It's the New Year, and people are looking back, looking forward, making predictions and picking the best stocks for 2008. So, in this month's column, I'm going to talk about... short-term arbitrage. Yes, I said short-term arbitrage. I promise to tell you what that is soon.

Why not make predictions and pick stocks for 2008? Mostly because I think we're seeing the continuation of trends that we've already talked about in past columns.

For example, I see the financials continuing their downtrend. At the very beginning of this series, I argued that everything comes in cycles. And financials definitely saw the top of the cycle in 2007. After several years of growth and record profits, Wall Street finally had to face the fact that it had gone too far, and today we see commercial banks and investment banks near multi-year lows in their stock. Those who invested in financial instruments - “ funds, insurance companies, etc. - “ were all taken down at the same time. For the next few quarters, I see no reason why the downtrend shouldn't continue. If anything, a weakened economy will help push things along. That being said, I continue to believe there are great long-term opportunities in this sector. As mentioned in last month's article, I still see US Bancorp as a good value, and Citibank as a solid buy sometime over the next 3-9 months.

In past articles, we've also talked about the economy weakening. Financials and real estate have already made a major contribution to that, but rising prices in everything from commodities to the staples and limited credit are going to force the consumer to pull back. Next come layoffs, particularly in the financial sector.

Those trends will continue to depress other sectors, especially retail and real estate. The retail case is fairly obvious; with the consumer in trouble, retailers are seeing their worst season in years. We haven't discussed real estate in this column, but I've been a real estate bear for a long time - and I continue to be. Some think that the market might bottom this year. I think the bottom will be several years from now. Consider this - “ prices in New York and LA haven't fallen as much as in Florida, San Diego, Las Vegas and Phoenix. With Wall Street facing major layoffs and bonus cuts, and the writer's strike in LA, price drops in NY and LA are just around the corner.

Many continue to expect infrastructure, oil, agriculture and international to be the stock engines well into 2008. They probably still have some room in them, but I would be cautious, particularly in this environment. Stocks in these sectors have had a big run, which makes them especially vulnerable when uncertainty hits. I also think they are due for a correction sometime over the next year. Problem is, I can't tell you exactly when. That's why I would be cautious.

Short-Term Arbitrage

So why talk about merger arbitrage? One interesting thing about arbitrage is that it is only somewhat market dependent. In brief, short-term arbitrage opportunities arise when a transaction is announced, and a differential exists between the final transaction price and the current stock price. For example, let's say a stock trades at $25. The company agrees to be acquired for $33 in six to nine months time, and immediately following the announcement, the stock jumps to the $31-32 range. What most people don't realize is that the stock will then drop to, let's say $30. So if you buy at $30, after the announcement of the transaction, and hold until close, you can make $3 on the $30 investment, or 10%, in the six to nine month time frame. If you really like to gamble, you can leverage the investment and make an even higher return.

Case Study: Lyondell Chemical

Let's take a look at a real world example. Late last March, I bought shares of Lyondell Chemical at $31. As you can tell by it's name, it's a chemical company, but it also owned a refinery. The company had taken on a lot of debt to pay for the refinery, but the refinery cash flow was paying off the debt. In other words, the company had bought a refinery that was paying for itself. By my calculation, the reduction in debt alone would increase the stock price by $3 a year or so (The decrease in interest payments would increase earnings. Multiply that amount by its PE, and that was worth about $3). Add a dividend and I expected a relatively safe 10-13% return based on debt reduction alone.

Then Lyondell became a takeover target. Industrialist Len Blavatnik had made a bid for Huntsman, another chemical company, but had lost out to Apollo Management's Hexion Specialty Chemicals. It had also tried to buy GE's plastics division, but failed to close that deal as well. Many believed that Blavatnik would make a bid for Lyondell. By early July, Lyondell stock had risen to about $40 a share. I figured I would ride out the merger interest.

