WCI #43: Merger Arbitrage with Peter Steinberg MD

This is the White Coat Investor Podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high income professionals stop doing dumb things with their money since 2011.

Here's your host, Dr. Jim Dahli. Welcome to podcast number 43, merger arbitrage with Peter Steinberg, MD.

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Thank you for what you do. I spent the last week or so learning a new electronic medical record while trying to battle my way through flu season in the emergency department. Sometimes we minimize the stress of what we do on a daily basis because we've gotten used to it, but it takes a special person to get into the physician training pipeline, much less get through it, and then survive two to four decades of work in the field. I hope this podcast helps you to not only survive, but also to thrive in your career. Our quote of the day today comes from Benjamin Graham, who said the true key to material happiness lays in a modest standard of living, which could be achieved with little difficulty under almost all economic conditions. Today we have a special guest on the podcast. Peter Steinberg, MD, is a urologist out in Boston who has an academic practice but has a very interesting side hobby involving investing in a very specific type of investments, basically stocks that are merging with other companies. He does this together with his father, a financial advisor, and it provides a great hobby for them as well as an interesting opportunity to try to make some outsized returns. So let's get into the interview with him. All right, well, welcome to the podcast, Peter. We're glad to have you here. Let's start out really at the beginning. Tell us a little bit about your upbringing before we get into the subjects we're going to cover today.

Sure, Jim. So I was born in Washington, D.C. and moved to Western New York, Rochester, New York when I was five. My folks still live there, so I grew up there and then basically Been in the Northeast ever since. I went to college in Vermont, med school in Philly, did residency at Dartmouth and then a fellowship in New York City, and I've been in practice about seven and a half years now. I started in Portland, Maine for my first two years in practice, and I've been in Boston for a little bit over five years now in an academic practice.

Okay. And I understand your father was in finance, is that right?

My father by training was an attorney, and I was born in D.C. because he was working in the Commerce Department. But when we moved to New York when I was little, he started in financial planning and accounting and has been doing personal financial planning for 30 plus years at this point.

But you ended up in medicine. How come you ended up in medicine instead of following in the family trade?

Well, my brother's an attorney also, so it is kind of, kind of amazing. I have an uncle who is a gastroenterologist. And sometime in elementary school, I think he started providing a lot of guidance to me. Indirectly, I think he advised me not to become a physician. But I didn't listen to him and I just watched what he was doing and he was my motivation for going into medicine.

It's funny how everybody, almost every doctor I know, somebody tried to talk them out of going into medicine and they wouldn't listen. Maybe there's some truth to the statement that if you can be talked out of it, you should be talked out of it.

That's probably true.

Not that it's so bad, but I think it just requires the sort of commitment that requires. Requires a willingness to go through just about anything to do it. And without that commitment, you just won't make it through the long pipeline.

Well, exactly. And I think in reality he might have tried to dissuade me, but I think once I was actually training, I think he really enjoyed having someone in the family he could talk shop with, even though I'm a urologist and he does gi. You know, we've always found common ground to talk about interesting things.

Yeah, that's great. Now, are you working full time?

Yes, Yeah, I work. I work full time in an academic practice. So it's, you know, the schedule is a little bit different than a private practice, but I would consider it full time.

Well, let's move a little more into the investing and finance kind of topics. Tell us about your asset allocation. What are you. What are you invested in? What's kind of the baseline from which we can go through the rest of this discussion?

Sure. So I've got about 80% of my investable assets are in your typical tax deferred accounts. You know, 401k. I had a 457 in my old job. We have a very unique setup in my current job where they actually, because we're in a large physician group, we actually have both a 401k and a 403b. I remember when I was interviewing, I asked if it was illegal and they said, well, it is now, but we've kept everything in line. So I actually have most of my money in that. I have a decent chunk of my investable assets my father actually manages for me and he's pretty cheap. So I've got him doing some of them. And then the part of my investable money, about 20% I've got in a taxable brokerage account where I do do the arbitrage type deals primarily.

And you're invested in what typical stock, bond, REIT index funds, or mostly actively managed funds, or what are you invested in?

