and short-term investments on its balance sheet and has decided to raise $22.5 billion in debt for the deal from a consortium of banks. Since this is a friendly acquisition, the key risk appears to be Pfizer’s ability to raise this debt. The deal is expected to close by the end of the third quarter of 2009 or in the fourth quarter.
Based on the Feb 27, 2009 close of $12.31 for Pfizer, the 0.985 share component works out to $12.12. Combining that with $33 in cash, the deal is worth $45.12 to Wyeth shareholders right now. Wyeth shares closed at $40.82 last Friday, representing a discount of $4.30 or 9.5% to the value of the deal.
Some of the analysis I have come across for this deal, tends to ignore the impact of Wyeth’s dividend on the overall return. Wyeth pays a $0.30 dividend per share each quarter. The first quarter dividend will be paid on March 2nd for shareholders on record Feb 13, 2009 and hence I have not included it while computing the total payment in the table below. The table below looks at actual returns and annualized returns for the arbitrage opportunity for two scenarios. The first scenario assumes the acquisition will close by the end of the third quarter, translating into a 7-month holding period (0.58 years). The second scenario assumes an end of fourth quarter close or a 10-month holding period.
|Acquisition Timeline||Total Payment||Actual Return||Annualized Return|
|Closes End of Q3||$45.72||12%||20.58%|
|Closes End of Q4||$46.02||12.74%||15.29%|
|Total Payment = $33 cash + 0.985 of a Pfizer share ($12.12) + Wyeth dividends|
In an environment where cash is yielding just 2 to 3%, a 12% actual return appears to be an attractive bet. Please keep in mind that the above returns are not taking into account the probability of success or failure of the deal. If you want to arrive at the estimated annualized returns based on the probability of success or failure of this deal, you can use the formula discussed in the Introduction To Risk Arbitrage article mentioned above,
Expected return = (GC – L(100%-C))/YP
G: Expected gain in dollars in the event of success
L: Expected loss in dollars in the event of failure
C: Expected probability of success in percentage
Y: Holding period in years
P: Price of stock at the time of purchase
Assuming the first scenario where the deal closes by the end of Q3, a 70% chance of success that the deal will go through and Wyeth falling $2 to return to the pre-deal announcement price if the deal does not succeed, the expected return works out to,
Expected return = (($4.9 * 0.70) – ($2 * 0.30))/(0.58*$40.82) = 11.95%
Pfizer generated $18.24 in operating cash flow in 2008 and paid out $8.5 billion in dividends. Starting in the second quarter of 2009, Pfizer plans to cut its 32 cent quarterly dividend in half, potentially conserving as much as $3 billion in cash for the company pre-dilution. With Wyeth generating $5.27 billion in operating cash flow in 2008 and the credit markets thawing, I believe the probability of Pfizer raising the capital required to complete this deal is quite high. Even with a 70% probability of success, the expected annualized return of 11.95% is decent given current market conditions.
Please note that I am only going to start a long position in Wyeth and am not taking a corresponding short position in Pfizer. Pfizer has dropped precipitously over the last few months, first on worries related to patent expirations on some of its blockbuster drugs, then on account of dilution from this deal and finally because of the new administrations proposed health care reforms. Shorting Pfizer does not seem to make much sense from a risk/reward trade-off at this point.
I plan on starting a position in Wyeth for my personal portfolio after this newsletter is sent out to subscribers. Since this is a high conviction idea and the SINLetter model portfolio is fully invested at this time, I plan on adding Wyeth to the Special Reports Portfolio.
Deal Website: For additional details including the original press release or subsequent developments, check out the deal website at www.premierbiopharma.com.
|Stock||Symbol||Number of Shares*||Cost||Current Value||Diff ($)||Diff (%)||Date Added|
|Companhia Siderurgica Nacional||SIDfirstname.lastname@example.org/share||$8,630||$2,642||-$5,988||-69.39%||4/30/2008|
|Powershares Water Resources||PHOemail@example.com/share||$8,840||$4,496||$-4,344||-49.14%||10/31/2007|
|Diamond Offshore Drilling||DOfirstname.lastname@example.org/share||$6,132||$5,011||$-1,121||-18.28%||1/3/2007|
|Procter & Gamble||PGemail@example.com/share||$10,008||$8,671||$-1,337||-13.36%||6/30/2006|
Voluntary Disclosure: From the stocks that are currently in the model portfolio, I own shares of PICO Holdings (PICO), Sterlite Industries (SLT), Intel (INTC), Activision Blizzard (ATVI), Towerstream (TWER), Lionsgate Entertainment (LGF), Tata Motors (TTM), PowerShares Water Resources (PHO), Barclays (BCS), Suntech Power (STP), Teva (TEVA), Alvarion (ALVR), WisdomTree (WSDT.PK), Unilever (UL), and BlockBuster (BBI).
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