Well, I figure it’s time to post a follow up to my previous post. To recap, here is the chart I posted on October 5, 2009. This is a three-year weekly chart which I typically use to determine the intermediate/long term market trend driving the stock.

In this chart, ISIS’ stock has breached its 50-week moving average. Remember that breaching the 50-week moving average necessarily means that the stock has also fallen through its 200-day moving average (not displayed). To me, this means that, on a short term basis, market participants have lost conviction in ISIS’ stock. More worrisome to me than the interim breach of the 50-week moving average was the negative divergence in RSI during the stock’s previous uptrend as well as the lack of any clear areas of support before the $12 range. Coincidentally, the $12 support level defined by several previous lows as well as the prior interim high seen on the far left of the chart also coincides with the $12.12 defined by the 200-week moving average. As such, I made the call that “a retest of the 200-week moving average is not out of the question” and that there was “a potential 15-20% additional value at risk” on October 5, 2009.

Okay, now let’s look at how the stock has traded since my call.

In the month following my call, ISIS hit a daily closing low of $12.31/share, basically right at the 200-week moving average (which averaged upwards slightly since October 5, 2009).

Am I clairvoyant!?
No, of course not. In fact, I don’t even consider myself primarily a technical investor. I merely use it to guide my short term decisions. For those that write off technical analysis, however, I think this is a great example of just how it can be used to improve your investing. I wasn’t analyzing ISIS in hopes of timing my trades. I was merely trying to establish a disciplined stop-loss for a position that I hold. In the end, I did not buy back into ISIS, but instead allocated capital to BX on November 5, 2009. In the interim, I saved myself from holding ISIS and losing an additional 12% on my position.

The key to remember with technical analysis is that it does not stand in place of or in contrast with fundamental analysis. But, absent a market moving press release, it is a method of understanding how “Mr. Market’s” voting machine will vote during a discrete period of time. I know this seems like very carefully chosen wording, but there is no such thing as one strategy which works in all situations in investing. The key is to stick with what you know and have the tools necessary to analyze different opportunities. In the case of determining emotionless stop losses and profit maximizing entry points, I am a believer in technical analysis.

Full disclosure: Author is long shares of BX at the time of writing. No position in any other stock mentioned.

What is arbitrage?
Rigorously speaking, arbitrage is the practice of taking advantage of a price differential between two markets which allows the arbitrageur, or person taking advantage of the arbitrage, to obtain a risk-less profit.

Technically speaking, an arbitrage refers to a situation where the same asset sells for a different price in two markets. For example, a textbook in the UK selling for $20 and a textbook in the USA selling for $100. The arbitrageur would buy the UK textbook and simultaneously sell the USA textbook and pocket the $80 difference. The simultaneous stipulation is sort of a idealized hypothetical case. This act would imply a completely riskless arbitrage since there’s no risk of being able to execute one transaction or another or risk of pricing changing at any instance in time.

Merger Arbitrage
There’s no such thing as a true riskless opportunity in real life is there? In fact, in today’s world of increasing information parity and quickening execution times, can arbitrage opportunities exist? Well, there’s one regular kind of transaction structure which creates potential arbitrage opportunities all the time – merger transactions!

When an acquiring company chooses to purchase a target, the stocks of the two businesses will continue to trade independently for a period of time as the deal works out regulatory and other issues before closing. During this period of time, there remains risk that the transaction will not close or any number of other events could prevent the transaction from closing. Provided the transaction does close, however, the merger transaction establishes an accepted price for the stocks in question and gives an investor the opportunity to extract value from variations to the closing price.

Five Opportunities if you’re interested
Here are five pending merger transactions right now.

The classic merger arbitrage opportunity is the all stock merger. In the above chart, you can see it with Black & Decker and Stanley Works. Here, the proposal is that Black and Decker shareholders will receive 1.27 SWK shares per Black & Decker share. Here, we know that at closing day, there is an established exchange rate for the two stocks. Yet, at closing prices, SWK’s closing price of $50.17, today, the exchange of 1.27 shares would yield an implied value of $63.72/share to Black and Decker shareholders versus Black and Decker’s closing price of $62.27 today. This is the arbitrage opportunity. As time passes, we know that the valuation gap must close since the stocks of each company technically represent the same combined entity (assuming the merger closes). As we don’t know how exactly the gap will shrink, we can buy the BDK at $62.27 and short SWK at $50.17 to lock in the spread that we have identified.

