2 Arbitrage Opportunities and Blatant Market Inefficiency

The CAPM is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece of MBA investment courses. Indeed, it is often the only asset pricing model taught in these courses. The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor—poor enough to invalidate the way it is used in applications. In the end, we argue that whether the model’s problems reflect weaknesses in the theory or in its empirical implementation, the failure of the CAPM in empirical tests implies that most applications of the model are invalid.” - Fama & French, 2004

Despite its numerous practical flaws and the many examples which any investor could bring up to contradict its basic tenets, the CAPM model and the fundamental idea that risk and return are perfectly correlated dominates current investment theory. As a result, it also is what the vast majority of financial advisors/professionals across the country explain to their clientele as they advocate portfolios and investments which they believe to be somewhere along the supposed risk/return frontier.

Below, from the same study the Fama/French quote comes from, they present low price-to-book firms on the CAPM frontier and the data (each observation is a group of stocks) seem to exhibit high “risk-adjusted returns” to say the least, along with no correlation to the portfolio’s volatility.

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Given that only around 5% of active exchange-traded funds have been shown to beat the market over a period of 15+ years, and that the vast majority of retail investors (and probably institutional as well) aren’t capable of successfully selecting that 5%, it is no large mistake to ignore the out-performers. In fact, I would say it is generally wise to focus primarily on low-cost indices given the challenge one would face in selection and the likelihood of relative long-term under-performance. When your universe consists of large exchange-traded funds, it is fair to say that since so few of them can provide long-term value, and since that value comes at the expense of other active funds, the market might as well be deemed efficient, at least for most investors.

Small non-exchange traded funds, particularly those focused on small-cap stocks however, have a much better chance for a few reasons. They aren’t bound by institutional imperatives and do not index hug as the majority of large funds do. They also have far more opportunities available to them, given that they are capable of investing in companies below $1b in market cap, which is something few large funds can do. Despite the fact that I personally find what I would consider bargains consistently above $1b in market cap globally, the most obvious examples are in the small-cap realm and special situations which afford the opportunity to generate a (near) risk-less profit via arbitrage.

Closed-end funds have been consistently pointed to as a very obvious and enduring exception to the efficient-market theory by academics for decades now. Closed-end funds, which usually have a single offering to the public and which primarily hold a portfolio of immediately liquid securities, mark to market the net asset-value of their fund on a regular basis, so at any point the public can see the market value of what the firm holds. Closed-end funds which trade at a discount are therefore trading below immediate liquidation value of the securities and have been shown in many studies to outperform the market on average-1, 2, 3. Closed-end funds often trade at a discount to NAV given that on average they under-perform the market, but regardless, simply purchasing a portfolio of them has been shown to lead to above-average risk-adjusted returns.

The discount on each closed-end fund tends to swing quite a lot. If there were a certain discount for each fund based on under-performance, illiquidity, or manager fees, it may be reasonable to assert that the discount is warranted. When these discounts are large and swing dramatically in short order however, it becomes obvious that they are subject to the sentiment of random buyers and sellers who have their own reasons for trading, regardless of NAV.

Bill Ackman’s Pershing Square Holdings (PSH) is a very prominent and obvious current example. A public company with a market cap of $3.5b, it trades at a substantial discount to its liquid NAV of $5.3b. Ackman’s recent underperformance is well-known and has been followed by many in the media, but he has, at least for now, ceased short-selling and holds 10 large and well known US stocks. The fund’s performance YTD in 2019 is over 30%, and yet the discount to NAV has not been erased.

Given that the fund is very well-known, and that this discount to NAV is also well-known, it is becoming a mystery why the discount remains. Reasons cited include the under-performance of 2015-2017, the high performance fee due to Ackman, and the fund’s PFIC structure which both limits demand for shares and increases the tax-reporting burden for most investors.

These aren’t good reasons why the fund should trade at a 34% discount to immediate liquidation value, however. The fund’s holdings and its allocation of those holdings are publicly known, and so one could construct a portfolio which very accurately hedges out nearly all risk associated with potential future under-performance or losses the fund may experience, while gaining a profit if and when the discount is erased. This is very close to a risk-less arbitrage opportunity that could be taken advantage of by large investors who come across it and who have no better options. I understand that large investment firms tend to be skeptical of cash laying on the ground, and they would prefer to simply hold constituents of the S&P 500 and great companies with “moats”, but this seems to be a very clear example of an unwillingness to divert from the crowd.

From what has been reported, it seems that many of PSH’s investors are willing to leave the fund at any cost which has and I imagine will continue to put downward pressure on the fund and so the discount to NAV may be stable or increasing in the short-term. Despite the fact that the trade may move against the arbitrageur for some time, I believe it presents opportunity, regardless of what happens in the next few years.

To further illuminate the illogic of PSH’s current price, we can think about the worst possible scenario. If PSH experienced a 66%+ loss in its portfolio, and if the discount to NAV remained, the market cap would drop to exactly $0, and the firm would have an NAV of around $1.8bn. Any further losses would eliminate the discount to NAV, since at that point the NAV would be less than the former discount we were looking to profit from. So for the market price to make any sense, PSH would have to experience a permanent loss of over 66%, which despite its poor recent performance has never happened.

The fact that the Pershing example is so public reminds me of the 3com/Palm example from the 90s which Nobel prize winning Richard Thaler described at length in this paper. In summary, holding company 3com had a position in Palm which was apparently worth significantly more than 3com’s market cap at the time. I imagine many investors were aware of the illogic but didn’t take advantage of it.

Another opportunity, albeit much less public, is a company called CBA Florida (CBAI). Previously focused on selling cord blood services, it sold almost all of its associated operating assets in mid 2018 for a purchase price of $15.5m. It currently has a market cap of around $9m versus equity of $14.5m, so clearly a tiny company which institutional investors cannot jump into (although there are a few small funds with significant ownership in the stock and on its board). Of its $15m in assets, $12m is in cash and $3m is cash held-in-escrow. With the high likelihood that no damages or liabilities will accrue from its sold business, it should receive that additional $3m in full and have, net of liabilities, $14m in cash, for a 55% premium to the current stock price. If something goes sour, then it would be around $11m in cash, for a 22% premium to the current stock price.

The company currently has no business obligations and has publicly stated that it plans to dole out much of, if not all of this cash in 2019. The primary risk is its current rate of cash burn, as it has some officers and administrators to pay while it waits around, but as of right now and since it has withdrawn its operations in full, it is only burning approx. $55,000 a quarter- as long as it keeps this rate low it will remain negligible relative to the NAV.

CBA Florida isn’t risk-less, but it is certainly an asymmetric bet in which it would be extremely difficult to not experience a reasonable profit. If things drag on or if the escrow deposit is lost, the CAGR from the investment could be lower than expected, but it is basically a liquidation situation which many investors aren’t willing or able to access.

I was happy to share the above two examples because the first one is well-known by many at this point and would require shorting to hedge the price risk of each security within Pershing’s fund, and I do not plan to act upon the second one given our current portfolio and list of options available to us right now. Generally, I also prefer not to invest in companies so small, illiquid, and trading on the OTC exchange- it would have to be cheaper to grab my attention.

To a true-believer of market efficiency, there could be some reasonable doubt as to CBAI given that the NAV isn’t a certainty and it would be understandable that a nano-cap could be mispriced. Pershing however, should be difficult to rationalize given its size and prominence in the investing community, as well as the fact that study after study shows such opportunities to be great bets with risk/reward potential far off the spectrum. I suppose it could be seen as just another anomaly, but these anomalies are much more common than an academic would expect and are what out-performers look for.