In one sentence: Danielle's first holding, Whole Foods, is bought by Amazon at $42 a share, so Phil and Danielle work out her return (basis, dividends, ex-dividend dates), explain why the stock traded above the deal price, and use merger arbitrage and Long-Term Capital as examples of speculation.
Key ideas
- Return depends on basis. Danielle's rough numbers: bought near $29, about $1 of dividends, sold near $42. Phil nets the dividends off the cost to get roughly a $28 basis and about a 50% gain in about a year. Her own recollection was 42%, and Phil notes these are round numbers. [01:00–03:00, 28:00–29:00]
- Check the dividend history, don't rely on memory. Danielle forgot she'd been paid dividends. Phil looks up the payments (about 13.5¢, 14¢ and 18¢ a quarter) on a public dividend page. [03:00–08:00]
- Ex-dividend date. If you buy on or after that date you don't get the next dividend. It falls a few days to weeks before the payment date so the company can sort out who owns the shares. Selling early also gives up the dividends still to come, about 36¢ here. [05:00–08:30]
- Why would the price go above the deal price? Speculators bet that a rival (Phil's example: Costco at $50) would top Amazon's $42. As that fantasy faded, the price fell back to almost exactly $42. Phil's point is that markets aren't fully rational when much is unknown. [09:00–14:00]
- Merger arbitrage. If the stock trades below the deal price, you can buy and collect the gap, weighing the chance the deal closes against the loss if it breaks (the pre-deal price, here about $32). Phil's example: win $2 for a possible $8 loss at a 99% chance of closing is probably a good bet. He says Buffett did a lot of this in the 1960s and 70s and that it has since become crowded. [15:00–19:00]
- Arbitrage is speculation, not Rule #1 investing. Phil calls it "speculation with a brain": gambling with an edge. [19:00–20:00]
- Ed Thorp and absolute return. Phil's example of an edge: Thorp counted cards and then ran a hedge fund with, as Phil tells it, no losing months. He explains absolute return (a gain in any period) against relative return (beat the index, even in a loss). Treat the detailed numbers (about 28% a year, no down months) as Phil's recollection. [20:00–23:00]
- Long-Term Capital Management. Phil tells it as a cautionary tale of Nobel-winning theorists who believed in efficient markets, levered up and put everything into the fund until it failed in 1998 and the Fed organised a rescue. He mentions a Buffett video on it and says he hasn't watched it yet. [23:00–27:00]
- Selling a company you love. Bezos' offer is set at $42, Phil told her to sell, and Danielle sat so long over the sell button that her session timed out. Phil compares it to his own sale of Burlington Northern after Buffett's $100 offer (about an 80% gain). [28:00–31:00]
- Rule of thumb check. Phil says the $42 deal price roughly confirms the rule: a Whole Foods margin-of-safety price of about $22–23 is about half the deal price. [27:00–29:00]
How it maps to RuleOne
- /holdings/ is where basis lives. The lesson is to compute return on cost net of dividends received, not from memory.
- The screen's event watch would have shown 8-K news on the Amazon deal. Deal-spread situations are not what RuleOne screens for.
- A takeover is one way a Rule #1 holding ends. There is no screen field for it, so decide ahead of time what you'll do.
Buffett, Munger and Graham links
- Buffett's arbitrage work in the Buffett Partnership years is described in his partnership letters of the 1960s (the "workouts" category) and in Roger Lowenstein's Buffett: The Making of an American Capitalist.
- Berkshire's Burlington Northern deal (2009–2010) is the example Phil gives of a holding bought out above his cost.
- Long-Term Capital Management is told in Roger Lowenstein's When Genius Failed. Phil says Fischer Black took a Nobel for the option formula and then ran the fund. The Nobel went to Myron Scholes and Robert Merton (Black had died in 1995), and both worked at LTCM. Phil's description of the Buffett video is from memory, so check it yourself.
- Graham's investment-versus-speculation definition (The Intelligent Investor, chapter 1) is the frame Phil is using.
Words to know
- Basis: what you paid for a holding, adjusted for payments received.
- Ex-dividend date: the first day a buyer no longer gets the declared dividend.
- Merger arbitrage: buying a stock that is being acquired, at a price below the offer, to collect the spread.
- Absolute return: a positive return judged against zero rather than an index.
Try this
Open /holdings/ and pick one position. Look up the dividends you received since you bought it, subtract them from your cost, and recompute your return. Then check the last ex-dividend date and say whether you would have been paid.
Check yourself
- Why can a stock trade above a cash buyout price?
Answer
Speculators bet that another bidder will offer more or that the deal will be improved. If that hope fades the price falls back to about the deal price. - When does merger arbitrage pay?
Answer
When the chance of closing times the small gain beats the chance of breaking times the large loss back to the pre-deal price. - What is the difference between absolute and relative return?
Answer
Absolute return asks whether you made money at all. Relative return only asks whether you beat an index, which can be a loss in a falling market.
Short quotes
"It is speculation with a brain." (Phil, ~19:30, auto-transcribed)