Thursday, January 31, 2013

Is this a fat Pitch?

Buffet has been frequently quoted on his strategy of swinging hard at a fat pitch (a juicy full toss for us Indian cricket lovers) when the right opportunity presents itself. Likewise, we have been swinging hard at two recent open offers where we believe the odds to be quite favorable. Needless to say that this post needs to be seen in light of our vested interests. 

The basics of open offer arbitrages have been covered in an excellent manner in Prof’s, Kiran’s and Neeraj’s blog. Over the past two weeks, the promoters of Orient Refractories (link) and Liberty Phosphates (Link) have cashed out of their businesses triggering an open offer for minority shareholders.

The broad specs of the opportunity are as follows:

Orient Refractories
Liberty Phosphate
CMP - (A) - 30th Jan 2013

Offer Price - (B)
Gross Arb (%) - ( B/A-1 )

Acceptance Ratio (AR) %

Promotor holding - (C )
Public shareholding - (100 - C= D)
Offer for - (E)
Theoretical AR (E/D)
Manufactured luck AR %

Quantity returned out of 100 tendered shares
Effective cost price of returned shares (Rs.)

All above calculations are ignoring transaction costs and taxes

In other words, in the case of Orient, if one buys today at CMP and tenders 100 shares, we expect 70 to get accepted at a price of 43. Adjusted for the profit made on these 70 shares, the cost price for the residual 30 shares drops to Rs 24.67. Thus the trade will be in profit till one is able to sell the residual 30 shares at a price higher than Rs. 24.67. In other words, one can create shares in these companies at a substantial discount to current price.But is that good enough ? Lets see,

Orient Refractories at a adjusted cost of Rs 24.67, will be the Indian subsidiary of the world's largest refractories player ( RHI AG) available at a trailing 12 months PE of 7.8, PB of 3.1, Div.Yield of 4% and ROE of 40%.
Liberty Phosphate at an adjusted cost of Rs86, will be part of the Murugappa Group (largest market share in phosphor fertilizers) available at a trailing 12 months PE of 2.7, PB of 0.7, Div. Yield of 2.1% and ROE of 55%.

Juicy enough ? We think so !!!!

Quite obviously, these nos will vary depending upon the actual acceptance ratio which is the only variable. The Acceptance Ratio we have assumed is higher than the theoretical ratio explained above since we have observed that a large no. of retail/other shareholders do not tender shares in open offers, thereby improving the acceptance ratio for those who tender. 

For the numerically oriented and scenario analysis lovers, here is how the deals stack up.

Return Profiles of the deal:

Exit Price for residual shares Rs
Absolute % Returns
Annualised % Returns

2 months
4 months
6 months
Exit Price for residual shares Rs
Absolute % Returns
Annualised % Returns

2 months
4 months
6 months
Fields in the red is the range of our expected return

Invisible Fielders

For us, it’s been a while since we are dabbling in special situations and both opportunities look quite attractive. In most cases generally the gross spreads hover in the range of 8-10%. We have tried to use the “Invert, Invert, Invert – Always invert “ framework to try and figure out what’s on the minds of Mr. Market. Beware again that we could be biased since we have already sized up our positions!!
  •  Deal Risk: Maybe people are speculating that the deal won’t go through and hence the spread reflects that. Our understanding based on annual reports/ cash flows and existing valuations don’t seem to suggest that they are sham (Khoka) companies. The profile of the acquirers (RHI AG – world leader in refractories and Murugappa Group – one of the largest South India based conglomerates) also gives us comfort as to the pre-deal due diligence and sufficient financial muscle to fund the acquisitions. Regulatory approvals could in our view, at best delay the offer rather than lead to the deal failure.
  •  Time Risk: SEBI recently has a track record of clearing clean deals normally in the time frame of roughly two months. Clean deals here should be construed as one where acquiring promoters have a clean track record of public market activities and where there are no controversial embedded clauses. Other regulators (RBI, CCI, FIPB etc.) may take their own time but in the current context they don’t seem to be a road block apart from the usual RBI approval for repatriation of open offer proceeds to NRI investors.
In cricketing analogy, we think that even if the fielders get a hand to the ball they might not be able to stop it  from crossing the ropes. Unless, we have missed noticing a fielder (risk) or two. Do let us know if you spot something not visible to us!!