Then in mid-July, Basell, a Netherlands company controlled by Blavatnik, announced that it would acquire Lyondell for $48 a share. Lyondell stock jumped to $47.25.

Just by chance, I was researching arbitrage at the time. I decided to hold rather than sell, and something interesting started to happen. The stock price fell. When you think about it, this makes sense. A holder of Lyondell will hardly wait several months to make the $0.75 difference between the stock price of $47.25 and the expected closing price of $48 several months later.

By mid-August, Lyondell had fallen to $44.719. Take $48, and divide by $44.719, and that's a 7.3% return in let's say, six months. I said, I'll take it, and bought. The next day, in the midst of all the subprime craziness, the stock had fallen to $42.74. Assuming that Lyondell closed at $48, that would be a 12.2 percent return in a half year. I bought more.

To give you the full story, it wasn't all about the numbers. The key assumption is that the merger would close at the expected price. Here's several reasons why this was likely to happen:

Strategic Merger. The first half of 2007 was full of record-breaking deals. With the subprime mess and the credit crunch, the second half of 2007 was full of several of those deals falling apart. Most of these deals were hedge fund or private equity transactions. The buyer was a financial company, betting on financing and the target company's ability to generate cash. When credit became a problem, or when the target company's financial expectations changed, the deals started to unravel.

In contrast, the Basell-Lyondell deal is a strategic merger. Both players are chemical companies, and the Basell saw an opportunity to create a stronger franchise. In tougher times, a strategic buyer is less likely to back out of a deal than a financial player.

A Cash Deal. I looked at several mergers before putting money into Lyondell. Many other deals were a combination of stock and cash. This made analyzing the deals much more complicated, because the final price would be dependent on the stock price of the acquiring company and/or the target company at closing. And in many situations, it's just too hard to figure out whether the cash and stock deals are a good value for the investor. Upon closing, Basell was expected to pay Lyondell shareholders $48 per share in cash.

No Issues in the Seller's Fundamentals. I didn't see any major problems in Lyondell's fundamentals (revenues, margins, etc.). Of course, you can't predict everything, but the chemical industry was in good shape and there were no problem signs on the horizon.

Compare that to the much publicized case of Sallie Mae. J.C. Flowers had made a $60 per share offer. Then the buyout market turned and legislation out of Washington was expected to cut subsidies to student loan providers like Sallie Mae. Flowers used the legislation to invoke the MAC clause and withdrew from the deal, despite a $900 million breakup fee. Sallie Mae is now suing J.C. Flowers for the $900 million fee, but continuing problems in the loan market may very well support Flower's point of view.

In addition, it's always good check two things in a merger:

First, Buyer Financing. You always want to check, as much as possible, the financing situation. If financing means going out and raising more money from investors, this could be a problem, especially if market conditions change. Last year, several hedge funds and banks assumed that they would be able to raise money based on liberal terms. The market turned, credit got tight, and it suddenly became much harder to raise money.

To be fair, it may be difficult to assess this, because the retail investor is the last to know. Still, if you follow the news, you will often hear of potential trouble or financing issues in the news.

In Lyondell's case, despite a market with several rumors about problems with other deals, there was no news about threats to the Basell acquisition.

Second, Check the MAC Clause. The MAC clause, or material adverse condition clause, states that the buyer can exit the deal if the target company has undergone a material adverse change. Usually, changes in general economic conditions are not considered a material adverse change. A MAC clause doesn't guarantee a closing by any means, but it helps to check the merger agreement to make sure there aren't any weaknesses or loopholes in the MAC clause. The details can be found in Form 14A, and usually has a title mentioning the merger agreement.

In Lyondell's case, there was a standard MAC clause.

In mid-December, the transaction closed at the expected $48 closing price. Here's a chart of history:

The Lessons: Why This Works

Overall, I'm happy with the investment. Short-term arbitrage can work and make you some money. I think, for a 10% or so return in 4-5 months, that's not too shabby.

