Thursday, November 01, 2007

Class Group Project Competition

This was sent to my class students today...

---------------------------- Original Message ----------------------------
Subject: Group Project Competition
Date: Thu, November 1, 2007 1:18 pm

Ok here is the deal...

There is a special situation opportunity available in the market today
which promises a return of at least 35% p.a.pretax (the max return in my
view is in the range of 50% p.a. pretax) with very low risk of loss.
Moreover, the deal is suited for debt financing, and is also liquid.

Which group can find this opportunity?

Hint 1: The announcement of the transaction which led to the creation of
this special situation opportunity was made on BSE sometime in the last
ten days.

Hint 2: The operation involves buying a security from the stock market and
thats it. You don't have to sell. You don't have to tender.

This is a competitive project competition. All class groups are invited to
compete. However, only the first TWO GROUP PROJECT REPORTS with the
correct answer and reasoning will be considered towards completion of
group project component for term 5.




Bunty.... said...

Was it Deccan Chronicle ??

Sanjay Bakshi said...

No, that can't be.

Hint 2 is very important. It says:

"The operation involves buying a security from the stock market and thats it. You don't have to sell. You don't have to tender."

What does that mean?

For you to make money in any investment operation, you must start with buying a security and ultimately end up with cash. The key question to answer is How can you end up with cash without selling, and without tendering the security in a tender offer?

Keep trying- I will post the answer soon....

Anonymous said...

Great blog. I am a real fan of your work (I just finished business school and am working for an investment firm in New York).

Could this be Essar Steel Preference Shares trading at Rs. 11.15 which the company wants to redeem at Rs. 12.50? The determining factor of returns is (a) approval by shareholders, and (b) time taken for the company to close on this transaction.

Sanjay Bakshi said...


Anonymous got it right!

Its a very interesting case. The last annual report of the company states the following:

"The company has issued 20,29,24,832 0.01% Cumulative redeemable preference shares (CRPS) of Rs. 10 each. Each 0.01 % CRPS will be
redeemable in four quarterly equal installments commencing from October 01, 2017."

Given these numbers, the fair value of the security was very low because the income return was insufficient, and the redepmption date was too distant.

Until the company made this announcement on 23 October:

"Essar Steel Ltd has informed BSE that a meeting of the Board of Directors of the Company will be held on October 31, 2007, inter alia, to consider the following :

1. Financial Results of the Company for the quarter ended September 30, 2007.

2. Premature Redemption of 20,29,24,832 0.01% Cumulative Redeemable Preference Shares of Rs 10/- each."

The second item on this agenda caused a jump in the fair value of this security. However, at this time, it was uncertain as to what would be the price at which the security would be redeemed prematurely. However, that price could not have been less than the par value Rs 10 per share as per Indian Companies Act.

Then, on 31 October, the board of directors decided to redeem the security at Rs 12.50 per share. See the following announcement:

"Essar Steel Ltd has informed BSE that the Board of Directors of the Company at its meeting held on October 31, 2007, inter alia, has decided to obtain consent by way of postal Ballot of the shareholders holding 0.01% Cumulative Redeemable Preference shares as well as equity shareholders for premature redemption of 0.01% Cumulative Redeemable Preference Shares of Rs 10 each at a premium of Rs 2.50 per share (viz, at Rs 12.50 per share)."

The company only requires to conduct a postal ballot which should be completed by the end of Nov 2007 and the money should come in by Dec 2007. So the indicatative return is high, with low levels of risk....

Charlie Munger's idea of backward thinking was appropriate here in context of Hint 2 which stated that you don't have to sell and you don't have to tender. This is a one-decision investment operation. And so, if the sale proceeds are to be delivered to the owner of this security without any sale taking place, then it could not have been an equity security because you need to sell it to convert it into cash. Nor could it have been a tender offer. And so, it had to be secutity which would have been redeemed. Once one knew that, all one had to do was to look for BSE notices on redemption in the last 10 days to find the answer.

I don't know what procedure Anonymous used in coming up with the right answer though. I would be most curious to find out!

Thanks everyone for participating in this thread...

Anonymous said...

ESTL-P1 is at Rs 11.15 (nov 2, 2007). Does the above discussion mean that the company is going to buy back the estl-p1 at a price of Rs 12.5 in december. If that is the case, then a purchase at Rs 11.15 would mean 145% annual return assuming it will take 1 month for the whole process.

A few years back, I bought 50 ESTL (EQ) and then the company replaced those 50 ESTL Eq with 30 eq and 20 p1 shares. P1 shares were quoting 12 times less than EQ meaning a around 90%. I could not understand why it was done and still hold those 20 ESTL-P1. COuld you please explain it.

Sanjay Bakshi said...

Assuming one month would be unreasonably optimistic, in my view. Assume a minimum of two months...

Also, note, that the deal risk is not exactly zero. One of the things I've learnt over the years in risk arb is that "stuff happens" and its not done until its done.

ESTL of a few years ago is not the same as the ESTL of today - the company has been transformed thru the combined effects of corporate restructuring and the boom in the steel cycle. You got the preferred stock as part of a scheme of arrangement done by the company. The value of that security was low, and, as mentioned by me earlier, that value has changed because of this announced planned corporate action.

Anonymous said...

How lowful are these scheme of arrangements because at the end, it leaves the investor with net loss. Isnt it?

Ravi S GHosh

Anonymous said...

I have been going through your blog and find it really good...However, one thing keeps troubling me: The concept of Annualizing returns achieved in a short period...Would like to know your thoughts....if I double my money in a week (not uncommon these days it seems) annualizing it is enough for a lifetime of earnings....shouldn't one not use this concept at all unless one had obtained the result, say, in more than 8-9 months

Sanjay Bakshi said...

Generally speaking, using annualized returns is a foolish idea unless one is comparing it with a borrowing rate and the transaction is suitable for leveraged financing.

Its much better to invest in an idea which will compound your money at, say 20% p.a. for a long long time, than to invest money in ideas which offer very high annualized returns but earned over very short time periods. Such a strategy will expose one to re-investment risk. After all, one is not trying to earn high IRRs. Rather, one is trying to maximise eventual net worth.

However, there are periods in the cycle of the stock market, where long-term opportunities which will compund money at a good rate are hard to find - perhaps this is one of those periods. In such periods, it makes sense, in my view, to have capital available for risk arb opportunities like the one discussed in this thread... And when one is looking at a series of similar operations, like in a regular business, where money deployed in an opportunity will come back in a short time and be available for deployment in the next deal, then the idea of using annualized returns, ceases to be foolish, in my view.

Sanjay Bakshi said...