Why is somebody selling it cheap??

The question still needs to be answered as to why sufficient volume is available at what we believe to be distorted prices. Here is our hypothesis.

Insiders/speculators generally buy into such counters at a rumor stage itself leading to a Pre deal run up in stock prices. Most of the liquidity after the announcement is provided by these people and we hear that most of the speculator community is on margin funding hence the need to liquidate ASAP, rather than wait for the 3 months of the open offer completion. 

Our guesswork in both cases suggests that there is a large proportion of shares disclosed as public shareholding which seem to be either related to promoters or preferential issue to corporate bodies (loosely we prefer to call them as friends of promoters shareholders).  The details of the shareholding are available in more than 1% categories on the exchanges. The shares have been acquired prior to one year at a fraction of the current cost and hence for these shareholders the gains would be significant. The taxability of the same can be very different for them depending on how they choose to sell their shares. They would be liable for a zero long term capital gains tax (after paying STT) if sold in the market OR if they choose to tender the shares in the open offer their incomes would be taxed at the normal marginal rates of taxation.  Hence it makes tremendous sense for them in our view to sell the shares in the open market even if it means at a discount to the offer price.  (In the case of Liberty Phosphate the bulk deals disclosures show Blue Deebaj Chemicals LLC holding roughly 14% of equity having sold nearly a third of their holding at Rs214 while the offer is at Rs241)

We have always had great difficulty in looking into the future, with or without the help of glasses. This explains why we normally do not try to emulate Sehwag and rarely swing hard at the ball, but when we do we also pray hard J. Given our weight exposure to both the stocks, we can only pray for luck and seek any disconfirming evidence if any, from your feedback.

This time, we seek the best of manufactured luck!!!


  1. Hi Abhinav and Niren

    Thanks for the excellent post. I fully agree with Liberty Phosphate, but would like to understand Orient refractories acceptance ratio. Retail shareholders (holding, 1L) holds just 10.6%. For acceptance ratio to go upto 70%, it is required that smart shareholders [SHs holding more than 1% and others with holding > 1L] should not tender fully in open offer. I agree with your logic that probably SHs holding more than 1% are related to promoter group [same SHs in orient abrasives too], but this would mean they would prefer to exit, once the original promoter is selling his stake. Why do you think they would prefer to stay.

    1. Hi Anil,
      Have replied to another comment on the use of models and our theory of coming up with these numbers. Specifically in the case of Orient Refractories 2.7% of the equity is held in Suspense account for want of claimants.
      Our limited experience, suggests that even the "smart shareholders"(including Institutional shareholders,bodies corporate and more than 1 lac shareholders) would not necessarily tender in their shares to the full extent. We can discuss specific instances of the same separately.
      At the same time, we acknowledge that excel skill and historical experience can only allow us to form a range(we have a single number in the post to make it not so complex) and the precise number will be known only in hindsight. Only incase we are very lucky will our assumptions match reality.
      I am glad you agreed on Liberty, but there again one can make a case for lower acceptance ratio now given the significant amount of volumes in the stock post announcement which presumably have been picked up arbitrageurs.

      Hope this helps and best of manufactured luck incase you do participate !!

  2. excellent anlysis. any reason for 80% AR for LP ? why not 70% why not 90%. there are 15% HNI who b=normlly tender there shares.

    i am new to this process. can you explain the actual steps after purchase. lets say i buy 1000 shares from marke tomorrow. it will come to my DP in 3 days. after that how can i tender ny shares ? how will i know the accepttance nuber and when wil i get back the balnce shares. will there be panic selling after return ?

