In a classic merger arbitrage, the investor ought to short the acquiror (ARCC) and buy the target (ALD). That is because, assuming that the deal closes, the target and acquiror shares are now representative of the same asset. Consequently, any price discrepancy between the two stocks represents a fundamental disconnect with underlying value*. In the case of ARCC and ALD, I posited that the proposed exchange rate of .325 ARCC shares for each ALD share creates an opportunity based on current closing prices.

*Those familiar with the concept of arbitrage will see my description of merger arbitrage as a flawed definition of arbitrage. Officially, merger arbitrage is a risk arbitrage and is not the same as a traditional riskless arbitrage opportunity. I intend to write a follow up post for those who have less experience with this concept later this week.

At Ares’ closing price of $10.46/share, ALD shareholders would be entitled to approximately $3.40/share in value. This represents a 7.9% premium versus ALD’s closing price of $3.15. In a classic merger arbitrage, however, shorting ARCC would require the investor to pay upwards of two quarters worth of dividends (the ARCC/ALD merger is expected to close by Q1 2010). ARCC currently pays a 13.4% annual dividend yield. Two dividends would equate to roughly 6.7% in yield. As such, the true spread between ALD and ARCC is closer to 1% than the 7.9% that is initially seen when only comparing stock prices.

Merger arbitrage does contain some risk. The deal may not close in time which could result in an arbitrageur missing more of ARCC’s dividends. The deal may not close at all which could have completely unpredictable results on stock movements, thus destroying the pair trade (short ARCC/long ALD) opportunity. As such, the minute 1% spread is a good sign that the market is pricing a near definite probability of this transaction closing and believes just 1% in return over the next 6 months is adequate compensation for the risk.

In this sense, a classic merger arbitrage of ALD and ARCC seems much less worthwhile to us retail investors who don’t have massive balance sheets to throw at small percentage gains. Despite this, I believe the initial thesis of my prior post on the opportunity to purchase Allied Capital stock holds true. Prior to this acquisition, Allied Capital’s auditors were issuing going concern warnings. With the balance sheet and liquidity provided by Ares, Allied Capital’s undervalued portfolio definitely looks much more attractive. That being said, on a risk adjusted basis, it would seem much more prudent to outright purchase ARCC at this juncture as you would be “guaranteed” dividends over the next few quarters and you won’t have to worry about the risk of the transaction not being confirmed.

Full disclosure: Author has no positions in the stocks mentioned in this post.

I, the author of The Curious Investor, am currently long Apple stock. In fact, it makes up nearly 10% of my personal portfolio. In my apartment are multiple Apple products including several iPhones, several iterations of the iPod, a MacBook, and an Airport Express. I believe Apple is more than just a trendy consumer products maker and that the iPhone truly represents a new growth engine as the world embraces mobile computing. As an investor, however, I understand that stocks do not only move in one direction. Valuations will overshoot and undershoot true value in the short term and a prudent investor must be aware of this and make decisions with this phenomenon in mind. It is possible for a great company to possess a not very great stock valuation (see: CSCO circa 1999-2000). So, please, leave your hate mail unsent.

Take a look at the chart below:

Apple’s stock gapped up through the psychologically significant barrier of $200/share following Apple’s earnings announcement last Monday. A headline related pop typically signals a breakaway gap, a stock gap which is typically followed by a continuation but, in this case, Apple’s gap was more suspicious. While related to good news, Apple’s Q4 2009 (FYE 9/26) results were not so much of an upside surprise as previous quarters and investors all but dismissed another characteristically conservative guidance. Moreover, volume doubled prior to the gap up and remained elevated during the stock’s near immediate fall over the last five trading periods, a tell tale signal of an exhaustion gap.

Exhaustion gaps are defined as stock price gaps which follow in the direction of the prevailing trend. A textbook exhaustion gap should be followed by a reversal soon after the gap and then move to fill the original gap. A reversal is confirmed when the gap is filled and price breaches the level prior to the gap.

