List of topics discussed in Tuesday’s class:
- Graham, Buffett, and Rubin suggested as role models for learning risk arb and the fermat/pascal way of probabilistic thinking.
- Case on Arcata Corporation from the Buffett letters was discussed at length to illustrate the idea behind risk arb
- Risk arb defined, Buffett’s four questions on risk arb deal analysis (probability of deal going thru, time to consummation, chances of icing on the cake, and worst case scenario)
- Graham’s framework on special situations from the appendix of the 3rd edition of Security Analysis, Walter Schloss on that appendix, and how my own career was deeply influenced by it.
- Robert Rubin’s philosophy on risk arb (students were asked to do substantial reading on Rubin prior to class), Graham-Newman’s arbitrage results over a long time, Buffett’s own results in the field.
- Extended discussion of the the GE Shipping spinoff deal, the twists and turns in that deal
- Discussion of some old deals from my experience involving bailouts, mutual fund arbitrage, creating cheap shares in schemes of arrangements, tender offers, buybacks, going-private transactions, merger arb, dividend capture, and recapitalizations.
- Fermat/Pascal system of thinking, the necessity of developing an expected value frame of mind (Fermat/Pascal letters can be seen from here.
- Rubin’s four principles of decision-making – the uncertainty principle, probabilistic thinking, decisions and actions being different (includes the ideas of preserving optionality and sometimes having to choose the least worst option), and the importance of process over outcomes.
- Process vs. Outcome- bad process will inevitably produce bad long term outcomes, but bad short-term outcomes do not necessarily imply a bad process, importance of luck in success.
- Frequency-Magnitude framework of expected value, how the world focuses on frequencies and not magnitudes and expected values, the jellybean experiment, how people give up an idea because they think its too tough without thinking thru the consequences of success, how long term-success almost never comes from the first idea, how conviction in oneself and cumulative learning produce good long-term outcomes even though they are improbable (you only have to get rich once), the venture cap model (low chance of success, high magnitude of success in a few cases), how someone can be wrong most of the time, and be right just a few times (Taleb’s bleed strategy).
- Preserving optionality – the deep simplicity behind black-scholes – options have value even when they are out-of-the-money because of time and volatility, the more the volatility, the more the value of the option, the importance of not making a decision i.e. deferring it, particularly in a dynamic situation, allowing new information to come in which changes the odds, Graham’s idea of never converting a convertible, how risk arb teaches the benefits of keeping options open till the last possible moment (“stuff happens”), we will cross the bridge when we come to it.
- Contrary viewpoint – when to burn bridges, when to close options and make decisions, how often big decisions in life often involve burning bridges, while generally the preserving optionality model is very useful, particularly in investing.
- Probability Blindness, how people make big mistakes when they estimate probabilities, denominator blindness (an example of anchoring bias), the monty hall problem, believing that trends are destiny, wrong perceptions of risk because some bad event has not happened for a long time (people assume its become safe when the exact opposite is true e.g. some earthquake-prone areas which have not experienced an earthquake for a long time), conjunction fallacy, mistakes in interpreting causal chains (a chain cannot be stronger than its weakest link)
- Why is risk arb fun apart from the money? Forces you to think rationally using expected value framework which is dynamic requiring frequent calibration of thinking in response to new information and new interpretation of old information, forces you to think about
opportunity cost, requires multi-disciplinary thinking (e.g. probability, psychology particularly game theory, law particularly corporate and securities law, and finance), and of course the availability of un-co-related to market opportunities arising out of corporate actions, giving the arbitrageur plenty of very interesting things to do…
- How the expected value framework, so well-taught by practicing risk arbitrage, can also be be used in regular straight value investing, Buffett’s case on investing in Wells Fargo, how he estimated worst case scenario and exploited the perception-reality gap in the