    1. Hey Anon,
      We have tried a multi-variant model with "Z" variables, "X" probabilities and "Y" back testings but to no avail ... Frankly its a number assumed based on historic experience and rounded off to nearest ten multiple for making a not so complex excel sheet .. So if you want we send you across our detailed sheet which we normally name "Paralysis by Analysis"...
      In case of the procedural formalities, you will get a form for tendering in the shares which you fill up and transfer the shares off-market to given Escrow Account. The payment & credit of the balance shares is usually within 10-15 days and one should expect panic selling post event. But here again, there is no exact science, case in point being Shanthi Gears where we participated.

  3. Nice post,i would like to point out that coromandel ferilizers belongs to the Murugappa Group and not coromandalam.

    1. Hi Anon ,
      Thanks for pointing out the "typo in haste error".. Now corrected...

  4. Absolutely amazing post Sirs..
    Would surely like to hear your thoughts on the portfolio allocation you would give to these 2 situations.
    Would you leverage for this?

    1. Dear Prof,
      Thanks for your reply .. We treat special situations as part of our debt exposure or lets say idle cash exposure and compare the attractiveness of return with the liquid funds / fixed deposit rates.. So portfolio allocation is a function of what your view on the cash % you want to hold , availability of other straight equity opportunities, level of the market, expected base returns on your core portfolio etc. etc. You would appreciate the subjectivity of the aforesaid parameters for every individual.
      But since you are "The Professor" and we need to give you an answer - Here it is - 20%-25%, split roughly equally between both primarily to mitigate deal and time risks.
      On the use of leverage for the deal, our limited (positive/no shit happening) experience suggests we should but as of now we have not executed the same.. Lets see !!!
      Best of manufactured luck !!!

    2. Thank you for the reply Niren. :)

    3. Hi

      Just trying to think aloud for logic of splitting bet equally between the two. These two are quite interesting in the sense that both are prevailing at same discount from open offer, acquirer reputed in both, fundamentals are equally strong and time duration is same. I think bet should be higher for liberty phosphate and less for orient for following reasons:

      1) In base case scenario, assuming theoretical AR and same % decline in share price after open offer, liberty phosphate will still provide absolute pre-tax return of around 6% but its almost nil for Orient.

      2) Keeping all things same, probability of higher AR is higher for liberty when compared to Orient.

    4. Further, I think in case of Orient Refractories, its better to sell one week prior to opening of tendering period instead of betting of higher AR. Though this strategy can be applied for Liberty too, but in case of Liberty just assuming that 50% of retail shareholders do not tender take up AR to around 80%, but in case of Orient even the smart investors should not tender.

    5. "expected base returns on your core portfolio" - wow, what are you guys smoking?

      IMHO, there is nothing to gain from making your positions public when you don't need to.

    6. Hi Anon,

      Thanks, you are right. We have absolutely nothing to gain from making our positions public, because both the size of our position and our opinions are not likely to influence the stock movement. It would help however, if through this post we received discomforming evidence, helping us shape our views better, for this and future such opportunities.

  5. Hi M Luck,

    I think you argument that:

    "Our guesswork in both cases suggests that there is a large proportion of shares disclosed as public shareholding which seem to be either related to promoters or preferential issue to corporate bodies (loosely we prefer to call them as friends of promoters shareholders). The details of the shareholding are available in more than 1% categories on the exchanges. The shares have been acquired prior to one year at a fraction of the current cost and hence for these shareholders the gains would be significant. The taxability of the same can be very different for them depending on how they choose to sell their shares. They would be liable for a zero long term capital gains tax (after paying STT) if sold in the market OR if they choose to tender the shares in the open offer their incomes would be taxed at the normal marginal rates of taxation. Hence it makes tremendous sense for them in our view to sell the shares in the open market even if it means at a discount to the offer price. (In the case of Liberty Phosphate the bulk deals disclosures show Blue Deebaj Chemicals LLC holding roughly 14% of equity having sold nearly a third of their holding at Rs214 while the offer is at Rs241)"

    Has flaws
    If I were such a company sitting on huge long term gains I would have booked those gains say today and would have bought the same number of shares or more shares the next day.
    This way I don't pay any tax when I book profit at say 210 and thereafter I buy it back again at say 210 and tender in offer at 240 this way I pay capital gains tax on rupees 30 only.