The reason that this kind of arbitrage works is because of time. In business school and in economics, they tell you that these short-term arbitrage can't exist for very long because arbitrageurs will come in and close any pricing gaps. They also tell you that the market has perfect information, and that the price reflects all the information about a stock in the market. So even the hapless MBA grad walks away thinking that there's something wrong, that opportunities like this shouldn't exist.

Somewhere between the theory and the application, what they forget to talk about are three things that make this work:

• Time
• Different players in the markets have different preferences and expectations
• Players are affected by other factors, such as short term cash needs

Time. A market is made up of many types of players. There are fast money people, who trade, and value players who are willing to wait. So here's the first factor, time. As soon as the merger is announced and the stock jumps to near the merger price, the fast money sells. They're thinking, "it's gonna take six months to make a small return, I should take my profits and put it to work somewhere else." They're not wrong. They spend their days looking for places to put money, and if they can get that return elsewhere, they should. So the stock drops.

Different Preferences Among Investors. Different players also have different return expectations. For example, hedge funds have been walking around for the last few years saying that they'll get extraordinary returns - “ as much as 40% in a year. If that's the case, 10% or so return in 4-6 months isn't helping enough. If they hold Lyondell shares at the time of the merger announcement, they're going to sell and go hunting elsewhere. Now little ol' me, I think that's a bit unreal. Very, very few people can come anywhere close to 40% on any consistent basis. The S&P is, on average, in the single digits. Buffet, considered the best investor of our day, manages to return nearly 25% on a consistent basis. In my book, 15% consistently is very, very good. So for me, 10% in 4-6 months is just great.

Market Conditions. The last factor that has helped things along is market conditions. Lyondell stock dropped to $42 in August, 2007. At that time, the first major subprime scare was hitting the street. Stocks were dropping, positions were being liquidated or covered. I think this helped drive Lyondell stock down, because many players needed to take money and put it elsewhere.

Other Considerations

So, the stuff can work, and if we look at this situation, there are a couple more things I could also have done to juice my returns. I could have sold right after the merger, and bought more when the stock dipped. I could also have made a much bigger return by leveraging my investment.

Lest you think everything is all roses, you should also know that this is not a riskless situation. I spent a lot of time trying to figure out if there was something I was missing, if there was something that I missed. Keep in mind that if the merger didn't happen, the stock would drop well below my purchase price, and I wouldn't be able to react fast enough to sell it. And once the deal is off, it's very unlikely that the stock will come back above my purchase price.

Last summer, I recommended buying Altria. That, in my opinion, is a far safer investment. That's because I believe I'm buying Altria at a price below it's intrinsic value. In the case of short-term arbitrage, I'm buying below expected value, but above the business's intrinsic value if no merger occurs. If you are new to this, I would say, play with money that you can lose, and if your risk appetite doesn't venture this far, stick with lower risk stocks like Altria.

So in sum, short-term merger arbitrage can make you some money if you can identify a good situation. In my opinion, it's not without risk, but it can be low risk, and many people invest in far riskier stocks or situations every day.

Buffett and Short-Term Arbitrage

Just so you don't think that short-term arbitrage is a creation of Ming's mad brain while sitting in front of the computer too long, I point you to a barely noticed event this summer. On August 15, 2007, the Wall Street Journal Online (yes, this didn't even make the print version) announced, "Buffett discloses Small Stake in Dow Jones." The article said, "Berkshire Hathaway Inc. bought a small stake in Dow Jones & Co. in the second quarter, during Rupert Murdoch's bid to win ownership of the company, publisher of The Wall Street Journal, from its controlling family."

That "small stake" was 2.78 million Dow Jones shares valued at $159.8 million, or about 3% of the company. The article went on to say, "Berkshire's stake comes as a surprise because Berkshire's chairman, Omaha billionaire Warren Buffett, has publicly voiced concerns in recent years about the newspaper publishing industry... "

That might be true if you think Buffett is investing for the long-term. I think Buffett was just engaging in some short-term merger arbitrage.

