By Maj Soueidan, co-founder GeoInvesting
You probably noticed that I often use the term “Information Arbitrage” (InfoArb) to highlight free or easy money opportunities hidden in corners of the microcap universe that investors can overlook.
An information arbitrage exists when a disconnect between stock prices and available public information on a company is noticeable, and monetarily worth pursuing. Sometimes, the mispricing of microcaps can be substantial.
Some of my own team members criticize my use of the term “InfoArb” because they think I could lose some credibility from sophisticated investors who understand what “arbitrage” means in its most literal sense. In its purest form, a financial arbitrage refers to situations that can result in a relatively risk free profit.
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. In principle and in academic use, an arbitrage is risk-free;
For example, such a scenario can arise when a company’s stock price that trades in the U.S. via American Depository Receipts (ADRs) is priced at a discount or premium to its homeland traded stock price, taking into account fees and exchange rates (i.e. U.S. ADR vs China Ordinary shares). You could lock in the “arbitrage” by shorting the relatively higher price stock and going long the cheaper priced stock. Over time, the prices should converge.
There Is No Free Lunch, But Easy Money Does Exist
There may not be enough free lunch classic arbitrage scenarios in the stock market to feed your portfolio, but if you look hard enough you will find that stocks are on sale every day with multi-bagger or mega-bagger catalysts not noticeable to the naked eye. While I’ve suffered enough investment losses to know that InfoArb is not risk free arbitrage, it’s as close as you can get to easy money.
Keeping It Real
From the onset of my full-time investment career around 30 years ago, I made it a point to favor practical investment strategies over vague ones. That is not to say I avoid complicated opportunities if the payoff is attractive. But all things being equal, I am more interested in lining my pockets with easy profits than with building my ego at a fancy Wall Street pow wow with dueling stories of “reverse condor spread option tactics”.
This is why I like InfoArb so much: the concept allows any level of investor to buy cheap stocks with simple stories that are about to be discovered or seemingly complicated stories that are actually simple. An added benefit of this strategy is that at times you are dealing with an over 90% chance of success, and the moves in prices can be swift. This gives you less time exposure to the market than other types of investment strategies. For this reason, it’s even a great investment tool for traders. Frankly, I believe it’s the easiest way to make money in short periods of time. These chances are best found in the microcap space where the flow of information through the masses happens at a slower pace than in larger capitalized stocks.
Information Arbitrage Case Studies
Eight microcap and nanocap #CalltoAction Alerts we sent to GeoInvesting Premium Members over the last 10 years illustrate how InfoArb could have “showed you the Kwan”.
Three of these companies ended up being acquired for large premiums. In a future article, I will show you how InfoArb could have saved you some pain.
1. The Acquisition Discount
Companies that are in the process of consummating acquisitions will usually trade at a discount to where they would trade if current valuation multiples are applied to the combined financials, assuming the acquisition closes (or I some cases has already closed). The “acquisition discount” prices in the possibility that (1) the proposed acquisition may not close, (2) there will be execution risk or (3) there is overall uncertainty on what the sales and earnings will look like after the acquisition. From my experience, this discount can be as high as 10% to 20%.
Acquisitions that are accretive to earnings enable small microcap companies to gain market share and accelerate growth. If the microcap stock has a low outstanding share count and does not issue too many shares to complete the acquisition, I become very interested. This is especially true if a proven management team is leading the charge. On the heels of 26 acquisitions, Patrick Industries (NASDAQ:PATK) has been the best performing listed microcap stock since 2009, up over 44,000% from post-recession lows of $0.17 and up over 3700% since we alerted members that we were beginning to track shares in August of 2010 when the stock was trading at ~$2.00.
Unfortunately, we only captured a small part of this epic run during 2012. Trepidation by some investors towards buying microcap stocks that have an acquisition on the plate is a great way to experience quick returns.
