Tags

, , , , , , , , , , ,

Continued from here.

Expected Return‘s probably the most important, and most difficult, return to calculate & focus on. In its simplest form, it’s binary (deal success or failure), but by all means incorporate multiple outcomes into your analysis, if appropriate. In fact, if you’re contemplating other types of Event Driven investing, this multiple outcome approach will prove essential. However many outcomes, you calculate a Gross Return and a likely probability (which must sum to 1.00, of course) for each, and then combine these to arrive at an Expected Return. This will give you a much more accurate (and lower) deal return. Of course, you won’t actually see this return on any single deal – but over time, this is the best risk/reward measure to employ to evaluate deals & your potential average return. Of course, you can calculate an Expected IRR also, if you wish, but let’s not go crazy here..!

Gross Returns are not too tough to calculate or estimate, but where on earth do you get the probabilities..?! Well, that’s a toughie..! You’ve got to estimate them yourself, and even when the deal completes you mightn’t have any real idea if your estimates were accurate or not! Terrible feedback loop, eh? Experience and tracking deals helps, but this is definitely art, not science.

So how about AGI? Well, let’s keep it simple and assume a binary outcome: Deal success will produce a 14.7% Gross Return, as we’ve already spelled out. Referencing all key components of the AGI deal, I assign a 96% probability of success. Note this is extraordinarily high, most rumoured/announced takeover deals have a lower probability of success as they’re usually still missing some of the key deal components I’ve specified. Deal failure’s therefore at 4%, which could prompt a 37.5% decline in the share price back to EUR 0.05, where it traded on average pre-deal announcement. Note I’m completely ignoring my intrinsic valuation here – while this is v useful in deal selection & support, it’s likely to be ignored by investors if a deal fails, at least in the short term. Expected Value is:

(14.7% * 0.96) + (-37.5% * 0.04) = 14.1% – 1.5% = 12.6%

This is a more realistic snapshot of a true AGI deal return, and still looks v attractive. Note any increase in the odds of deal failure, or expected decline in the share price, will decay the Expected Return very quickly. This also highlights the occasional gulf between professional/institutional investors and many private investors. Take a company announcement (in response to a price movement) confirming a potential bidding approach: At that point, I’m probably being generous to say the odds of an eventual successful takeover bid are 50%, at best – so the probability of failure’s also at 50%. Many deals like this are quickly marked up 20%, but still many private investors jump in, buying at what they believe is a bargain price.

This highlights two big mistakes: i) they buy in believing they still have far more upside potential – completely ignoring the fact that the average completed deal will likely trade up another 20%, at best, and ii) they ignore the returns, and associated probabilities, related to deal success and failure (which would likely prompt a 20% reversion in the share price). The Expected Return tells the real story here:

Success (20% * 0.50) + Failure (-20% * 0.50) = 10% – 10% = 0%

Right, back to AGI, a Recommended Cash Offer‘s pretty simple from an analytical perspective. The only complication is the fact the shares trade in EUR, but the offer’s in USD (and one can elect to receive USD, or equivalent EUR proceeds). This means you’ll need to update/track Returns/IRRs much more closely as the EUR share price AND EUR/USD FX rate evolve. But don’t be put off by the FX risk! I know many investors avoid small, or even large, prospective returns simply because it involves an FX risk. This is a pretty blinkered perspective – I’d counter with two (hopefully) strong arguments:

a) You’re contemplating a safe deal offering a quick 5% return, but you’re worried an FX rate move might wipe out your profit, or even push you into a loss! Yeah, who cares?! FX rates are pretty noisy/unpredictable, at least in the short term, and often end up back where they started. So FX often has little net impact on a deal, and of course it’s just as likely to improve your deal return! A small loss on a deal’s sure to be offset by a significantly better return on another deal, and I can assure you FX won’t be a factor in success/failure (over time) as an Event Driven investor.

b) Big picture, I believe it’s essential to have a truly global portfolio in terms of stock AND currencyallocation. I’ve argued this before, and I’m sure I will again! And this applies whether you’re a defensive or an offensive investor. If you’re defensive, you’re far more likely to suffer from ‘home bias‘, which can be lethal to the safety of your portfolio. Your cozy familiarity with the stocks, businesses & personalities in your home market, and your resulting savvy stock picking, aren’t worth a toss if your home market is relentlessly dropping 70%… And if you’re aggressive, just think of all the opportunities and the better growth/value & risk/reward on offer outside of your home market..!?!

The same arguments are equally true for currencies. Probably even more so, as domestic equities can often survive a government’s fiscal/monetary inflationary policies, but currencies generally have little room to escape the impact of this onslaught. Politicians like to pretend this isn’t true… Sure, for centuries they’ve debased currencies while confidently assuring their gullible citizens that the pound/dollar/denarii/etc. in their pocket’s still worth the same after a devaluation as before… What a crock! But a great reminder why you need to diversify away from your home currency if you wish to maintain & increase the true/underlying purchasing power of your portfolio.

Personally, I achieve this by setting target currency allocations in my portfolio, and then try to invest/reinvest accordingly. I only change these target allocations rarely & incrementally, as relative value & prospects usually change v slowly for most currencies. You can contemplate/use currency hedging to achieve your targets, but I think it will inevitably tangle you up in all the short term FX noise. I also don’t want to over-stress currency allocation. Stock picking’s always going to be more important – if you have a successful 3-5 year investment, your ‘stock return‘ should far exceed any related (+/-) FX return.

What I think really helps though is a broker (and a bank) who permits you to hold cash in a variety of currencies. If you’re smart about it, this allows you to avoid multiple FX conversions. In fact, don’t even think about commission rates until you nail down one or more brokers who offer international stock market access AND true multi-currency accounts, which are far more important. Once you’re set up in this way, you can think about investment in terms of respective currency ‘pools. For example, a new USD stock pick is ideally funded from spare cash or a good stock sale in your USD pool.

When I was contemplating an AGI  investment, my spare cash happened to be concentrated in my USD pool. This quickly suggested a slightly different strategy: Round-tripping my USD. I’d obviously incur a small FX spread each time I used USD to pay for EUR share purchases, but by opting to receive USD takeover proceeds I’d eliminate all FX risk from the deal and end up back in USD cash.

To be continued…

Advertisements