    I think there can only be one reason here which is the risk of deal failing or the uncertainty over the approval time which is keeping the price at a substantial discount to the open offer price.

    There are so many people close to this deal who understand the transaction well.


    1. Hi Excel,

      Thanks for your word of caution. As mentioned in the post itself, its possible that some risks exist but we have failed (or do not have sufficient knowledge)to spot them. However, you would also probably know from experience that the current price is not always right. Do make your own judgement before thinking of participating.

  6. Hi abhinav / niren
    do you factor fundamental analysis when sizing the position and looking at the attractiveness of the deals.
    from a cursory review, orient's fundamental biz seems to be more attractive. LP seems to be in biz where the profits and ROE are good, but the cash is stuck in the recievables (govt subsidy) and inventory. there is a strong competition between the sugar and fertilizer biz on which is worse :) ?
    in view of above, if both deals seem similar will not make sense to bet more in orient where is things go bad, one will still get a cash generating biz at 11 times earnings


    1. Hi Rohit,
      Thanks for your continued interest and your support.
      In our view while cursory fundamental analysis is required (since AR is not likely to be 100%), a deep dive will only lead to illusion of control, since all we are trying to judge is what could be a possible exit price in a short period like a month after getting back our shares. Markets can be fickle in such short periods as we all know. Infact things that we generally dont look at viz 52 week lows, where was the stock consolidating before deal news momentum etc. could sometimes be better pointers in these situations.
      Its tough to choose between the two in our view. While we agree that orient at the margin gives more fundamental comfort, liberty has better acceptance ratio & slighlty better spread going for it.

  7. if the open offer of LP goes through , promoter's stake will become 87%.
    will it be delisted then ??

    1. Hi Anon,

      as per our understanding, the new delisting regulations have eliminated this possibility. Due to an open offer, in the event that shareholding crosses 75%, then the promoter is forced to sell down his stake to <75% within 12 months. A similar case is that of Thomas Cook and you can read management commentary in this regard.

  8. This comment has been removed by a blog administrator.

  9. Hi

    The assumptions at my end are fairly similar to the assumptions that you guys have made in terms of acceptance ratio & exit price post the open offer. There are a few points that could be looked at

    1) One of the biggest risk with such thin spreads is the timeline on the deal. We are factoring in the best case scenario in terms of SEBI approvals. Also if you look at the Orient deal, from the time of announcement to receipt of money the timeline is about 83 days. So similarly in the Liberty deal a 3 month timeline would be more realistic as opposed to 2 months. In case of Liberty they have already missed one of timelines. According to the takeover code the detailed public announcement should be out within 5 working days of the initial announcement subject to the acquirer completing the primary acquisition of shares. The primary acquisition of shares took nearly 7 days from 24th to 31st, so we should now expect the detailed public announcement before the 7th, post which they will file with SEBI.

    2) Any extension in timeline on the deal, not only reduces the return but but more importantly also increases the market risk and the risk of the underlying business deteriorating. This is a double whammy. So the exit price that we have factored in becomes a moving target. To Rohit's point I would assign a significant weightage to the comfort on the underlying business. Invariably post a acquisition the new owner will start cleaning up the books which would have been decked up for the suitor. I unfortunately have learnt this the hard way by paying tuition fees on a few demerger transactions :-).

    3) While annualising the return we of course need to factor in reinvestment risk. Annualised returns tends to anchor the mind more positively towards the transaction. Also transaction costs do play a important role as they make a significant impact on thin spreads.

    Having said all of the above I continue to be very interested in both these transactions :-).

