Lesson 5 of 7
In Progress

Assuming more risk in markets you know well can yield even more reward potential.

Team-Carepital August 18, 2020

As a kid, Warren Buffett would buy a 25-cent six-pack of Coca Cola from his grandfather’s store. He would then sell individual bottles on to his pals for a nickel each. There was certainly a risk involved: if the neighborhood kids weren’t thirsty that day, he’d have extra bottles on his hands that he couldn’t move. But if he had a good day, he would earn 20 percent on every six-pack.

The key message here is: Assuming more risk in markets you know well can yield even more reward potential. 

Buffett didn’t know it, but with the 25-cent Coca Cola deal, he’d done his first arbitrage. He was capitalizing on the price difference for one product – his Coca Cola – in two different markets – the store, and the neighborhood kids.

Arbitrage is a way to bet on what you think a company will be worth in the near future. Returns on arbitrage bets can be very attractive. But to get it right, you have to know the businesses, and their respective markets, intimately.

When that product is a piece of a company, this is called merger arbitrage. “Merger arbs” were one of Buffett’s specialties during his years as an early investor. He would buy stock in a company at one price, betting that it would be worth more once it merged with another company.

Returns on merger arbs may be enticing, but the risk can be great. That’s why arbitrage is usually tricky for the average investor. Unless the deal is in your specialized field and you’ve studied it inside and out, it’s probably best to leave it alone.

But experienced investors who don’t want to mess with merger arbs can also get their control fix with what Buffett aptly referred to as Controls. That’s when you buy a large enough piece of a company listed on the public stock exchange that you have the right to influence how it’s run.

As you might imagine, this type of deal can lead to stressful confrontations between company owners and new board members who may demand drastic operational changes. Buffett was vilified for these deals early in his career; he thought he was saving a company by removing the inefficiencies.

But as he matured, Buffett stopped getting involved in Controls, which could turn out to be messy and uncomfortable with layoffs or firings. His core investment principles have never changed, though. In the next chapter, we’ll learn why the steady-hand approach has been key to his fabulous investment success.