GTT Communications (NYSE:GTT) and Gain Capital Holdings (NYSE:GCAP) are two stocks we wrote about and bought in 2013 that we believed would fill a valuation gap created by the stock market’s failure to reward shares with accretive acquisitions.
|Symbol||Industry||GeoBargain||Premium Member Alert Price||Target set by GeoTeam||Time to Target Range||Holding Period High Return||Source Link|
|Gtt Communications Inc. (NYSE:GTT)||Network Solutions||7/31/2013 – 9/19/2014||$4.30||$7.50 to $13.50||3 Months||211%
|Gain Capital Holdings Inc. (NYSE:GCAP)||Currency Trading Services||6/6/2013 – 8/12/2014||$5.30||$9.40 to $12.50||3 Months||175%||Article|
2. Changes in Poison Pill Terms
Staying with the theme of acquisitions, The Board of Directors of many public companies approve amendments commonly knows as poison pills to:
- Prevent a hostile takeover
- Prevent a takeover that does not maximize shareholder value
- Make sure management is compensated in the event of a takeover (Golden Parachutes)
Basically, poison pills can increase the hassle and expense to a potential acquirer (also referred to as the “Suitor”).
The InfoArb tactic here involves searching for companies that have put in a poison pill for the first time or changed the terms of an existing one already in place. That could mean that a takeover is imminent or that shares are so cheap that management with low stock ownership or disliked by its shareholder base is fearful of a hostile takeover.
|Symbol||Industry||GeoBargain||Premium Member Alert Price||Target set by GeoTeam||Acquisition Price||Time to Acquisition Event||Holding Period High Return||Source Link|
|Merrimac Industries Inc (AMEX:MRM)||Circuit Board Assembly||6/30/2009 – 12/24/2009||$7.70||$14.00 to $17.50||$16.00
|5 Months||107%||History of Research|
|(NASDAQ:MKTG)||SaaS Email Marketing||4/10/2013 – 1/2/2014||$6.42||To Be Acquired||$27.00||10 Months||320%||Original Article|
I could not believe the opportunity presented in these two cases. Out of the blue, Merrimac Industries (MRM – no longer public) issued an 8-K with no press release outlining management compensation in the event of a change in control.
“On December 10, 2009, the board of directors of Merrimac Industries, Inc. (the “Company”) approved a bonus for Mason N. Carter, the Chairman, President and Chief Executive Officer of the Company, in the event that the on-going process of investigating strategic alternatives for the company results in a sale of the Company or similar transaction. The bonus would be based on a percentage of the sale price of the Company and the estimated range of the bonus is $300,000 to $1,200,000.”
MRM was essentially telegraphing with near 100% certainty that the company was about to be gobbled up. Seven days later, MRM issued a press release stating that it agreed to be acquired for $16.00, a 37% premium to its then current share price of $11.50.
Investors punished Responsys (MKTG – no longer public) for what was a slight blip in a quarterly earnings report that sent shares tumbling over 33% to a low of $5.75 equating to an EV/S of < 2. The email marketing Software as a Service (SaaS) industry segment was experiencing tremendous M&A activity in 2013 and 2014. Public and private comps were being acquired at EV/S multiples of near 6 to 8. The Board of Directors quickly adopted a poison pill amendment. MKTG was eventually acquired at $27.00 or an EV/S ratio of 5, where we exited our position.
3. SEC Filing Analysis – Management Discussion
10Ks and 10Qs include a section called “Management Discussion & Analysis” (MD&A). This section typically contains boring verbiage beyond the obvious facts or beyond related press releases. The MD&A usually offers little introspective on future outlook. However, if you turn over enough rocks in the microcap space you can find verbiage in the MD&A that is not in related press releases.