So in my tax deferred accounts, those are just your typical low cost index funds. I've got blue chip growth and a couple things like that, but all low cost. Primarily Fidelity manages our money. In my current job and in my old job, I've still got some money in the 403 plan there, which is primarily Vanguard. And I've got a couple of America's funds in that. My father does a couple of different things. He's got a mix of some low cost funds and then a couple of other more actively managed things which are designed to outperform in a bear market is some of what that's in.

Now that's fairly typical, I think, among our listeners. But I didn't bring you on the show to talk about index funds. Today we're going to talk about something a little more interesting and maybe get out into the weeds a little bit when it comes to investments. I brought you on here to hear about this merger arbitrage that you're doing with a small portion of your investments. Can you describe what that term means for the readers?

Sure. So arbitrage is the umbrella term that basically means exploiting a difference in prices. That's all it means. And you can arbitrage anything. You can arbitrage Patriots T shirts in Philadelphia and selling them back in Boston or tax rates between states. But arbitrage just means exploiting a price differential for something. So one of the classic types of arbitrage involves back in the old days, before trading was electronic, you could have a stock traded on two different exchanges and For a short period of time, you might be able to buy it cheaper, say in London, and then sell it at a slightly higher price in New York, and eventually the price differential will go away. But arbitrage just refers to exploiting a price differential in a market. A couple of the specific types I get involved in, one type is merger arbitrage, and then another type involves stock buybacks or what's called tender offer arbitrage. But merger arbitrage specifically deals with exploiting the price differential that exists when a company is going to merge with another company, the company that's being taken over. Usually there's a little bit of a difference in price between what they're going to be acquired for and what you can buy the stock for. And exploiting that difference is merger arbitrage.

Now, this is a technique that hedge fund managers have been doing for a long time and with varying amounts of success, like with any hedge fund. How do you personally go about doing this? How much of it have you done and what kind of success have you seen?

Sure. So I've been doing this for about four years. This is, you know, the brainchild of my old man. So this is something that he was reading about and doing a lot of academic investigation of for a long time. And, and as I got a little bit more into practice and had a little bit of extra money on my hands, all of a sudden we were able to put together his book knowledge with a little bit of the capital that I had to start actually doing this. So around 2015, we started doing this in earnest. And the way I've gone about it, I've done a fair amount of reading both of sort of economic papers and some books on this. But basically what we do is we find deals we're interested in investing in. And the majority of the way I do this for mergers is with a website called insiderbitrage.com where literally the gentleman running this site has a list of all the publicly announced mergers that exist and what the asking price is, the current price of the stock, how much you can expect to make SEC filings related to that. And I'll just look at that and figure out what type of annualized returns I'm interested in, and then invest some of my taxable brokerage account into those deals. I'll also do, like I mentioned, some stock buyback deals which I frankly just search Google. I've got an automatic search that'll pop up in my email when new deals are announced. And I'll look at them and decide which ones to go into in that same brokerage account. I would say that I was looking back through what I've been doing the last couple of years in anticipation of talking to you. I'm doing somewhere between 10 and 20 arbitrage type positions per year. Some years it's been a little more, some years it's a little less. But somewhere in that range. And my overall track record with this, the way you track this is you report what's called an annualized gain because that's the only way you can compare it to, to other investments. Because by definition, these are relatively short time periods, usually months, where you're holding one of these stocks. So my annualized returns doing this are right around 30% since 2015. Doing this.

Yeah, obviously that's a great return. I mean, when you can make your money grow at 30% a year, you become very wealthy very quickly. Now you say you're basically buying the stock. You're buying the stock that's being acquired, or you're buying the stock of the company that's doing the acquiring, or which one are you buying? And how do you determine that?

