While all investment goes back to the same purpose of putting in cash now to receive more cash at a later date, the activities of this fund can be categorized into three different investment strategies.
Undervalued Common Stocks
The use of the term undervalued stocks has gone misinterpreted for many decades as a synonym for companies having a low price-to-earnings ratio or low price-to-book value. More confusing has been the public’s desire to categorize stocks between growth and value. While this misinterpretation is understandable, it is, for all intents and purposes, completely wrong. To quote the world’s most successful investor Warren Buffett, “all investing is value investing”, for what is the purpose of investing in something unless you are getting value for your money.
Our goal with common stocks then is to estimate how much cash a business is going to earn, and then purchase their stock at a price that yields a favorable return. If a company can be expected to earn $30 per share over the coming years and their stock can be purchased at $100 per share, an investor would receive a very adequate 30% rate of return.
The goal of an investor is to answer 3 main questions as it relates to common stocks:
How much money is this company going to pay me?
When do I expect to get paid by this company?
How sure am I that this company is going to pay me?
Finding the answer to these questions involves a substantial analysis of both quantitative and qualitative factors. Performing this analysis is one of the main purposes of this fund.
Similar to common stocks, the purpose of investing in bonds is to receive enough value from the income of the bond so it produces an adequate rate of return. While the market for bonds is much larger than the market for stocks, common stocks almost always represent a better investment.
However, there are occasional instances, usually during times of panic, when certain issues of bonds become extremely mispriced. The use of the term “mispriced” here is used to describe bonds which yield extremely high returns but whose issuer shows no sign of defaulting.
As an example, suppose a municipality in southern California issues a bond to build a new highway. At the time of issuance the bond comes with a 6% coupon attached, or $60 (bonds are mostly issued in $1,000 increments). After a panic inducing event occurs, perhaps an earthquake in an area close by, the price of the bond falls from $1,000 to $300 resulting in the yield going from 6% to 20%.
Now, while all other similar bonds are yielding a mere 6% we have purchased our bond at a price to yield 20%. Because this earthquake was not strong enough to cause damage to our bond-issuing municipality, and the bond’s drop in price was based on fear rather than rationale, it became “mispriced”, presenting a wonderful opportunity for the observant investor.
Arbitrage originally pertained to the process of purchasing and selling a security in two different places at the same time. If 1,000 bushels of wheat was selling for $2,500 in the European commodities market and for $2,550 in the American commodities market, an arbitraer would purchase the 1,000 bushels in the European market and then instantly sell them in the American market, pocketing the $50 difference in the process.
Event arbitrage relates more specifically to the purchase of securities with the expectation that a certain corporate event will occur, such as a merger, recapitalization, tender offer etc., with the arbitrager expecting to make a small profit as a result of the event occurring.
A non-hypothetical example may suffice. On May 19, 2020, Epsilon Energy filed a tender offer with the SEC for the purchase of 2 million shares of their common stock at a price of $3.06 per share, with the tender to be completed by July 30 (a tender offer is the process of buying in one’s own stock). On the day after the filing was released Epsilon’s common stock was selling at $2.89 per share. If the vigilant investor were to have purchased the common stock at $2.89 and sold it into the tender offer 8 weeks later they would have realized a 5.9% gain in less than three months, resulting in an annualized return of 35.4%.