Could it be the economy is so bad these shareholders need the cash now!

Or more likely that they need the cash now to invest in more lucrative ventures. Times like these are when fortunes are made. AB stock is a safe bet, but you don’t strike it big on a safe bet.

Risk Evaluation
Let’s say you aren’t among the first in, however. How do you know if it is still a good deal? Well, one way is to use Benjamin Graham’s risk-arbitrage formula to determine optimal risk/reward. His equations state the following:

Annual Return= CG-L(100%-C)/YP

Where:
• C is the expected chance of success (%).
• P is the current price of the security.
• L is the expected loss in the event of a failure (usually original price).
• Y is the expected holding time in years (usually the time until the merger takes place).
• G is the expected gain in the event of a success (usually takeover price).

Granted, this is highly empirical, but it will give you an idea of what to expect before you get into a merger arbitrage situation.

Ok, so let’s look at Graham’s arbitrage formula to calculate the expected annualized return if Anheuser-Busch is bought out by InBev. The numbers I’m using are conservative and I consider them to be pretty accurate.

[GC-L(100-C)] / (YP)

C (Expected chance of success): 95
P (Current price): 65
L (Expected loss in event of failure): 20
Y (Expected holding time in years, time until merger takes place): 0.5
G (Expected gain in event of success): 5

This formula gives us an expected annual return of 11.53%. Nice, eh? Maybe, but not considering the target price is propped up artificially. Understand that the DJIA has dropped 13.5% since merger talks began. 13.5% - 11.5% gives us a 2% loss.

It appears there is little to no more money to be made in BUD arbitrage which is a likely reason for the spread.

Dave–What do you mean the target price is artificially propped up? Cash deals don’t change in price based upon how the Dow changed in the past. That’s an irrelevant comparison.

It’s a fallacious assertion that there is a 2% loss coming.

Either the deal gets done at $70 or it doesn’t get done at all. The price won’t be adjusted based upon a change in a market index.

Paul,

I know the target price of 70 is non-negotiable but what happens after the deal is done? Won’t the stock then be subject to the same market forces that caused DJIA stocks to retreat 15% since May 23rd? (That point in time is where the 2% loss would come to play in my mind — not before.)

In the period since May 23rd:
- BUD has increased 22% (w/ a buyout price fixed at 70)
- DJIA has decreased 16%
- Related companies in the Alcoholic Beverages sector have faired worse than the DJIA (ABV:-32%, TAP:-17.3%, HINKY:-19%)

Don’t forget to figure in the cost of capital, which has increased, to the equation as well.

The receding markets are increasing the perceived risk of financing failure which increases the arbitrage spread. And perhaps investors are thinking about the state of BUD stock directly after the buyout. Just something to think about.

Have a look at a spreadsheet I put together: http://spreadsheets.google.com/ccc?key=p35w8L8jX3KGyVFCi4-cmIQ&hl=en

Dave (innov8ion)

Dave, what is the symbol of the stock that is going to see a 2% drop after the merger?

I was thinking about this some more. Have people lost their noodles? Let me tell you something — BUD stock ain’t worth $70. You may think it is, but it ain’t. In fact, it’s only worth $64.40 at the close on 9/17/2008. (I see it going down further if people begin to realize that stocks don’t exist in Disney Land.)

Rules of Investing
#1: Shares are worthless pieces of paper until you sell them.
#2: Shares are only worth the price at which buyers and sellers agree.
#3: Markets do not exist in vacuums. (Especially the cool Dyson ones)

On July 12th, InBev offered up a deal to pay $52B for x-number of BUD shares @ $70/share. It’s clear they were willing to pay that amount for the right to gain a controlling stake in the company. But just because InBev was willing to pay that price does not mean the residual BUD shares are worth that amount. Remember Rules #1 & 2 - Shares are worthless until you sell them and sale price is only determined by the price at which buyers and sellers agree.

So you think that BUD is worth $70/share? Ok, fine. If this deal was never even thought of, I suggest BUD would be worth approximately $45/share now. That’s a spread of 55%. Are you telling me that InBev can instantly make BUD 55% more valuable just by purchasing it? I don’t think so.

Don’t forget Rule #3: No stock exists in a vacuum. The DJIA has decreased 15% since May 23rd. Companies highly correlated with BUD in the Alcoholic Beverages sector have faired worse than the DJIA (ABV:-32%, TAP:-17.3%, HINKY:-19%.) Is anyone going to tell me that these market forces apply to every stock in the world except BUD? BUD is special, right? I don’t think so.

You are now aware that there is little real correlation with the BUD shares bought by InBev for $70/share and the residual BUD shares. But many investors thought there was! And the more people that thought and acted in that manner, the closer the spread became over time. It’s kind of neat how herd mentality / arbitrage works. If enough people believe in and utilize a given strategy, the market will in fact be influenced by it.

Get this. If a majority of investors develop a strategy that values companies with multi-billion dollar losses, those companies’ share prices will in fact increase! Pretty stupid, eh? Sure, but who ever said the market had to make sense.

Warren Buffett admitted he made a mistake selling 61% of his BUD holdings. I bet you and I would love to make the kinds of mistakes Warren Buffett does. Because you know, making these kinds of mistakes over time has helped Warren get to the point where he is now. Just because he said he made a mistake doesn’t mean he believes it! Hasn’t anyone listened to what he’s been really been saying and doing?

Remember kids, a noodle is a terrible thing to waste!

Dave I think you are smoking some BUD. You are saying some real crazy stuff.

Let me quote you:
“Are you telling me that InBev can instantly make BUD 55% more valuable just by purchasing it? I don’t think so.” “You are now aware that there is little real correlation with the BUD shares bought by InBev for $70/share and the residual BUD shares.”
“It’s kind of neat how herd mentality / arbitrage works.”
” And perhaps investors are thinking about the state of BUD stock directly after the buyout.”

What are your thoughts about the state of BUD stock directly after the buyout? Doesn’t seem like there is much to think about there… kind of like thinking about the state of the current Beatles tour, state of Stag brewing beer in Belleville, or the state of flight plans that Bob Richards will file this month with the FAA.

goneape - thanks for the feedback. i understand that not everyone understands how markets work nor concepts that may seem counterintuitive to them. sometimes not being a lemming can be lonely, but i’m ok with that.

i think if the economy worsens, we’ll see the spread getting bigger and the deal still happening. but the longer it takes for the deal to consummate, the greater risk of the deal falling through. i would ask this critical question: “how exposed are the banks financing this deal to the derivatives markets?” the derivatives markets are highly exposed and there will likely be further carnage.

i think the bud / inbev merger will bring synergy to the new company — just not 55% worth. there was just this fixation with $70, and a lot of people thought it was easy money (even while the dow traced back 15%.) and since they did, and acted on it — it was. but $70 was only real for the people that sold to inbev.

there will be a correction in BUD at some point. things are pretty shaky right now in the macro market. too many people are getting scared. think monetary policy. think stagflation. what will the drop and recovery be like? how sudden? how smooth? just some thoughts. it will be interesting to watch.