The second kind of merger transaction is the all cash deal. This is simple enough. For example, Oracle offers Sun Microsystems $8.50/share in cash. In this case, there isn’t really an “arbitrage” opportunity as you won’t be buying and selling the shares on each side of the transaction. The $8.50 simply sets the exchange value and purchasing the target’s shares (JAVA in this case) allows you to profit from any spread.

Finally, there’s the Pepsi and PepsiAmericas deal where you see that consideration is given in 50% stock and 50% cash. This is simple enough. Calculate the spread as though the transaction were 100% stock. Then, average that with the value of the cash exchange. And, voila, the implied price!

Full disclosure: No position in the stocks mentioned in this post.

What I mean by technical analysis isn’t meant for predicting is that rigorous technical analysis isn’t a means for front running what you “think” may happen to a stock. It’s a means for gleaning information from an existing chart about an existing trend and helping the practitioner to make investments with underlying market supply and demand behind them.

I came across this post, “Are Sears Holdings shares headed for a correction?,” at wallstnation.com. The thrust of their argument was that SHLD’s shares had traced a head and shoulders pattern and that a significant correction was likely.

Here’s a “text book” head and shoulders pattern:

1. The stock rises to a peak and then declines.
2. The stock rises to a second higher peak and declines, but does not breach support defined by the first decline.
3. The stock rises to another peak but is unable to recapture the second peak.
4. The stock breaches the support level formed by the first decline and confirms a reversal of trend

Wall St. Nation posted this chart of SHLD as of 9/30/09:

Wall St. Nation’s contention is that a head-and-shoulders pattern is defined by the three peaks it labels. Wall St. Nation claims that this formation is “one of the most reliable trend-reversal patterns.” What they miss is the fact that simply the formation of three “head-and-shoulders” style peaks is not the predictor of a trend reversal. The head and shoulders pattern must include a breach at the end of the pattern formation. That is step 4 listed above. The head and shoulders pattern is a trend reversal  not just a “reliable pattern” for predicting a trend reversal.  Once the full pattern is formed, one can typically expect a continuation of the downtrend after initial support is breached. In the case of SHLD, baseline support was never breached. In Wall St. Nation’s own example, lows never breached the initial low in the formation and in fact have maintained an upward bias that they themselves identify in the chart.

In fact, in the chart they show, it is just as likely that a long term uptrend remains well intact and that the chart is merely in-between a series two “higher highs.’ Well, a month later, what has happened?

Well, the stock ripped off an upward run and made a high beyond the “right shoulder” of the supposed head-and-shoulders pattern. At this point, it’s hard to identify any near term trend at all. Generally speaking, it seems the 50-day moving average has provided rough support, MACD shows a bullish bias, and a lower low has not been seen all year.

In the case of the 3-year, weekly price chart, SHLD has just this year managed to return above its 50-week moving average which I believe signals a potential long term trend reversal. For more on that, check out my post on long term technical analysis and trend reversals.

Full disclosure: Author has no position in the stocks mentioned in this post.

For this case study, it will help to know how to calculate various working capital turnover metrics – Receivable Days, Inventory Days, and Payable Days. You can find that in my Fundamental Analysis Series. But, I’ll review it quickly as we go.

Here, we have two businesses. Jimmy’s Computer Builders is a computer business for which customers order a computer, pay money immediately, and then Jimmy builds the computers and sends them to the customer ten days later. Joey’s No-Money Down Computers is trying to win over customers by offering to allow customers to pay for their computers 60 days after they order them. Otherwise, Joey operates exactly the same as Jimmy’s by building computers within ten days. Both companies use the same suppliers and have received 30-day terms. That is, their suppliers expect to be paid within 30 days of delivering parts to the businesses.

Despite operating basically the same business, Jimmy has negative net working capital of $3,288 where as Joey has positive net working capital of $4,932. What does this mean? It means that Jimmy’s business “creates” $3,288 of cash simply by operating. He collects money up front, buys parts, builds the computers, sends them to the customer and then leisurely pays back his suppliers. Joey’s business, on the other hand, requires $4,932 to operate. He needs to find a way to get cash, buy parts, build the computers, then pay his suppliers all before getting any money from his customers.

What we’ve just described is each business’ cash conversion cycle (CCC). The CCC determines how much financing a Company needs to operate and grow or how well a Company may be able to finance its own growth and operations. Let’s look at these two businesses one at a time.