Sure. So the way we decided to do this, and I can't tell you how many hours of father son bonding time have occurred talking about this. What we decided to do would be a couple of things. So number one, this is only with publicly announced deals where there is an actual intent of the two companies to merge. And this is filed with the sec. This is not dealing with rumors or speculating. These are actual deals that are announced. So that's one thing. And what we decided to do, when two companies merge, they can either be acquired for cash, stock or a combination. And we decided that the best and most conservative way to do this is to deal only with the deals where the companies are being acquired for cash. I've done a few where there's a mix of stock or other conditions. But generally speaking, we do that because you can just look and see does the acquiring company have the cash on hand to buy the other company. And generally speaking, if a company is going to buy something for cash, usually their position to consummate a deal is better than some of these other situations. So we look for deals where it's a cash acquisition. I personally don't like to have the money tied up for more than about three months when I do this. My father's got a little more tolerance for stretching it out, more like six or 12 months. But I'll look for deals that are closing usually within the quarter or around 90 days or so, and I look to try to get an annualized return of at least 10 to 12% on the deals I'm going into, because otherwise I just don't really find that it's worthwhile to be invested. Other people would take a lower annualized return, but that's sort of the benchmark return that I've wanted and that's what I've decided to go with. And all I do is purchase the company that's being acquired, buy its stock. I'll usually watch what the stock is doing and I'll often buy in at a few different points in time. I generally don't commit more than about 5, 5 and sometimes 10% of my available funds in that account to any one deal so that I don't get too overweighted. And I'll just buy the stock of the company that's being acquired. And I often will hold it. I usually don't hold it until the deal is consummated because a lot of times when the deal is about to close, you've realized most of the gain that you're going to get. And I'll sell the stock back on the market at that point, but sometimes I'll just hold it till deal consummation. And that's generally how we do it.

So of course those are pretty much all short term capital gains. So you're fully taxed at your physician income on them.

Correct.

But Even so, your 30% returns that you've seen over the last four years, that's a pre tax return, I assume?

That's correct.

Okay. And tell us about the, you mentioned the other technique you were using, the stock buyback technique. Tell us a little bit about your experience with that.

Sure. So I personally like doing the stock buybacks more than mergers for a variety of reasons that are related to sort of some of the unique risks that exist. But I also like them because these are by definition a 30 day long period. So a stock buyback. A lot of your listeners might have heard this come up recently in talks with the new tax bill. One of the big complaints was, well, companies are going to repatriate money and buy their stock back. And when I heard this, I got excited. Other people don't really know what it means, but stock buybacks are something a company can do with money that they have literally sitting around. They can put it back in the company, they could buy another company or they can purchase their own stock back. There are two ways of doing this. Most commonly this is just done on the open market where a company will say, we're going to buy back a billion dollars of our stock over the next year or two. But there's something a company can do, which is called a tender offer, where they will again registered with the sec and there's specific laws and regulations that apply to this. They will make a public announcement saying, we are going to buy back a certain amount of our stock. It's either a fixed dollar amount or a certain number of shares they want to acquire. And they either name the price they're going to buy, which is what's called a cash tender offer, or they have a range of prices they'll buy it in, which is something a little more complex called a Dutch auction. This is actually how Treasuries are actually sold. And it's the opposite of a normal auction. A normal auction, the highest price wins. In a Dutch auction, the lowest price wins. It's a little bit confusing, but nonetheless, the company will say, we're going to buy back a certain number of shares of stock at a certain price for a set period of time. And what I'll do then is I'll acquire the shares and you utilize your broker to actually execute a more complex trade to do that. And what will happen is people will put their shares back into this buyback. And if the number of shares the company has coming back in is less than the offer, all of your shares will be bought back. And if it exceeds the number, you'll get a prorated number of your shares purchased back. I've personally had better success with this because I think I understand the mechanics of this a little better. I mean, I always learn new things each time, but I get the mechanics of that a little bit more than the mechanics of mergers, which are subject to a lot of different factors. So I do a fair amount of that. There hasn't been as much of that lately. There was a lot of it a couple years ago when the market was quite high and a lot of companies didn't know what to do with cash.

Now, I'm still trying to sort out on this stock buyback why there is a difference there, why there's money to be made there. It seems a little odd to me that it's not a little bit more efficient than that, that the price they're buying it back has been basically the price you bought it at. Why is there a difference there? Why is there room there for you to make a profit?

