The Top Three Mistakes Event-Driven Investors Make
On its face, event-driven investing seems simple. There’s a corporate event that changes the fundamental value of a company: a merger, acquisition, spinoff, regulatory development, or legal ruling. There’s a start and a finish to the event, and often, there is a concrete price for the “before” and “after.” You just have to catch the waves of each event to make money.
Yet the simple appearance of event-driven investing is misleading. We see a number of common mistakes among event-driven investors, ranging from trading on faulty information, to improperly weighing risk and return, to misjudging the likely outcome of events. Here are the top three mistakes we see event-driven investors make:
- Giving credit to unsourced rumors
Event-driven investing, particularly merger arbitrage and special situations, relies on fundamental catalysts to create value. There has to be a tangible development, such as an acquisition, regulatory development, or legal ruling for the company’s value to change. Because stock prices begin to shift on rumors, many investors are tempted to jump on trades before properly confirming the value-creating event. That’s speculating, rather than investing, and it’s the biggest mistake made by event-driven investors.
- Taking on excessive risk relative to the opportunity
A truism of life that aptly applies to investing is to be wary of “putting all your eggs in one basket.” Couple that with another aphorism, “picking up nickels in front of a steamroller,” and you’ve got the potential for disaster. When an investor allows their portfolio to become overexposed to an individual risk, or takes on too much risk for too little reward, they’ve lost sight of the necessary risk-vs-reward balance inherent in smart long-term investing.
- Letting faith and belief override probable regulatory outcomes
The last of the top mistakes that event-driven investors make is a kind of irrational exuberance. Many event-driven opportunities are so fraught with risk that it’s best to avoid them entirely, but for emotional reasons or other biases, investors may rationalize the investment. Consider the efforts by Staples to acquire Office Depot in the face of substantial concerns about resulting anti-competitive behavior, or Pfizer to acquire Allergen despite the Treasury Department’s avowed stance against inversion deals. Believing that the companies involved will somehow find a way, when the law is clearly not on their side, makes for a poor investing strategy.
Avoiding the mistakes with a rules-based approach
ArbitrOption works to systematically avoid these mistakes with a rules-based investing approach. For instance, we only invest in event-driven opportunities that have been publicly disclosed by corporate management or the Board of Directors; ArbitrOption does not initiate positions, or exit positions, based on rumors. Ever.
Similarly, we use position caps to ensure that the portfolio does not become overexposed to any one situation, and we have minimum expected return thresholds that each trade must meet. If we can’t meet or beat the minimum expected return, we don’t make the trade.
Lastly, we have approximately 20 years of experience thinking about anti-competitive behavior, and we use that experience to anticipate regulatory obstacles to investment opportunities. If we’re uncertain, our approach is to avoid taking on the risk until the regulatory treatment becomes clear and we can invest with confidence.
For more information about ArbitrOption’s investment strategy, or to request details about making an investment, please contact us.