The Hindu Business Line : Profit from arbitrage in stocks

THE Web site riskglossary.com defines arbitrage as free lunch — a transaction that enables you to make profits without taking risk. It is rare to find potential for arbitrage transactions in an efficient market. Only once in a while is the market benevolent enough to throw up such a situation. The Indian stock market now has on offer a number of such possibilities, mainly due to the increase in merger and acquisition deals. Investors can generate returns from these transactions that are far better than those offered by the money market.

Ten deals: You would scarcely believe the traded stock prices of Siemens and Siemens VDO. Siemens VDO is set to merge with Siemens and the swap ratio set is 1:12. Ideally, Siemens VDO should trade at a price that is one-twelfth that of Siemens. Siemens VDO, however, is trading at a discount of 8 per cent to that price.

Similar price patterns are evident in stocks involving mergers such as IOC-IBP, BPCL-Kochi Refineries, TCS-Tata Infotech and HLL-Vashisti Detergents.

These five deals are significant in that investors can lock into the gains. This is because the five stocks — Siemens, IOC, BPCL, TCS and HLL — are traded in the derivatives segment. Investors can short the futures contracts of these stocks and buy the stocks of the companies that are to be merged. By doing so, investors will lock into the arbitrage profits, irrespective of how the stock prices move.

The average gain could be 4-5 per cent, depending on the price at which the transactions are put through. The closing prices of these stocks indicate a yield of 6.1 per cent before costs. Siemens, IOC and BPCL offered yields of over 7 per cent.

Only retail investors stand a chance of profiting from these transactions. This is because volumes in the acquired companies are low. For instance, in Siemens VDO, traded volumes on an average are about 500 shares. In IBP, volumes were about 4,000 shares. While that would not interest the institutional investor, it will offer the retail investor significant opportunities for profit.

There are five other deals where a similar opportunity is evident. Gains will, however, accrue only if the stock price of the acquiring companies stays above its present level. These are McLeod Russel-Williamson Tea, Gujarat NRE Coke-FCGL Industries, Shriram Transport-Shriram Investments, Indian Rayon-Birla Global-Indo Gulf, Colour Chem-Vanavil Dyes. In particular, stocks of Williamson Tea, FCGL Industries and Shriram Investments offer returns in excess of 7 per cent. If investors can get half the promised returns, it would still beat money market returns handsomely.

Spotting pricing gaps: Investors expect the market to be efficient. If a stock is trading at a particular price, it factors in all the possibilities for gains. There is no free lunch. Investors are, therefore, reluctant to go after such securities.

While this may be true for the market, in a few individual cases such gaps in pricing may exist and investors should capitalise on such opportunities. Investor apathy often allows such opportunities to continue for a number of years.

Sample the discount at which Morgan Stanley Growth Fund and Tata Investment Corporation traded for a decade. It has taken 10 years and a sustained bull market for the discount to reduce significantly. Even now, the discount levels in these two securities are significant.

Or consider Benchmark Split Capital Fund. Option A of this fund is trading at a discount of nearly 18 per cent to its net asset value. It offers investors an unprecedented opportunity to lock into yields of 4.6 per cent per annum for the next 31 months. It also offers the potential to earn additional returns, should Nifty keep rising. This close-end fund will be redeemed in August 2008 and the discount levels may decline only in early 2008. If you keep your eyes open, you would probably spot such opportunities in the valuation difference in companies that are certain to be merged in the years ahead. For instance, valuation differences persist between associate banks and State Bank of India, or IPCL and Reliance, or Shriram Overseas and Shriram Transport. When the demerged ventures of Reliance get themselves listed, you might again spot such opportunities.

When you do spot such opportunities, go after them. The yield pick-up would be good for your portfolio. After ten years of such hunting, you may have even beaten many professional investors without any significant addition to risk taken.

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