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.

* To be completely fair, significant value in property can often be unlocked to stave off bankruptcies or generate tremendous shareholder return through sale-leasebacks which generate plenty of cash or potentially attracting buy out firms interested in getting a piece of the real estate. 

Warren Buffett’s consumer products and retail business picks are typically mature businesses with a proven cash flow. But, a look at the top ten returning stocks over the ten years leading up to the peak of the markets in 2007 finds that 30% would have been significant retail or consumer facing businesses – Chico’s (CHS), Apple (AAPL), American Eagle (AEO). Arguably 40% with Dish Networks (DISH). The only other industry or sector with similar representation in this list was oil and energy stocks and this was due to the commodity price bubble more than any thing else. Admittedly, retail stocks take a beating in recessions, but CNN Money’s recent article highlighting stocks which have bucked the trend in the decade ending in 2009, is similarly heavy on retailers Apple, Autozone (AZN), and Carters (CRI). 

The appeal of retailers is that they are simple, easy to understand businesses. Investing in such businesses, however, requires more nuance than just solid financial analysis. Value for these businesses can be transient ebbinging and flowing with consumer tastes and management execution which ultimately drives demand. This also means that, in many cases, investing in these kinds of businesses is never just a buy and hold proposition. Yes, some companies like Coca-Cola have significant moats around their businesses and the type of brand value that its hard to imagine any situation that could affect its ability to sell product and throw off cash. But, most of the time, a long term investment in a retailer or other consumer products business is really a form of “educated speculation.” As such, here’s my framework for how best to “speculate” in these businesses.

1. Know your target
I use a simple four question framework when first approaching a retail or consumer product business known as VRIO. 

1. Value – What is the firm’s value proposition to its consumers? Is this compelling? 
2. Rarity –  Is the firm uniquely able to provide value to its consumers? What competition is the firm up against?
3. Imatibility - Is the firm’s ability to deliver on its value proposition easily imitated? What barriers to entry are there?
4. Organization - Does the firm have the core competencies to continue to execute its value proposition? Is it organized, ready, and able to do so? 

Businesses which provide a unique and high value product to its consumers, have limited competition, and significant barriers to entry with the in-house talent to continue to adjust and execute will always be able to defend their earnings power, an important factor in protecting the value of your investment. In addition, firms with these qualities are usually in the best position to act as market leaders, growing and scaling their businesses faster than other market participants.

2. Determine relative value 
As I’ve re-iterated, my belief is that assigning an exact value to these types of stocks. As such, I spend time researching comparable businesses and their valuations. Businesses with strong VRIO characteristics are potential market leaders and investors typically reward them with better than average valuation premiums. As a result, your best bets will be to find strong VRIO characteristics in businesses that have not yet been bid past their peers on a valuation basis.

Metrics of particular interest to me are P/E and PEG (see article: PEG Analysis). Also, because many of these businesses use significant amounts of debt to finance growth, some attention must be paid to EV to EBITDA as well as Debt-to-equity ratios in order to ascertain whether or not the business can continue to support capital expenditures and other investments necessary to execute their business models.  

3. Let the trend be your friend
Just as consumer interests ebb and flow, so will interest in your favorite retailers and consumer products. And, so will investor interest in their corresponding stocks. The positive benefit here is that positive headlines and other seemingly innocuous events can prove to be strong catalysts for your target investments. The negative is that the bottom can just as easily fall out of these stocks as investors lose interest for seemingly unexplained reasons. 

As such, while I am not typically a market timer, I don’t make a habit of trying to average down into these types of businesses. Instead, I’d prefer to give up some early return for the security of being able to identify clear support (for me, stop loss) points and with the benefit of a long term trend. For those interested in how I do this, check out my articles on How to Draw Trendlines  and Technical Analysis for Fundamental Investors. 

Full Disclosure: Author is long shares of AAPL at the time of writing. No positions in any other stocks mentioned. 

There are, however, a few situations (events) where an investor using fundamental knowledge can extract quick profits. Fundamental trading is probably more accurately described as event driven or “special situations” trading. 

Earnings Releases
As we saw with Apple’s recent earnings release, some  bloggers like Andy Zaky performed intense analysis of Apple’s performance last quarter and determined that Wall Street expectations were much too low. As earnings announcements are highly publicized and catch the eye of many investors, you can expect large scale movements in a stock as material information comes public. Here, a trader with fundamental knowledge can have a leg up on the broader market. This often works best with growth companies where mainstream projections are rarely in consensus. About a year ago, I documented a potential fundamental strategy for targeting potential earnings beats in high growth stocks.