Jimmy’s Computer Builders (Upfront Payments)
In the case of Jimmy’s business, as the Company receives more and more customers, each customer pays up front and allows Jimmy to use their money to finance his business’ growth as he can take their payments and invest in new inventory to build and sell. Jimmy has a negative working capital business. For Jimmy, however, if business tapers off or he’s forced to liquidate, he will lose the benefit of new cash but still have suppliers to pay. As such, in a downturn, Jimmy cannot be complacent with his cash management. In a larger sense, he can’t be taking all his extra cash and dividending to his shareholders or investing in new projects unless his business is stable or consistently growing.

Joey’s No-Money Down Computers (Delayed Payments)
Joey, on the other hand, requires financing to get his business started. He needs to find money (probably through issued debt) in order to get inventories and pay suppliers while he waits for his customers to pay 60 days later. Joey has a positive working capital (think: he requires capital to do work) business. As Joey’s business grows, he will need more and more outside financing to invest to service his increasing customers. This could be difficult and limiting. On the other hand, if Joey’s business cycles down, he should theoretically be able to collect his receivables and pay his suppliers as well as the debt he incurred to run the business. There is however, more payment risk as some customers may just not pay and Joey will be left holding the bag for having spent time and money building a computer.

Cash Conversion Cycle Days
Just how much of his business can Jimmy self finance? Or, how much cash does Joey need to finance his business? This is calculated by a simple equation:

Cash Conversion Days = Inventory Days + Receivable Days – Payable Days

Basically, the time it takes to turn your inventory into sales plus the amount of time it takes to receive cash from each sale minus the days you have to pay your suppliers shows how many days worth of cash you business either makes available or consumes. Inventory days is calculated by dividing average annual inventory by cost of goods sold (inventory turns) and multiplying by 365. Receivable days is calcuated by dividing average annual receivables by sales (receivable turns) and multiplying by 365. And, finally, payable days is calculated by dividing average annual payables by cost of goods sold (payable turns) and multiplying by 365.

As to be expected by the negative working capital, Jimmy’s Computer Builders creates 20 days worth of cash. This implies that Jimmy has 20 days to freely use a customer’s payments before either getting more cash from other customers (if the business is growing) or using this cash to pay off his current liabilities (in our example his suppliers). On the other hand, as implied by Joey’s positive working capital, Joey ‘s business has a 10 day CCC which implies that he needs outside financing of 10 days worth of operating cash in order to keep his business operating smoothly.

These companies are known as Business Development Companies (BDC) and, when publicly listed, are roughly akin to closed end funds. Ares and Apollo represent the most typical style of BDC – those which provide financing through debt and equity instruments to middle-market companies. Typically speaking, the deals that these types of BDCs invest in are leveraged buyout transactions sponsored by a whos who of middle market private equity firms – GTCR, Audax, Apax, etc.

In order to classify as a BDC, the companies must follow two very particular guidelines. First, they must maintain leverage no greater than 200% their net assets. Second, they must distribute 90% of their income. This generally means that BDCs are slow moving, high yielding stocks and well suited for income-oriented investors.

Over the past year, BDCs have fallen out of favor and their stocks have nose-dived. Declining investor appetite towards debt investments as well as forced sales in debt and equity securities have taken a toll on the market value of BDC investmnts. Two of the most well known BDCs – American Capital Strategies (ACAS) and Allied Investments (ALD) – have fallen on hard times and are in the process of deleveraging through forced sales on their portfolio. In the case of BDCs, the 200% of net assets rule can turn into shackles despite the company’s modest leverage (versus other financial institutions).

BDC stocks, however, have fallen at an even greater rate than their net asset value.  Before the “Great Recession of 2008-2009,” BDCs, much like closed-end funds, almost always traded near or above net asset value. Today, very few trade at even 90% of NAV.  Instead, analysts believe that the funds are now priced on dividend yield with investors demanding significantly higher returns for the perceived risk. Could the recent success of capital raising activities by Apollo and Ares be a sign that investor appetite for private equity originated securities be returning? If so, BDC shares could benefit both by a rebound in portfolio market prices as well as a return to “closed end fund-like” valuations.

Interested in potentially investing in this space? A “related companies” search on Google Finance pulls up nearly every participant of note. A word of caution, while these businesses provide access to investments in private equity companies, it is often difficult to get much information outside of the names and market values of each portfolio company through public filings. Furthermore, since very few are trading at market caps representative of the book value of their investments, it is advisable to spend time reading each Company’s 10Q before taking a dive into this space.  I would suggest looking for BDCs with time left on debt commitments, net asset value to debt <1.9x and as much liquidity as possible.

Full Disclosure: Author does not have a position in any of the stocks listed in this article.