Well, there isn't always. So not every buyback that is put out there offers a good arbitrage opportunity. So there are a couple of things that come up. Number one, when you're dealing with many of these companies, a lot of times you're dealing with fairly small companies as far as their market cap goes. I mean, I remember the first one of these I did in 2015 was a very small virtual currency company in Seattle whose total market cap was about $10 million. And that's a company where they've got a small number of shareholders, probably a lot of family members and insiders. So you're not dealing with hedge funds and private equity firms competing with that. There have been some other big ones I've done, like Wendy's H and R Block. There have been some others. But you're dealing with a lot of times relatively small companies with stocks that are not trading a lot of shares each day. And so there's not a huge market for this. And you're dealing with a lot of people who are holding their shares and not really parting with them. So a lot of times you'll get an opportunity there, because a lot of times that's just how the market will work. Sometimes when you're dealing with a bigger company or a more liquid stock where there's more trading or more institutional involvement, where there are more shares being moved around, oftentimes the fluctuation of the stock price during that buyback interval will give you an opportunity to have an arbitrage profit there. So the movement of a lot of stock in and out, a lot of, say, big investors selling, once this is announced to realize a profit, will often give you an opportunity to exploit this.

Now, like any individual stock investing, you know, if you're making a profit there, somebody's taken a loss. So you're really competing against the other people that are buying or selling that stock. Aren't you in these situations?

Well, it's a little bit different than that because there are a couple of different rules that govern buybacks. So, number one, with some of these companies, there are people who want nothing to do with the buyback. These are people who are holding this stock for a long period of time. Perhaps they're insiders. Maybe it's someone who just has a few shares of the stock, doesn't even know this is happening, or forgot he owned them. And sometimes you're dealing with institutions that are trying to, say, acquire some of the shares of stock. So there are a lot of different dynamics that come into play. One of the things that does happen during these, and one of the reasons why a lot of companies do this is to flush out A lot of small investors, there are rules that actually prevent you, if you have 99 shares of the stock or fewer and you put into the offer, from being prorated. So any small investor who puts his shares back into the buyback gets all of them bought back. So there are a couple of different dynamics here at play. The other thing is, a lot of times management will do this to just remove shares from circulation. So if you're a company and you're retiring 25% of your shares, the company is getting more control there. And it's a little bit different than the rest of the market, where everybody wins and loses. Your shares are being retired permanently. So the dynamics are a little bit different than sort of I'm just buying and selling on the market. But you're also dealing with a fixed price that the company will pay you for your shares within that month, which is different than the market the rest of the time. There you're dealing with what people think it's worth, and you know how things are going to be in the future or whatnot. Here the company saying, look, we're going to give you this 30 days from now. Do you want to participate or not? So it is a little bit different than your typical open market trading.

I guess the way I would think about it would be if. If the company has said, we'll pay you $30 a share at some point in the next month, I would expect the stock price to just lock into $30 a share for the next month. Why is it that it fluctuates?

So once these deals are announced, and this goes for mergers or buybacks, let's say your stock is plunking along at a particular price. Once the deal is announced, the stock prices invariably, with rare exception, will shoot up and get close to what the deal price is. So often with a stock buyback, the company's doing it because they think their stock is. The market price is undervalued. So let's use your $30 buyback price. So let's say the stock is trading for 20 bucks and the company thinks it's worth 30. They'll announce the buyback, the price will shoot up because that's what people will think it'll be worth. But then all of a sudden you're going to get a lot of people who are going to say, you know what? I just made 50% of my money. I'm selling my shares. And that will drive the price down. So that's often what will happen is you will get some initial movement up, but it Just doesn't stay there because you've got some people are selling their shares to realize a gain. And there can be other dynamics going on. Like I said, the companies might be trying to get control of shares of stock, so insiders might be buying. You might have institutions that hold large positions who are doing things. So there are a lot of different dynamics that will usually give you a little bit of a spread. Not a big spread, but a little bit of a spread. Frankly, I just did one of these recently where for some reason the market price was 10% below the asking price. I can't explain why that was the case, but it was a great arbitrage opportunity. And as someone who just wants to exploit this for a short period of time, I don't really care if the stock is trading for what the company says it's worth. I just want that arbitrage spread. In some deals, there isn't much of a spread. Some deals you can't make a reasonable profit, and those are deals you just avoid.

Now, some critics of merger arbitrage have said it has a limited upside and a huge downside. What's your response to that?

