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The arbitrage mindset

One skill that  I feel that it’s important to develop in order to become a great investor is what I call the arbitrage mindset.

The definition of “arbitrage” according to Merriam-Webster is:

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“The nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies.”

The traditional example is an arbitrage between the price of gold in New York and London.  (For this example, we will ignore commissions, fees and exchange rates.) Say gold is trading at $1,275 per ounce in New York and $1,280 in London.  In that case, you could buy 5 ounces of gold in New York for a total price of $6,375 and simultaneously sell the 5 ounces in London for proceeds of $6,400 netting a profit of $25. The trades in this case are riskless, if done simultaneously, as you have no chance of losing money.

When you possess the arbitrage mindset, as you go through your day, your mind instinctively detects arbitrage relationships in normal everyday situations. I came across one such situation this morning when an advertising circular fell out when I opened this Saturday’s Wall Street Journal:

I am a coffee drinker and have an affinity for Dunkin’ Donuts coffee. The advertisement stated that for $10 you could get a gift card for 6 large coffees. With 8.875% sales tax the total outlay for the gift card is $10.88. A large coffee in New York City costs $3.04 including tax. Multiply this by 6 which equals $18.24 which equals the intrinsic value of the card. If I pay $10.88 that means I am getting a 40.4% discount to intrinsic value.  But I actually get medium coffees which are $2.54 including tax which implies an intrinsic value of $15.24. So the discount for me is 28.6% which is still extremely attractive.  Where else can I earn a return of 28.6% in 6 days on my money?

Back in 1999, when I taught my class – Applied Value Investing – at Columbia Business School, I handed out an article that I cut out from the New York Times to demonstrate the arbitrage mindset.  The story discussed a crisis which occurred in May of that year in the town of Great Cape Girardeau located in southeastern Missouri:

This story also illustrates market efficiency in action as the article states, “In the first few hours, local people brought in more pennies than the bank knew what to do with.” Evidently, a risk-free 10% return was not lost on the local populous.

Another story of the arbitrage mindset is about a man who saw an opportunity to accumulate a lot of frequent flier miles at a great price. David Phillips, a civil engineer at UC-Davis was in his local supermarket when he saw a promotion on a Healthy Choice frozen entree. It said that he could earn 500 frequent flier miles for every 10 UPC codes he sent to the company by December 31st of that year. But there was another nuance to the promotion – if it was mailed by June 1st, it was double – 1,000 frequent flier miles for every 10 labels. He did his research and found that the least expensive Healthy Choice product he could buy was pudding cups for 25 cents each. He wound up buying 60 cases for a total of 12,150 pudding cups which would translate to over 1.2 million frequent flier miles.

There was one problem though – he needed to remove the UPC codes from 12,150 pudding cups.  But he had an idea. He went to a local food bank and offered to donate the pudding if the people would assist him with removing the labels. Since the total cost of the pudding was $3,037, he was able to take a tax write-off of $815. But it gets even better. Because he surpassed the million mile mark on American Airlines, he was able to get Aadvantage Gold status for life, entitling him to a special reservation number, priority boarding, and free upgrades.

Yet another article I handed out in class was from the New York Post in 2005 which discussed a 60-year-old British born international arms dealer named Christian Cranmer. Cranmer actually trafficked in historic firearms and in addition to selling antique firearms, he also rented his inventory out as movie props and provided guns used in movies such as Saving Private Ryan and Band of Brothers.

In 2003, he struck a deal with the Nepalese military to purchase 430 tons of antique war materiel for $5 million. The weapons cache included over 50,000 rifles, some dating back to the early 19th century including rifles used in the Zulu Wars in South Africa, Enfield rifles made by the British East India Company in the 1840s and 146 bronze cannons from the Napoleonic period. In the article, it quotes Cranmer as saying, “We paid $5 million and we’ll make $25 million back, even if we have to wait 10 years.”

If we do the calculations, that implies a return of 17.5% per annum. For comparison, the S&P 500 for 10 years ending in 2013 was 7.3% per annum. Now keep in mind, this return was not riskless.

Investing is, in essence, arbitraging the current stock price vs. your estimate of future value which we discuss at length in our book Pitch the Perfect Investment in chapter 8: How to Add Value Through Research. In order to be successful, you must have a variant perception versus consensus expectation concerning the intrinsic value  and/or the time horizon as we show in Figure 8.15 on page 291 of the book:

The key takeaway is that it is critical to cultivate the arbitrage mindset in order to become a world class investor.