Analyst Upgrades and Downgrades
It isn’t just earnings expectations which are highly driven by analyst recommendations. A stock’s short term direction can often be affected by unanticipated analyst upgrades or downgrades. With the rise in the popularity of main stream stock prognosticators, we’ve even seen this phenomena extend beyond analysts to the “Cramer effect” or “Barrons pop” after a positive or negative affirmation from our beloved media prognosticators. Linn Energy (LINE) just happened to be the recipient of both a Cramer rally and a Barrons pop over the last quarter months. The reaction to these upgrades and downgrades is easy to anticipate and for trader with a quick trigger finger, possible to take advantage of. Even after a quick rally, these reports often attract irrational over buying or over selling and a trader with a fundamental knowledge of the business in question can continue to take advantage of any retracement. 

Stock Splits
Some believe that stock splits create short term buying pressure because a split typically lowers the price per share thus allowing a broader swath of retail investors to invest when they otherwise couldn’t have. For example, if Google were to split it’s stock from $300 to $150, it may look more attractive for retail investors to pick up a few shares of the stock even if it doesn’t ultimately change the fundamentals of the Company.

Spinoffs
Another situation some people have found profitable is the spinoff of an operating business. The basic premise of a spinoff is to allow investors to better understand a business which management might believe is being masked by being part of a larger corporation.  There’s a whole host of other reasons why spinoffs typically create valuation mismatches and they’re best described by Joel Greenblatt in his book, You can be a Stock Market Genius (Read my review).

Mergers and Acquisitions
Merger arbitrage is likely the single most popular form of true fundamental trading. When M&A activity was plentiful, this strategy became so popular that even retail funds (The Arb Fund) popped up to allow at-home investors an opportunity to take advantage. Whenever a Company attempts to buy out another company (i.e. Pfizer and Wyeth), the shares of the target will usually move dramatically towards the buyout price depending on how serious the offer seems. After the announcement, the possibility of the offer falling through, a higher bid, or emergence of new bidders creates a plethora of opportunities to trade the volatility for a fundamental trader. 

All in all, it is likely more difficult to be a fundamental trader than it is to be a technical trader as knowledge of one Company is not necessarily broadly applicable to many different stocks. I, personally, have shied away from it in recent months. But, with valuations as depressed as they are and outlook so negative, someone who’s bold enough may be able to find some terrific fundamental trades during this earnings season.

Contrarian Ripple Trading

Contrarian Ripple Trading as a strategy is a trading strategy built around the idea of mean reversion. Basically, the investor starts by looking for stocks trading at their 52-week low (or some other relative low). As with most mean reversion strategies, the safest course of action is to focus on large cap stocks that have a more or less established baseline value. Mean reversion strategies also make sense for use when the investor has a particular knowledge of a company and believes that a recent decline in stock price is unwarranted (but this begins to verge on value investing and leaves the scope of our trading strategy).

Upon identifying stock trading at a relative low, the investor then looks to take a position in the stock as the stock bottoms. This is based on the general principles outlined in Dow Theory which predict that a stock will trade randomly (a.k.a. ripples) in a tight lateral range after a big move down during periods described by market sentiment as despair and accumulation. What I believe the authors fail to warn the reader of is that it’s not enough just to identify a stock falling to its 52-week lows, but also to ascertain that there is things will not keep getting worse. The authors address this tangentially by warning readers only to purchase the stock of large cap companies or companies that they have particular knowledge of, but this isn’t really enough to protect person looking to make short-term profits in a stock.

Moving on from the identification of a bottom base comes the most interesting part of this startegy and an area where the authors of Contrarian Ripple Trading are either geniuses or simply very, very lucky. The reason it is advised that traders and investors avoid periods of lateral trading is that “ripples” are characterized by essentially random movement. It is difficult to time in and out of these trades and make money regularly. The only way to do so is with a very precise sell strategy. Here, waiting just a bit too long to sell can ruin the trade and force the investor to hold the position much longer than is worthwhile. This is outlined by the fact that the authors of Contrarian Ripple Trading, while supposedly never realizing any losses have managed to hold positions in excess of 2 or 3 years without any real return. That being said, the authors’ of the book choose a seemingly minimal target for nominal gain (read the book to find out or read the reader reviews on Amazon.com) and, for reasons unknown, it is successful in the majority of their trades. For someone looking to extend this strategy or turn it into a true algorithmic trading strategy, some research into how big “ripple” movements during a basing period tend to be could prove quite lucrative.

An Example of Contrarian Ripple Trade

Let me walk you through, what I believe would be a classic application of Contrarian Ripple Trading. Microsoft, a large cap stock with strong competitive position and in an indespensible industry, fell into a trading range near its 52-week lows in the last six months. This, in and of itself should be enough to warrant consideration for trading the stock at these levels, but let’s add in the fact that we know at least part of the fall was due to a dilutitive (and questionable) merger offer which (at the time) was not very likely to go through (and subsequently fell apart).