Buffett is an old hand with short-term arbitrage. In Buffetology: The Previously Unexplained Techniques That Have Made Warren Buffet the World's Most Famous Investor by Mary Buffett (Warren's daughter) and David Clark, the authors write:

"... Warren prefers to commit capital to investment for the long term, but when no opportunity for long-term investment presents itself, he has found that arbitrage, or workout, opportunities offer him a vastly more profitable venue for utilizing cash assets than other short-term investments."

Interesting, huh? Now consider his record with arbitrage, as described by the authors:

"In fact, over the thirty-odd years that Warren has been actively investing in these types of arbitrage situations, he estimates that his average annual pretax rate of return has been in the neighborhood of 25%... in the early days of the Buffett Partnership, up to 40% of the total partnership funds in any given year may have been invested in arbitrage, or workout situations. And in dark years like 1962, when the whole market was headed south, it was the profits from workouts that saved the day. They allowed the partnership to be up 13.9% compared to the Dow's miserable performance of being down 7.6%. (However, the Buffett Partnership's investments in normal operations actually lost money in 1962. It was the arbitrage / workout profits that turned a disaster into the stuff financial legends are made of."

Even more interesting, isn't it. The authors describe arbitrage as critical, and yet, in this 320-page book, there are only six pages on the subject.

For Those Who Want To Play: Huntsman

Have I piqued your curiosity? If so, I thought I'd take a look at another arbitrage opportunity, Huntsman Corp. I own shares of Huntsman, and may buy more. Again, if you are new to this and want to play, toss a little bit at it, or toss money that you can afford to lose.

So you'll remember that Len Blavatnik, the buyer of Lyondell, made a bid for Huntsman Corp., the chemicals company. Last summer, he offered $25.25 a share for Huntsman. Apollo Management's Hexion Specialty Chemicals stepped in and offered $28. After Blavatnik's Basell failed to raise their offer, Huntsman agreed to Hexion's offer.

Like the Basell-Lyondell merger, there's a lot of things to like about this transaction. First, it's a strategic marriage. Combined, the two will be one of the largest chemical companies in the world. Second, it's a cash deal, and holders of Huntsman stock will receive $28 per share. If the deal is not consummated by April 5th, 2008, Hexion will pay interest at a rate of 8% per annum. Three, I didn't see major problems for the industry or for Huntsman. Financing didn't seem to be a problem, and there was a standard MAC clause in the merger agreement.

Unlike the Lyondell merger, the Huntsman deal had a particularly interesting twist. The Huntsmans, who already control 24% of the stock through several investment vehicles, purchased additional shares of Huntsman Corp. in September and November.

Below is a chart of Huntsman's stock. You'll see that right after the Basell bid, Huntsman stock shot up to just under $25. Then, when Hexion purchased the company, the stock shot up again to under $28. And then the stock started falling, hitting the $23 range in mid-August. That's when Jon Huntsman Sr., Chairman, and his eldest son, Peter, currently CEO, President and Director, purchased 637,700 shares for $15.4 million at prices from $23.25 to $24.50. Then in late November, Jon Huntsman bought another 25,000 shares for $23.85, and Peter Huntsman bought 20,000 shares for $24.41 to $24.45 each. I bought around the same time for $24.31 to $24.75 (and oh, yeah, I bought a lot fewer shares).

Hexion has until July to close the deal, and so, I believe that the market is discounting the time value of money. The stockholders have approved the merger. That leaves the regulatory issues, which I believe can be negotiated. For example, if a government objects to some part of the merger, Hexion could change the combination by selling off assets that would prevent the transaction's closing. A reasonable assumption is that if there were a regulatory issue that was hard to resolve, the Huntsmans would not have purchased additional shares.

It seems that Huntsman stock is taking another dip, and to be honest, I may very well take another nibble.

Happy New Year and happy investing. Until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.