A Poor Man's Arbitrage
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In discount Direct Stock Purchase Plan (DSPP) investing, one advanced technique investors can utilize to achieve profits, is investing in a DSPP with optional purchase discounts in order to exploit the difference in share price between the purchase discount and the current market price. For example, Pembina Pipeline (NYSE: PBA), an energy transfer company operating in Canada, with a mediocre margin of 7.17%, but a manageable beta of 0.68, offers an optional purchase discount of 5%. Investing in companies like PBA, although perhaps a subpar example in its sub sector, may in fact prove useful in achieving a type of arbitrage more readily accessible to retail investors.
So, let's look at another company offering a discount purchase option. The Toronto-Dominion Bank (NYSE: TD) offers a 0-5% discount on direct purchases. TD Bank is a Canadian bank, which largely avoided the sub-prime mortgage crisis so prevalent just a few years ago in the U.S. It currently sports a 3.7% dividend, but like most financial institutions maintains a roughly 1:1 ratio of total debt to total assets, which is more or less expected in its sector, so no problem there. However, TD is in relatively good financial shape compared to its American counterparts and was in fact able to acquire U.S.-based Commerce Bank in 2007 due to favorable Canadian economic factors, such a good currency exchange rate and better domestic economy, which had not been nearly as adversely affected by the global financial meltdown of 2008-2009.
Third, we'll examine Marathon Oil (NYSE: MRO). While, MRO is not one of the leaders among integrated oil and natural gas companies, it nonetheless offers a 0-5% direct purchase discount. That being said, although MRO is still an emerging player in the energy sector, it sports a healthy 11.85% margin. Also, its total debt is less than half of its total assets. However, it possesses a 1.5 beta, which may too risky to perform a poor man's arbitrage (see below-written explanation) as wild swings in the share price, may negate any potential short-term capital gains.
Therefore, in order to perform the (above-mentioned) type of arbitrage, an investor would purchase, typically a large amount of shares, wait until settlement, and then quickly sell their recently acquired lot and pocket the difference between the current market price and the discounted 5% purchase price. Making money on this kind of spread has been referred, by many DSPP investors as a "Poor Man's Arbitrage (search keyword: poor)."
In terms of risk to retail investors, the main danger with this investment strategy is if the stock loses more than 5% in value, any (potential) profits would be negated. Perhaps an easy way to mitigate this risk is purchase a stock with a low beta and avoid buying around earnings calls. By doing so, investors seeking arbitrage can help mitigate potential wild swings in the overall share price.
While this kind of investment strategy is not without risk and despite investors despite are likely to profit from it, I think the poor man's arbitrage should be avoided. This is because within DSPP plans with discounted optional purchases, should the company offering the plan observe unusually high volume in the stock, it will either end the DSPP or suspend it indefinitely. Therefore, arbitrage by even small players will often ruin opportunities for the long-term "buy" and "hold" investor which is both unfortunate and completely avoidable by making well-reasoned, ethical (investing) decisions.
Also, another aspect to keep in mind is when working with smaller amounts of shares, commissions, fees, and (short-term) capital gains taxes can eat away profits. In this way, the poor man's arbitrage works against the small "Mom and "Pop" investor seeking long-term capital appreciation with a focus on dividends. As such, it is abusive to the long-term investor, as likewise is the case of professional and institutional arbitrage.
As the senior investor Lou Mannheim remarked to Bud Fox, in Wall Street, "Man looks in the abyss, there's nothing staring back at him. At that moment, man finds his character. And that is what keeps him out of the abyss." I think as is in the film, short-term gain often leads to long-term market pain. Therefore, value investors should act ethically and make sound decisions within the broader (retail) investor community. By doing so, we establish the kind of good will, which is so rare in today's market.
This is just one investing technique! There are even more. While, no single technique or strategy is a sure thing, each one has its advantages and disadvantages and must be carefully weighed prior and during investment. But some investment decisions are sounder than others. By examining each carefully, you'll go a long way toward improving your investing skills and learning how to separate out the most attractive investment strategies, arbitrage, or otherwise, from the rest.
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This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.