I realize that I may be early to call this reversal. After all, technical analysis is not clairvoyance. Trends and reversals must be confirmed through chart movements as opposed to “predicted” by the apparent formation of patterns. Traditional technical analysts will always miss the exact top or bottom of a price movement in preference to investing with the certitude of a confirmed trend or reversal. As such, it would seem that the seeming formation of an exhaustion gap here is just a red flag. Apple’s stock has yet to fill the gap, but it has breached the initial gap and looks to be on its way to filling the gap. If so, could it be possible that the Company’s stock is headed for a reversal of its uptrend? Or, possibly entering a consolidation period following an aggressive upward move? If so, it may be time to take some gains off the table and wait for a re-entry point.

Full disclosure: Author is currently long shares of AAPL.

On Monday, a major shakeup was announced within the BDC industry. Ares Capital (ARCC), one of a few BDCs which has managed through the recession while maintaining a substantial dividend, announced that it was acquiring a former giant of the industry, Allied Capital (ALD). The acquisition is expected to be an all-stock deal where ALD shareholders will receive 0.325 shares of ARCC for each share of ALD they own.

ALD, which had breached the asset coverage covenants on its debt, has not been able to pay a dividend since the third quarter of 2008. Allied, in fact, has taken almost a year to restructure its debt agreements leading its auditors to issue a “going concern” warning in its 10Qs in each of the last few quarters. While concerns regarding the Company’s debt agreements has weighed down the stock’s value, the Company’s net asset value per share was reported as $7.49 on June 30, 2009 which includes serious write downs taken by the company over the last year.

Why then does the stock trade at 43% of NAV/share? For one, questions about the Company’s continued ability to access financing make it difficult to handicap whether or not Allied will ever have the luxury of time to “wait” for its investments to mature and be refinanced. In fact, pressure to de-lever has already forced the Company to make hundreds of millions in distressed investment sales over the year. Further, the Company has a history of questions being raised over the quality of Allied’s investments and its methodology for establishing fair value for its reporting. (See David Einhorn’s Fooling Some of the People All of the Time)

With all these headwinds facing the Company and the difficulty that the average investor would have verifying the Company’s portfolio quality, Allied was more likely a value trap than a good value investment even at <45% of NAV. But, all that has changed now that Ares Capital has decided to swoop in and acquire Allied. Ares Capital Corporation is one of few BDCs which has weathered the recent recession without having to suspend its dividend and has not seen outsized portfolio market value depreciation. Further, it is managed by Ares Management, a distant descendant of Leon Black’s famed private equity shop, Apollo Management. While a good investor should always do his own due diligence, Ares’ vote of confidence likely goes a long way to provide an investor some comfort with Allied’s current stock valuation.

Further, given Allied’s troubles securing affordable financing and continued  portfolio difficulties, Allied has little incentive not to close this transaction (though some shareholders seem to disagree). As there’s a high likelihood of completion (currently expected to close 1Q 2010), there seems to be a quasi-arbitrage opportunity presented by ALD shares and value investor’s dream opportunity to enter into ARCC shares.

As mentioned above each ALD share will be exchanged for 0.325 shares of ARCC. ARCC and ALD closed today at $10.61 and $3.20, respectively. As such, if the deal were completed today, ALD shareholders should receive the equivalent of $3.44 per share in ARCC stock which implies that ALD is currently trading at a 7.75% discount. Now, if you’re not interested in investing in the BDC space and simply would like to take advantage of this pricing irregularity, you could buy ALD and short ARCC and simply wait to pocket the spread – a “riskless” arbitrage of this merger. (Caveat being that if the merger falls apart the whole these blows up in your face.)

But, I believe that ALD’s current discount is even more compelling from a value standpoint. By my estimates based on June 30, 2009 reporting, the combined Allied and Ares should have a net asset value around $15.30/share. At today’s $10.61 closing price, Ares is trading at just 70% of combined entity NAV and at 95% of its own reported NAV of $11.05 (post a recent dilutive share offering). This would seem a pretty good discount for a BDC which has proven its ability to manage through a very difficult market environment and a demonstrated ability to access financing, the key trait necessary to realize value from Allied Capital’s portfolio.