Looking at the chart, it is not enough simply to begin buying shares of the stock as it hits its 52-week low. Instead, one has to ascertain some amount of buying support at this level. Here, we must wait for a bounce off to establish a possible trading range/bottom base. This is identified in the a bove chart by the support line created by the previous 52-week low and the subsequent bounce back to the top of the gap-down identified by the first green circle. Now, as no contrarian would buy on a bounceback rally, we must wait for the stock to approach support level once again. Here, one would begin the first of his ripple trades. Buying as the stock approaches support and selling at some predetermined profit taking level. The stock loses its appeal once it breaks past its resistance level and we move onto another stock. In the case of Microsoft, the stock seemingly broke out but quickly moved back into the previously identified trading range. It’s hard to say whether or not one should buy the next test of support, but given that the stock holds on its support line for 4 trading periods, it would seem tempting enough and would have rewarded the trader with quick pop within a day or two.

Now, while playing this ripple trading game, one cannot simply assume that support will always hold. Sometimes, as is the case with Bank of America’s stock over the last few months (and much to my dismay), the stock will bounce around its 52-week low before plummeting through support. Buying here is not contrarian, but simply catching a falling knife. How does one avoid riding the ripples too long? It’s hard to say, but some tell tale signs can be found. The two most tell tale would be that ripple rallies only ascend to lower and lower highs and selling volume increases with each downward test of support. If this begins happening during your ripple trades, move onto the next target.

All-in-all, this strategy would seem to have a chance of working, but is likely best suited for people with a lot of money to invest. In the example of Microsoft, ripple rallies moved no more than $1.50 per share and there’s no guaranteeing that you will buy the absolute bottom of a support test and absolutely no way to time the top of the rally. Instead, you must be able to buy enough shares so that a small per share gain will yield a satisfactory nominal gain. This is akin to the way merger arbitrageurs often play by investing large sums to capture small changes in price in a stock. If your interested in how you might be able to do this at home, the authors of Contrarian Ripple Trading present a crude and unscientific way of doing it. But, I think most of the savvy readers of this blog might be able to come up a few of their own ideas.

John feels the main difference between traders and investors is “mainly in terms of the exit plan.” More specifically, he described the difference as follows:

Traders generally have them going in, meaning they have a specific set of criteria which will trigger an exit – often something related to price action, but not always.

Investors, though, handle things a bit more nebulously. They will exit a position when the fundamentals no longer support their being long. That, however, isn’t something which can easily be defined since there are so many factors involved. It’s not usually as cut and dried as falling short on the latest quarter’s earnings.

Chad uses a casino/gambler analogy to describe what he sees as the investing/trading paradigm. In his own words:

Here is an analogy for you; investors are the casinos, whereas traders are the gamblers. Investors have the odds stacked in their favor, just as the casinos are guaranteed winners over time because the games they offer have a win percentage built-in…

Traders, on the other hand, are trying to win big on short term trends, much like a blackjack player hopes for a hot shoe and then cashes out his/her chips. The gambler knows that they don’t have a statistical advantage but they play nonetheless, trying to make some money and getting out before they give it all back.

Now, before all you traders get up in arms over this definition. Chad does acknowledge that the odds are not necessarily stacked against a trader. In fact, to extend the gambling analogy for Chad, I would liken trading to counting cards. Stock traders believe that stock price movements have “memory” much like black jack. What happens in the past gives you a clue as to how things will act in the future. Traders use technical indicators and various techniques to measure the market’s attitude towards a stock – the supply and demand structure, enthusiasm, etc. Again, this isn’t a perfect analogy as one cannot mathematically conclude that trading strategies do in fact give you a concrete statistical advantage like counting cards does, but one can see how these techniques could give you some sort of insight into the price movements of a stock.

So, how do I view the difference between trading and investing? Well, as a lead in, I’d like to steal an anecdote that I read recently in Seth Klarman’s Margin of Safety. Imagine, a market for canned sardines. A trader doesn’t care what types of canned sardines, what flavor his sardines are, or where his sardines came from. He wakes up day in and day out and tries to buy the cans as cheap as he can and then sell them for as much as he can. An investor does care what’s inside the cans. He would open up cans, go to the factory, interview fishermen and find out whether or not these sardines will taste better as time goes on. He’ll buy the best sardines he can find; happy that he’ll either be able to eat the sardines in the future or that he’ll be able to sell these sardines for an improved price later.

Okay, weird anecdotes aside. Let’s try to answer some simple questions about investing and trading

What is the difference between investing and trading?
The basic difference between investing and trading is a difference of perspective. An investor looks as stocks as representative of fractional ownership in a company. They have an underlying value even if they decide never to sell the stock because the company will eventually pay out dividends and cash flow to shareholders. A trader looks as stocks as pieces of paper which can be traded day in and day out depending on market supply and demand. While the underlying business’ operations and success have an impact on a traders’ success, it often times does not matter to the trader because he believes that these fundamental concepts are represented in the stock’s day to day pricing action.