    1. As this is the first time I am participating in the open offer I was thinking about exit strategy for the last few days. I fully agree with Ninad the market risk and risk of underlying business deteriorating and apart from expected return I think one should also be quite clear, whether one is willing to hold the balance shares for long term. As I am not comfortable holding LP for long term, I will prefer to sell the stock before opening of tendering period once share price is around 228-232. If the price continue to remain depressed till the opening of the tender offer, then would prefer to sell it in open market rather than tendering the shares, treating market is right in lower acceptance ratio/ assuming steep fall post open offer ends. By selling in the open market I may earn a few % less, but will avoid market risk of steep fall in price post completion of open offer.

  10. Hi Ninad,
    Thanks as always for your interesting inputs.
    1)Completely agree with you on the time risk in general. Just that the spreads in both the trades are higher than what we have usually observed in our limited experience, hence the position and the post.
    2) Interestingly in both the case, there is a "one up one down" situation in the context of underlying business vis-a-vis acceptance ratio. One might also look at selling the position in the run-up to the event rather than wait for the whole tendering process. (We tried were a bit lucky with timing such moves going into the event of Shanthi Gears). Also, both the variables mentioned are completely subjective and to that extent one can only do so much.
    3)The only reason for annualising the returns was to compare the same with the returns on the existing debt investments since we typically play this as an opportunistic substitute to debt/ idle cash. Transactions costs and taxes off course are a big drag.
    Best of ML!!

  11. Hi,

    I was also referring to same case with same argument, so i fully support your views. I am trying to understand why our market (participants) give same discounts to all similar cases. In above 2 cases discount is around 14-15% and that can move up to above 20-25% as well. (In past we have seen in case of Sabero organics and Camlin). If you can help to identify the major reason for such difference it will be really useful. I can identify following factors
    1) Acceptance ratio
    2) Transaction cost
    3) Tax implication

    You can add more reasons and if some how you are able to justify price discount compared to open offer price than probably we can term it as risk free return.

    Please correct me if i am wrong somewhere.

    Thanks & Regards,
    Apurva Shah

  12. DPS is out in Financial Express on 1st of Feb.. this was the last day and they have met the deadline just in time.

    1. Hi Anon,
      We had missed this one .. thanx a ton for highlighting it here ... Atleast some framework to evaluate the time risk becomes clearer, post this doc ..

  13. price of liberty phosphate shot up till 228 now it is back to 221. blue deebaj have almost sold 70% of his position.. wats d view now

    1. No great change of view as such, just that feeling a bit lucky to have timed the post exactly around the lows.
      We were earlier as well expecting 100% tendering by Blue deebaj, which now will be tendered by host of large arb guys, so statusquo in terms of the AR.
      Even at todays price of Rs220 , we are making a broad spread of 5% absolute for 5 weeks since the post. Having said that,we were not lucky to sell at Rs 229.75(the high hit on 20th Feb 2013) but if someone has been then we think it makes sense to re-enter given that some more time has elapsed since the original offer. Also the deal risk which was one of the key risks to the offer seems to be lower now, with a few hurdles being cleared.
      The final call off course depends on other available opportunities, expectation of acceptance ratio , your view on time risk etc.etc..
      Best of ML !!!

  14. orient have recvd sebi approval n the process will be getting over by 29 april. so now just less thn 35 days for the entire procedure.. wat do u think will b d 70% post offer

  15. Hi,

    Orient has fallen a bit & is now available at 33-34.
    Liberty is at 215.

    Still decent money is on the table for both the deals..
    Why is so much money on the table?

    What do you think of the risk-reward ratio at current price?


    1. Hi Jatin,

      Orient is now trading on an ex basis. The open offer has closed with an acceptance ratio of 73.8%. Its back to fundamentals and your decision to buy/sell should now be dictated accordingly.
      Liberty however is still with SEBI and the clearance is taking longer than originally anticipated. We are not certain as to the reasons for the delay but suspect it might have something to do with historical trades made by the erstwhile promoters, for which they have made some disclosures recently. Nevertheless, given that Coromandel has already taken management control, there seems no deal risk. We think risk reward is favorable.