But, you don’t have to settle for ARCC’s discount to NAV. As mentioned earlier, ALD trades at a near 8% discount to its conversion price. So, by just purchasing ALD shares today, you can enter ARCC at a below market value discount at a significant discount simply for taking on 6 months of risk as the merger approaches its closing. Is it worth it? More diligence probably needs to be given to Ares’ debt portfolio, but I would say on the surface ALD shares have gotten significantly more appealing.

Full Disclosure: Author has no position in the stocks mentioned in this post.

What I mean by technical analysis isn’t meant for predicting is that rigorous technical analysis isn’t a means for front running what you “think” may happen to a stock. It’s a means for gleaning information from an existing chart about an existing trend and helping the practitioner to make investments with underlying market supply and demand behind them.

I came across this post, “Are Sears Holdings shares headed for a correction?,” at wallstnation.com. The thrust of their argument was that SHLD’s shares had traced a head and shoulders pattern and that a significant correction was likely.

Here’s a “text book” head and shoulders pattern:

1. The stock rises to a peak and then declines.
2. The stock rises to a second higher peak and declines, but does not breach support defined by the first decline.
3. The stock rises to another peak but is unable to recapture the second peak.
4. The stock breaches the support level formed by the first decline and confirms a reversal of trend

Wall St. Nation posted this chart of SHLD as of 9/30/09:

Wall St. Nation’s contention is that a head-and-shoulders pattern is defined by the three peaks it labels. Wall St. Nation claims that this formation is “one of the most reliable trend-reversal patterns.” What they miss is the fact that simply the formation of three “head-and-shoulders” style peaks is not the predictor of a trend reversal. The head and shoulders pattern must include a breach at the end of the pattern formation. That is step 4 listed above. The head and shoulders pattern is a trend reversal  not just a “reliable pattern” for predicting a trend reversal.  Once the full pattern is formed, one can typically expect a continuation of the downtrend after initial support is breached. In the case of SHLD, baseline support was never breached. In Wall St. Nation’s own example, lows never breached the initial low in the formation and in fact have maintained an upward bias that they themselves identify in the chart.

In fact, in the chart they show, it is just as likely that a long term uptrend remains well intact and that the chart is merely in-between a series two “higher highs.’ Well, a month later, what has happened?

Well, the stock ripped off an upward run and made a high beyond the “right shoulder” of the supposed head-and-shoulders pattern. At this point, it’s hard to identify any near term trend at all. Generally speaking, it seems the 50-day moving average has provided rough support, MACD shows a bullish bias, and a lower low has not been seen all year.

In the case of the 3-year, weekly price chart, SHLD has just this year managed to return above its 50-week moving average which I believe signals a potential long term trend reversal. For more on that, check out my post on long term technical analysis and trend reversals.

Full disclosure: Author has no position in the stocks mentioned in this post.

Before we begin, I want to help a fellow blogger promote his new Value Investing Forum. Jonathan Goldberg is an MBA from the University of Western Ontario and has a value investing blog at JonathanGoldberg.com and hopes to inspire a community of investors to share ideas (much like my goal at TheCuriousInvestor. So, COMMENT!)

Without further ado, here are some articles which piqued my interest last week (or two).

• Chris Whalen, managing director at Institutional Risk Analytics (via Jesse’s Cafe Americain) believes that Q4 will be a bloodbath for the banking industry.
• Dividend Growth Investor discusses the benefits of an emotionless sell policy. I absolutely agree. I’ve written a few posts on this topic myself:
  • Selling – All, Some or None
  • Devising a Sell Strategy
  • Be rational, be disciplined, and sell for a profit
• Ino.com presents a detailed technical analysis of Oil ETFs. (Full Disclosure: Curious Investor is an affiliate)
• I highly suggest this excerpt from Andrew Ross Sorkin’s new book, Too Big to Fail. It’s a great inside look at what really went on as America’s banking industry was at the brink.
• Contingent Capital discusses an easy ratio for determining the health of banks.
• Naked Capitalism talks about the continuing shift away from denominating oil in US Dollars. Looks like Kevin Philips’ warnings in Bad Money may be coming true faster than we thought.