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In 1988, Warren Buffett gave the blueprint for trading a weird thing happening right now

Myles Udland
·Markets Reporter
Warren Buffett
Warren Buffett

AT&T’s (T) proposed $108 billion merger with Time Warner (TWX) dominated headlines on Monday.

The deal values Time Warner at $107.50 per share. But in afternoon trading on Monday, shares of Time Warner were down over 3% closing the day at $86.74 per share, way below the implied deal price and indicating that many in the market aren’t sure the deal will close.

While this discrepancy is a bit weird, it’s not unheard of.

Initial jawboning from lawmakers indicates a potentially long, drawn-out review process for the deal, and comparisons to the scrutiny faced by Comcast’s acquisition of NBC Universal have been made.

There are also reasons to think an AT&T-Time Warner deal isn’t nearly as anti-competitive as early takes suggested, with a Reuters report out Monday suggesting it might take the unloading of one Time Warner-owned TV station to seal the deal. But as Bloomberg’s Matt Levine wrote Monday, market concerns might simply come down to the fact that big deals garner big scrutiny.

In markets, these combinations open up some of the most creative ways for traders to profit off the uncertainty inherent in both stocks over the next several months.

Warren Buffett and merger arb

Merger arbitrage — commonly known as “merger arb” — is a strategy that allows investors to profit from ongoing discrepancies between proposed buyout offer strikes and prevailing market prices.

Say, for example, you didn’t think the AT&T-Time Warner deal was going to go through. In this case you might choose to bet against Time Warner stock. Alternatively, if you think the deal will close, you’d likely bet against AT&T stock while betting on Time Warner shares.

 

And from time to time, this strategy has been a favorite of someone who has garnered a reputation not for short-term speculative bets but long-term investments: Warren Buffett.

“In past reports we have told you that our insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents,” Buffett wrote in his 1988 letter to Berkshire Hathaway shareholders.

“We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long-term investments.”

And when looking at potential arbitrage opportunities, Buffett says investors must be able to answer four questions. From the 1988 letter:

“To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire — a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?”

Earlier this year, Bloomberg reported that hedge funds had picked up their investments in merger arb strategies amid a lack of attractive investments with stock valuations elevated and bond yields near record lows.

Which brings to mind Buffett’s cautionary comments from nearly 30 years ago, which singled out what then seemed to him a too-enthusiastic merger environment and resulting fervor for merger arb strategies. Of note, the $108 billion AT&T-Time Warner deal isn’t even the year’s biggest: that honor belongs to AB-InBev.

“Even if we had a lot of cash we probably would do little in arbitrage in 1989,” Buffett wrote.

“Some extraordinary excesses have developed in the takeover field. As Dorothy says: ‘Toto, I have a feeling we’re not in Kansas any more.’

“We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. We have no desire to arbitrage transactions that reflect the unbridled — and, in our view, often unwarranted — optimism of both buyers and lenders.”

Myles Udland is a writer at Yahoo Finance.

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