A growth PLUS value selection, Golden Enterprises (GLDC – no longer public) released information in its Q2 2016 SEC filing that was omitted from the related press. The details in the filing indicated the declining/unexciting revenue performance that the Company experienced over the last several years was about to reverse. We noted the following passage:
“We do not expect to see a continuing trend of declining sales going forward. This year’s decrease in selling, general and administrative expenses was due to reduced fuel cost, reduction in cost associated with our fleet, and efficiencies from our ERP System. The efficiencies gained from the ERP system are expected to continue in the future.”
Our attempts to interview management were not successful. So I decided to call an activist shareholder in GLDC. He pointed me to GLDC’s Proxy filings, where I learned about a second information arbitrage opportunity hiding away:
“The Voting Committee will continue to vote the Company stock owned by SYB, Inc. (5,283,128 shares) and by the Martial Testamentary Trust (600,279 shares), respectively, until the SYB, Inc. Common Stock Trust and the Marital Testamentary Trust terminate. The Marital Testamentary Trust will terminate upon the death of Joann F. Bashinsky and the SYB, Inc. Common Stock Trust will terminate upon the earliest to occur of the following dates: (i) in the event the Company should be sold, five (5) years from the date of the sale of the Company, or (ii) December 31, 2020.”
I thought there was a good chance that once the Trust referenced in the above quote dissolved, that the Company could put itself up for sale. Even though this appeared to be a longer term catalyst, we told our subscriber base that we put some shares on just in case our timeline was off. We felt comfortable with this decision since we thought the stock would move higher based on fundamentals alone due to our first InfoArb finding.
|Symbol & Industry||Growth Value Proposition Identified||Premium Member Alert Price||Press Release Verbiage||(MD&A) Verbiage||Catalyst||Acquisition Price||Time To Acquisition||Holding Period High Return||Source Link|
|Golden Enterprises Inc. (NASDAQ:GLDC)
|April 4, 2016||$5.97||Mundane||Sales & EPS growth in the cards.||Reports strong numbers. Gets acquired for 71% premium||$12.00||3.5 months||101%||Case Study|
On April 7, 2016 the company reported strong Q3 results as telegraphed by the MG&A and on July 19, 2016, earlier than we expected, GLDC agreed to be acquired by Utz Quality Foods, Inc. for $12.00.
4. SEC Filing Analysis – Regulatory/Legal Risk
A key part of the research process includes understanding the risks and legal issues that could debunk a bullish investment thesis. However, investors sometimes fail to pose the opposite question. What would happen if some of these risk factors or legal issues get resolved? Lingering legal issues, especially with microcaps, can lead to significant depressed stock valuations at near bankruptcy levels. Companies you identify that you determine have a high probability of curing their legal problems can reward you quickly and handsomely.
De-risking or rebalancing of risk inflection point events are some of the easiest ways to experience quick multi-bagger returns. If you are willing to spend some money you can subscribe to services like PACER which track court cases tied to legal issues you may be following. Alternatively, if you’re bored you can attend court. But for many of you, these may be unrealistic options. The more practical alternative is to read earnings press releases to find some of these issues and then read SEC filings to see if management expands on them. That’s exactly what we did with Evans and Sutherland, (OTC:ESCC).
|Symbol & Industry||Premium Members Alert Price||PR Verbiage||(MD&A) Verbiage||Catalyst||Time to Target||Holding Period High Return||Link|
|Evans & Sutherland (OOTC:ESCC)
|$0.14||Touches upon past due pension liability||Pension Liability likely to get resolved||Liability gets resolved in April 2015 Stock goes over $1.00 shortly after.||2 months to low end price target of $0.40 met. 1 year 2 months to high end of $0.90 surpassed||~957%||Case Study|
I came across the stock in February 2014 during an earnings research skull session with my team. We noticed that the company generated healthy revenues, but was struggling to maintain profitability. The management commentary touched upon why its bottom line outlook was uncertain. ESCC was hindered by a past due pension liability, but management didn’t really elaborate too much beyond acknowledging that they were addressing the situation. That was enough to get my greed juices going.