Well, I think in many ways they're right, but I think there are a couple of caveats. So let's talk about the upside first. The upside is limited, absolutely. Let's say your company's being bought for $10 a share. That's a limit. It's not going to be 20 unless the deal gets renegotiated. But you know that someone's going to pay you $10 for the stock, and you know that that deal is going to close in three months, six months, whatever with the rest of the market. You neither know what it's going to be worth in the future, nor do you know what the dollars you've got now are going to be worth. So, yes, the upside is limited, but you actually know what you can actually get for your shares. And you also know what the time period that the money will be occupied for happens to be. And as compared to, say, indexing, you know, 30 years from now, you're going to get 10% a year in your S and P index fund, but you don't know six months from now what you're going to get. So that is the difference. The upside is known, although limited. I would say on the downside, I don't think huge is exactly the way I would describe it. Sometimes the downside is huge. But the fact of the matter is when you're dealing with mergers, I just ran some numbers for just the last couple of years, you're dealing with in excess of 90% of mergers in the last three years closing after they're publicly announced in 2017. So last year, 95% of the publicly announced mergers that existed closed. So you're dealing with 95% of the time the deal is going to be consummated in the 5% of deals that fall apart. Sometimes they do so spectacularly. But when you're dealing with a deal that doesn't work, or with the downside here, it doesn't usually mean that the company you bought went to zero or went to bankrupt. Often it just means it went back to what it was trading for before the merger was announced. Another factor, the spread between what the market is paying for the stock right now with the market price of the stock and the deal price happens to be the wider that number is, the lower the probability of the deal being consummated. So it's not like you're dealing with deals that are likely to close close where you're very close in value to what they're going to buy the company for, and then those deals fall apart. That's very unusual. And usually there's not much money to be made on those deals. The deals where there's a bigger spread, there's a lower risk of those coming together. But the stock usually doesn't have as far to fall if those deals fall apart. So there certainly is a downside, but it's not like every single deal is likely to fall apart. So that's really what the advantage is compared to the rest of the market. You basically know with high probability what the security is worth and over what time period, as opposed to with the rest of the market. In a very long time period, you've got a good idea, but in a short time period, you don't.

Now, have you had one of these deals that didn't go through or the merger didn't happen?

Oh, yeah, I had one that was a disaster. Which was the worst single one I've had was the Rite Aid Walgreens merger, which got delayed for an exceedingly long period of time and fell apart. And just before we came on, Walgreens was talking about merging with amerisource Virgin, and I started shaking my head. I was having flashbacks. But that is one of the deals that I've been in that has. That has come apart. That's probably the single worst one that I've been involved in.

And what happened to your investment on that one?

So what happened there? I Held the shares as the stock price, they renegotiated the terms a couple of times, and then the deal basically went kaput. So I held onto that stock for quite a while, waiting to see if someone else would come along and buy them. And then ultimately I decided to take the loss on it to do some tax loss harvesting.

And do you remember about what your.

Loss was on it in terms of the dollar value or the percentage?

Well, mostly the percentage.

It's hard to pull it out that way because the tricky thing is you're sort of recycling money to do this. So I can't tell you my total account lost X amount of value of that, but I can tell you it knocked my gains down substantially for that year from where they would have been otherwise. I would say it probably dropped my annualized gain that year by 50%.

That's with many other deals going on during that year. This one had a fairly large effect on at least that portion of your portfolio you were doing this with.

Yes, it was also partially because I put a lot more into that deal than others, because I thought this was surely going to close and a whole bunch of other things. And so I overweighted that one in the portfolio. And that was part of why it hurt so much when it fell apart.

Now, I understand hostile deals have a much higher break rate than the less hostile mergers. Do you avoid hostile deals because of that? Why or why not?

Yes, I entirely avoid any deals like that. So a hostile takeover, you'll see this in the news periodically. And one of the classic guys who does this is Carl Icahn, who runs this big investment house. He will basically solicit shares of a particular company that he wants to acquire control of, and he'll put a notice out his own tender offer, if you will, for shares of particular companies, and the management of the companies will say, you know, we suggest you reject this, et cetera, et cetera. So that's a deal where the parties have not agreed to merge, but where someone is trying to take the company over through acquiring its stock. That is very different than where two companies have agreed to merge, the documents are in place. Often the boards of the companies have voted for it, are going to vote for it, or the board of directors approves it. So I completely avoid those. The upside is much, much higher, but the downside is very high there, and you just don't have that high probability of those deals coming together. So I completely avoid hostile takeovers entirely.

