Making Money with “Workout” Investing

1. Making Money with “Workout” Investing Vancouver Stock Investment Group June 26th, 2008 Alex Roman Scorpion Capital Inc.

2. How do workouts fit into the big picture of your portfolio?

3. General Principles of Work-outs “…we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long-term investments.” – Warren Buffet • A workout situation occurs when an announced corporate activity produces a spread between a stock’s current price and what the proposed closing price will be at the conclusion of that activity. “…in other words, they are securities with a timetable where we can predict within reasonable error limits, when we will get how much and what might upset the applecart.” • Because work-outs are non-traditional opportunities not generally correlated with the stock market, they are used by investors to produce a positive return in hard times. • Work-outs also serve the purpose of keeping investors occupied so they don’t do something really stupid like buying a poor long-term investment or speculating in stocks instead of waiting patiently.

4. The 6 Types of Special Situations

5. Where to find workouts • Some detective work is required. • Special Websites such as • http://www.arbitrageview.com/riskarb.htm • http://www.mergerinvesting.com/pendingmergers • The newspaper or news media (remember, we are only looking for announced deals, inside information is should not be necessary for a successful work-out) • SEC filings (3 forms of interest: 13E , 14A/14C, S4/maybe S1 for spinoffs) • http://www.sec.gov/cgi-bin/browse-edgar?company=&CIK=&type=SC+13E3&owner=include&action=getcurrent • SEC aggregator sites that search filings for specific keywords, ‘e.g. merger, liquidation, spinoff, etc..’

6. Some points to consider in searching for deals. • Work-outs should be announced in the general media (we are not speculating on unknown deals). • Friendly deals – it is more likely to go through if the proposal is desired by both parties. • Small companies and small deals have less coverage. You have a bigger advantage than in a mega- deal, as well as wider spreads. • Two philosophies depending on skill level: • Most investors should look at investing in a diversified work-out portfolio. You are aiming for an aggregate annualized profit even if a few deals blow-up. (Ben Graham actually proposed this even for the pros) • More experienced investors should think about doing 1-4 high certainty deals per year. • Cash deals are preferred. • “I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behaviour…my self imposed limit is 25% of partnership net worth…when we do borrow is it only as an offset against work-outs” – Buffet Partnership Letters • CAUTION: Watch a few deals before jumping in. Some deals have regulatory approval and financing issues which may delay or even kill the deal. • The faster the deal closes and the lower your cost basis, the higher your return. Delays erode rate of return and tie up your capital. • Realizing your profit : You must decide whether to receive your profit via the deal terms or by selling in the open market prior to deal closing.

7. Ben Graham’s formula to determine expected return • Annual Return = [GC – L (100%-C)]/YP Where, G: Expected gain in points if successful L: Expected loss in points if unsuccessful C: Expected chance of success (%) Y: Expected time of the holding in years P: Current price of the security • Expected return is the average return over many workouts, not the actual return since a successful deal should be weighted 100%.

8. Case Study: Usana Health Sciences (NASDAQ: USNA) • Company announced going private offer from founder May 13, 2008. • Founder & control group own 68% of company stock (seek to buy the remaining 32%) at $26/share via a public tender offer. • Financing by Able Finance, a division of Cerberus Capital Management. • Tender offer expires June 27th, expected to close June 30th, 2008. • When looking at a work-out, enumerate all the possible outcomes, their probabilities, and the risk/return profile of each option. In Usana’s case, the 5 main options are deal at $26, deal above or below $26, no deal, or delayed deal. • Between May 23rd and June 9th, you could have bought the stock for as low as $24.50 or a spread of $1.50 for 27 days prior to closing. A 6% spread in less than 30 days is about a 72% annualized return if the deal closes. • Expected Return = [($1.5 * 80%) – ($3 * 20%)] / .08 * $24.50 = $1.2 - $0.60 / (1.96) = .306 * 100 = 30.6% • Last 2 weeks of June price ranged from $26-$28.50/share. • I did invest in this workout, but made the mistake of selling too soon given my comfort level with the deal…still, the annualized return was 46% but a common mistake is leaving money on the table even when your level of confidence is very high.

9. Conclusion • Adding work-outs to your portfolio can provide a solid return in bear markets while waiting for your general long term investments to appreciate. • Work-outs require hard work and knowledge. For most people, making fast, easy money is a myth. Only 1/5th of 1% of the world’s population has over $1 million liquid assets (10 million out of 5.7 billion people!!), and only 100,000 people have over $30 million. • Books: ‘You can be a Stock Market Genius’ – Joel Greenblatt, Security Analysis, Ben Graham • Workout Excel Spreadsheet: http://focusinvestor.com/RiskArbModel.xls “One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do.” – George Soros GOOD LUCK!

10. The best investment for most people (and some professionals too!) • A low-cost index fund (such as Vanguard) is the best alternative for most investors who cannot or do not want to invest considerable time in education and improvement. • There is a mathematical proof showing that actively managed portfolios (such as hedge funds) must underperform passively managed portfolios (such as buying the S&P500 index) in the aggregate. • If you are not a professional and do not bring anything to the table, why should you expect an above average return? • Remember the ‘sleep’ test. If owning a position makes you sleep poorly at night, sell some immediately. A good night’s sleep is the best way to make money. • Excellent Book: “Juggling Dynamite” by Danielle Park. Investors are too active and not fully aware of the risks involved in investing. “Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb” – Warren Buffett