Are traders necessarily short term oriented and investors necessarily long term oriented?
Given the nature of trading and the tools that are available to a trader, a trader usually must think in a short-term oriented way. It’s difficult to construct technical indicators with multi-year time scales. This is because news, company performance and changing market environments will necessarily affect the supply and demand characteristics of a stock. This doesn’t mean traders won’t stay in a stock with strong upward momentum for months and even years. Most stocks, however, don’t maintain strong upward momentum for years and a trader is usually trying to time peaks and valleys in a stock’s price in order to capitalize on the frenetic behavior of people in the market.

Investors usually need to enter a stock with a long term outlook. They determine a value for the stock based on fundamentals and projections of future performance. They don’t sweat the day to day and week to week fluctuations because they know that, as long as business performance and fundamentals hold up, the stock price should follow suit. That being said, an investor must also understand the meaning of a stock’s price and is willing to sell a stock when its present value outstrips that of potential future value. For example, if a stock shoots up 100% in 3 days without any real change in fundamentals – i.e. many biotech stocks – an investor should be willing to count his blessings and sell his position knowing that the fundamentals may take months or even years to catch up to such a valuation. In such a case, the value found in fractional ownership in the company is outstripped by the speculative ownership of the stock.

Are trading and investing mutually exclusive?
The Benjamin Grahams, Seth Karmans, and Warren Buffetts of the world are probably going to hoot and holler at my answer to this. But, I don’t believe that investing and trading are mutually exclusive strategies. I don’t, however, believe in “fusion” strategies purported by many new investors (and sometimes seasoned investors) who want to get the best of both worlds.

Investing and trading as a mindset and perspective are mutually exclusive but, when practicing one, it can’t hurt to acknowledge the other. Many traders don’t like being called “traders” or “speculators.” They claim that they do look at fundamentals and that is what distinguishes them as true investors. The truth is, they shouldn’t be so taken aback by being called “speculators.” It’s not a bad word. And, it doesn’t mean you are a common gambler. It just means that you look at a stock based on its price performance and act accordingly. Most traders look at fundamentals only to check that the company behind the stock isn’t about to collapse or to make sure that recent price strength hasn’t put the stock in such a ridiculous pricing stratosphere that the demand for the stock could come crashing down at any minute. These are ideas which come from investing, but rarely are they capitalized on when using a trader’s mindset. Fundamentals, to a trader, ought to be viewed as a safety net rather than a motivation for action.

Getting back to the point, an investor can often use technical analysis and trading strategies to their advantage. Particularly in trying to maximize near term buy and sell decisions. In the grand scheme of things for an investor, trying to time a buy and sell isn’t necessarily important as most investors enter an investment looking for long term value that far outstrips few percentage point gains from day to day. Still, acknowledging trading strategies can help an investor make more informed decisions about short term price actions and determine whether he has more value in his fractional ownership in the company or simply in his ownership of the company’s stock.

Case Study
To demonstrate, let’s take a look at internet stocks. During the first bubble, many traders of internet stocks convinced themselves that they were “investing” in these companies because the internet was a fast growing sector and that one day valuations would justify prices. This despite the fact that they traded these stocks based on current price movements – particularly the very sexy and, in hindsight, completely irrational upward trends in prices. For these traders, it was not the potential future growth of the companies and it definitely was not the current performance of these companies (many were marginally profitable at best), it was the market demand for these stocks from which they derived profits.

True investors would never buy a stock which is fairly valued (or clearly over valued as in the above example) even if there was strong price momentum. They may, possibly, buy such a stock if the business is showing strong earnings and cash flow growth, but this would have to be verifiable not simply generally assumed. In the case of internet stocks, an investment case can be made for some internet and tech companies – Google, Amazon, Microsoft, etc. – and this is because they have verifiable business strategies coupled with true performance in earnings and cash flow growth. Furthermore, while these companies trade at premiums to many others, their current valuations could typically be classified only as fairly valued given reasonable assumptions of growth. Future earnings growth can propel these stocks to new, higher prices without fear of loss due to valuation premium contraction.

Conclusion
As seen above, while investors and traders can often utilize each other’s thinking in their decision making, it is difficult to apply both to an investing strategy due to a mismatch in their intrinsic perspectives on the value of a stock. As traders believe that value is derived from market supply and demand, they can only at best acknowledge fundamentals as support for their investment decisions. Investors believe value is derived from fundamentals in the business the stock represents and as a result can’t pay too much heed to a day-to-day changes in market demand for the stock.