Now, another criticism of merger arbitrage is that the transaction costs eat up Most or all of the profits. What's your response to that criticism?

For me, I've got a Merrill Edge account that I do these trades in and I have no transaction cost for them. I get 100 trades a month because it's affiliated with my bank of America accounts. So there's no cost. I would say when I do the actual tender offers, the actual buybacks, those are broker assisted trades where you actually need to call a person with the company I work with, with Merrill, and you need to give them instructions to go into the offer and that costs $30. So. So that's a little bit pricey, but you factor it into how many shares you want to buy and how you're going to handle them. And frankly, given how well those types of deals work out, I think it's a very reasonable cost. Especially when you're trading something where your profit's going to be hundreds or maybe even thousands of dollars, 30 bucks is not a big deal. But for the other transactions, I don't have any questions costs. So I don't think that's a, that's a problem. And if you have a low cost brokerage, you know, you're not, you're not talking about lots and lots of trades here. You know, you're talking about a handful a month. So I think the costs can stay pretty low.

Now even, even when you're not paying commissions, you've at least got to be paying bid ask spreads on some of these. You mentioned they weren't very liquid. Do you find those bid ask spreads add up to much?

So that can be a bit of an issue. And I had some, I mean, I could see spend an hour telling you about every bad experience I had doing this with each type of deal that, I mean, I learned something new every time. But I had a couple of issues early on where I got what's called whipsawed by a relatively illiquid stock. So if you're dealing with a stock that's relatively illiquid, and by that I would say if you're dealing with a stock that doesn't trade tens of thousands of shares a day, once you're up in the 20, 25, 50,000 shares a day range, you can generally just sell it at the market price and you're not going to have an issue. But stocks that trade hundreds or thousands of shares a day, you've got to be very careful about how you put your orders into your brokerage software. If you're doing it yourself, you often need to become familiar with something called a Limit order, where you either want to buy something at a certain price or, or sell it at a certain price. Otherwise you can get what's known as whipsawed, where you think you're selling it for four bucks and you sell it for 250 or something. So you have to be very careful about that.

So what else could go wrong with this strategy?