Simple math showed that if this pension liability was removed from the company’s financial statements, it would be profitable to the tune of somewhere between 3 to 8 cents per quarter. The stock was trading at $0.14. So you guessed it, I went on to read a number of SEC filings and learned that this 30 year old, $32 million revenue run rate operation with a market cap of $1.5 million was a top 3 player in a small niche market. But more importantly, in the SEC filing, management gave a much deeper explanation of what was going on regarding the pension liability and the steps the company was taking to resolve it. We promptly published our first update about these findings here. With each future quarterly filing it became increasingly more and more evident that a resolution was imminent. It got to a point where one of the filings actually included what date the problem would likely be put to bed! We knew that a resolution would bring a few benefits:
- An improvement in the shareholder equity of the company which was negative at the time
- Shares should not be priced for bankruptcy
- Because ESCC would start to show profits, investors could start to apply typical valuation ratios to the shares. This would lead to ESCC showing up on more stock screens.
- Banks and customers would probably be more willing to deal with the company going forward.
On April 24, 2015 ESCC announced a settlement agreement with the pension regulatory authority. The stock is currently sitting at around $1.17 after hitting a high of $1.48. In the background, billionaire investor Peter Kellogg continues to aggressively add shares.
5. Conference Call Arbitrage
Live earnings conference calls and archived transcripts are an excellent tool to dig up info not fully discussed in related press releases. Here are three companies we let our followers know we were pouncing on after shares dropped due to misunderstood or unclear information in earnings press releases.
|Symbol||Industry||Pounce Price||Conference Call Arb||Shares drop %||Time to recover drop in price||Holding Period High Return||Source Link|
|Cpi Aerostructures Inc. (AMEX:CVU)||Aerospace/
|6.10||CC clarifies that weak quarter was the result of one time event.||~25%||Same day||169%||Conf Call notes|
|Supercom Ltd. – (NASDAQ:SPCB)||Software Security||7.20||Mgmt. reveals that a big contract is on the horizon. CEO comments he would buy stock on dip.||~20%||1 day||100%||Conf Call notes|
|Energy Focus Inc. (NASDAQ:EFOI)||LED Lighting||$5.78||CC transcript reveals bullish commentary not in quarterly earnings press release||15%||1 day||71%||Conf Call notes|
Conference call arbitrage is a strategy built for traders who want to pepper a dose of fundamental strategy with their technical trading methods. As I discussed in my presentation at the Traders4ACause conference in Vegas on October 8, 2016, traders are looking for an edge that gives them less market exposure risk as well as less business risk that longer-term investing can expose them to.
SPCB and CVU traded down on earnings press releases. The ensuing conference calls cleared up some confusion on items in the releases. This led to an immediate reversal in their sharp drop in prices. In the case of EFOI, an earnings conference call transcript available on Seeking Alpha was basically unreadable. We were able to hunt down a clean copy of the transcript for Premium Members which revealed the existence of some fairly strong commentary not in the company’s press release. The market eventually figured this out and sent the stock roaring to $29.20, well past where we locked in gains.
As successful as all three of these examples were in the short-term, longer-term investors still holding shares were left reeling in pain as all three companies have encountered growing pains.
The hard lesson learned for longer term investors is that an InfoArb strategy in the microcap space can turn against you if you stop performing research and/or hold your stock past the identified inflection point catalyst.
Even though an InfoArb strategy can lead to easy stock purchase decisions, that does not preclude the need for hard work and hours of research to identify potential positive catalysts. So make sure you develop an efficient research process that will enable you to find great opportunities before other investors. If you have an open mind, I suggest that you allocate some of your research efforts toward the microcap and nanocap universes. This is where a good amount of InfoArb scenarios will present themselves.
Stay tuned for part 2 of this article when I will discuss FIVE more places where hidden information can be found.
Part 2 will cover:
- Late SEC Financial Filing Notifications
- SEC filings Filed Before Press Release
- Annual Reports
- SEC Filing Analysis – Use Of Proceeds