Lots of things. So I think the way I think about what can go wrong, I break it into mergers and tender offers because they have unique risks. So when you're talking about mergers, one of the most interesting problems that I ran into was what I would call antitrust risk or governmental risk I think is the bigger umbrella. And by that I mean when President Obama was in office, the Federal Trade Commission took a, in my opinion, a somewhat anti merger attitude. And the ratio of deals that went through was about the same as we're seeing now. But a lot of deals got extended by the Obama Federal Trade Commission. And when you're looking for annualized returns, if you're thinking you're going to be invested for 90 days and it gets stretched out to 180 days, your annualized return just dropped by half. So that was a big risk that I became aware of. And now with the Trump administration, I think that everyone would agree they've got a little more pro business, pro merger deal. But they have a very big anti China bias. And there have been some mergers that have fallen apart. A lot of these made the news. One of them was called Lattice Semiconductor where it was a computer chip company that was going to be bought by a Chinese company. They blocked that deal and it fell apart. So there's governmental risk to these deals, antitrust risks and other things. One of the other issues you can run into with mergers is just the underlying nature of the health of the company that's being acquired. Earnings can affect this. They can have a bad quarter. There can be some other issues. Other things can come out during the merger period where the probability of the deal coming together goes down. There can be other regulatory issues and regulatory approvals that can impact these. And then one of the other issues that can impact these is the funding of these deals. You know, there's always a risk that the company says it's got the money or it's going to take a loan from Deutsche bank to buy it or whatever and they don't really have the funding. So those are all possible risks with mergers that are sort of unique and things you wouldn't think of immediately. You know, the deal not consummating is one of them. But these other factors really do really do play in. And I will say that the spirit between the deal price and what the stock is trading for, it does reflect that risk. So if the deal is, if the market doesn't think the deal is going to go through, that number widens. The discrepancy between those gets bigger and your chance for arbitrage profits goes up. But the chance of the deal not closing also does as well. With tender offers it's a little bit of a different risk because the company that's buying back the shares needs to to tell you and the SEC how they are going to fund the buyback. So they can't really do a switcheroo on you and say we're going to buy back half a billion dollars of stock and then not have the money. That's securities fraud. So the real issues there, the single biggest issue is getting your shares prorated. So that means that the deal is oversubscribed. Let's say the company is going to buy back a million shares of stock stock and 5 million shares are offered for buyback and all of a sudden you're holding 80% of the shares you bought. So that's a unique risk to that. And one of the best ways to tell if that's likely or not is to look at the volume that the stock is trading. Well, the deal is announced during that month relative to the number of shares they're buying back. When there are institutions involved in this, then you're going to trade hundreds of percentages of the deal size. So if the deal size is a million shares and there's 5 million shares that trade hands in the first week, that's got a high risk of proration because institutional players are involved. If they're buying back a million shares and 100,000 shares trade hands in the first week, that's where smaller players are involved and prorations less of a risk. You've also got just general risks of the market collapsing while one of these deals is going on. Although during any single 30 day period the risk is low. But some of these can be called off because of that or other catastrophic events like wars and things of that nature. Although I think that's just a general risk with everything else. And the only other thing with tender offers that's an issue is when the shares are bought back through this Dutch auction process. You need to name a price you're willing to pay for the stock. If you put in a bid that's higher than the price they buy the shares Back for none of your shares get bought back. So you've got to be strategic about those deals and be very careful about how you deal with those auctions, or else none of your shares will get bought back. But really, I would boil it down to the merger risk. Is the deal not closing or being delayed, which is probably really a bigger risk, frankly. And with the tender offers, it's being prorated by institutional investors overwhelming the deal.

Now, it sounds like you, and at least together with your father, are doing this yourselves. Now, why bother doing that instead of hiring a hedge fund manager or some sort of professional to be doing this for you?

Sure. So there are a couple things. There are actually merger arbitrage mutual funds that exist. The problem is they can't really be selective about the deals that they go into. They're required to invest the money they have. So they end up spreading the money around a variety of deals, some with low risk of success and some with almost no spread. And so the returns you get when you're going into that many deals are not quite the same as when you can be selective. As far as a hedge fund manager goes, I mean, the reality is, I don't know about you, but I don't have enough investable assets to go to a hedge fund and say, will you play my money for me? So that's really the issue there. And the other issue is when you're dealing with the black box of a hedge fund, you don't really know exactly what strategy they're using and are they going to get into, are they using options and doing all these other crazy things? So that's really why neither of those things appeal to us. But the biggest thing being with the mutual funds, they need to go into so many deals. It dilutes the returns, frankly, just by virtue of the way those are structured. So I think those are the big reasons why I wouldn't do that. Plus the lack of money to have my money managed by a hedge fund, I think is another big reason why I would avoid that. And, and frankly, I mean, this stuff sounds complicated. It's actually not that complex. When you start doing it and read about it a little bit, it's really not that complicated. You can make it very complicated, but it's really not that complex.

All right, let's ask some of the tough questions now. First one, what's the point? I mean, isn't a boring old index fund portfolio enough for a doctor to meet all of her financial goals? Why bother with all this hedge fund merger arbitrage garbage?

Well, I think if you want to get the market, which, and don't get me wrong, I mean, as you know, and your show is espoused in many of many fine publications and a lot of brilliant minds on this just say, hey, you know, get a low cost index fund, that's great. If you do index fund investing and that's where you're putting your investable assets, you will do really, really well, but you will get the market return. I think that as with all investing, the goal is to make money. And I'm not saying I'm doing this, but doing something like this gives you a chance to get returns in excess of what the market returns. Since the goal of investing activities is to try to make money, I think that's one of the reasons too, to try to do something like this, to try to get better than market returns and the real ammo, I would say, and don't get me wrong, I don't think I'm Warren Buffett, but Warren Buffett and Charlie Munger have done a ton of arbitrage. Not so much now because they can't because they're so big. But back in the 60s and 70s and in the early days of Berkshire Hathaway, they did a lot of this. And I figure if that's one of the ways these guys were making money and it's a big chunk of their excess returns, it seemed like a strategy that was worth trying to learn more about and try to implement.

So how much time do you spend doing this?

That's a pretty good question, I would say. And again, when you're talking to your father on the phone about the stock market, I mean, I don't really. That's usually pretty fun if you ask me. But I would say I probably at this point devote a few hours a week to this. I'd say I probably spend maybe four hours a week at this point. When I started out, it took me a lot longer to analyze deals, look at the underlying companies, figure out if it was a deal I wanted to do or not, figure out how to track my returns. But I would say I spend a few hours a week on this.

Do you think once you subtract the value of your time, I mean, you're a urologist, your time's worth a lot. Once you subtract out the value of your time and once you subtract out the fact that you're paying short term capital gains rate on your gains, do you think this is still worth it or do you think you're doing this just because it's something you really enjoy.

I think it's both. I mean, I think, I think the reality is this is, for me, this is entertainment and this is, you know, frankly having a hobby with my father is really what this boils down to. So I think that that's, I mean I derive a lot of enjoyment just from seeing what's going on with different deals, talking about different spreads and the risks. And just for me that's fun. I think when I compared to when I first started doing this and I was spending a sizable amount of time, you know, reading underlying books and articles about how this is done, trying to back calculate returns and things, I spent a lot of time on this. And it's easy to say now that maybe that wasn't the best use of my time, but I think it's worthwhile. And I think that now it's pretty easy for me each time a deal comes along to sort of roll this through. And I extrapolate to in the future if this is something I'm going to keep doing when I've got more investable assets. I think in a few years this might actually pay off financially in some ways. And really what this amounts to is this is really almost like a cash substitute in your portfolio. You know, the idea is you get a small return annualized, it's a little bit bigger, but if interest rates were normal, you'd plunk your money into government bonds or something. You get 5%. But since they're not, this is sort of a way to tweak some cash you've got sitting around and get more than nothing on it.

Okay, so a doctor walks up to you in the doctor's lounge. Maybe not a very financially sophisticated doc. Maybe this doc doesn't know the difference between a Roth IRA and a traditional ira and he heard you talking about merger arbitrage in the or. He wants to get into it. What do you tell him?

So I would tell him and I've done this for a couple doctors I work with where I've actually bought them this book. Warren Buffett's ex daughter in law, Mary Buffett has written a number of books about her former father in law. But there is a great book, it's about 120 pages long. It'll take you literally an hour to read called Warren Buffett and the Art of Stock Arbitrage. The chapters are about four pages long each and the type is big and you can read it in about an hour. I would get that book off of Amazon, flip through it, see if it's something that interests you, and if it does, I think you could be off to the races pretty quickly. And if you read it and you think this sounds ridiculous, then it's not for you.

All right. Well, I sure appreciate you coming on the show today, and I wanted to thank you for that and for enlightening our listeners to a little bit of different way to invest and some of the risks and opportunities available there. I appreciate your time this evening.

Absolutely, Jim. It's been great listening to your show and I wish you nothing but continued success.

Thank you very much. Same to you. Well, we've got Dr. Steinberg off the phone now, although I'm sure he'll listen to this podcast later. Later. That was an interesting dive into one of the ways in which you can do individual stock investing long term. Listeners and readers know I'm not a huge fan of individual stock investing, whether you're doing it for merger arbitrage or stock buybacks or whatever your strategy is in picking stocks. The main problem with picking individual stocks is you're running uncompensated risk and perhaps you're really good at it. And maybe this is something that, you know, you really enjoy and you're willing to spend 20 hours a month on. But I think for the typical physician who just wants to get a fair return on their investments and who's really focused on spending their time on their practice and their family and their hobbies, I'm not sure I'd recommend diving into an investing strategy that's going to require, you know, 15 or 20 hours a month in order to be successful and even then not know if you're going to be successful. So not exactly my recommended method for everybody, but it's interesting to see all the different ways to invest and how many other options there are, and just how interesting it can be to delve into the world of finance.

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