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Dhandho 302: Fixate on Arbitrage
The author recommends investors to "fixate on arbitrage", especially in those situations where downside risk is eradicated, even if upside prospect is limited. He talks about the following types of arbitrage, with special emphasis on the last one:
- Traditional: Buying gold at a lower price on one exchange and selling it at a higher price on another.
- Correlated: Buying shares of a Class B stock while shorting the shares of Class A if there is a price/value disparity.
- Merger: Acquiring a company about to be bought out by another. It is crucial to note that this kind of arbitrage is normally not risk-free.
- Dhandho Arbitrage: It is the primary theme of this chapter. It allows businesses to earn above-normal profits for a restricted time before competitors and substitutes enter and demolish these higher returns. According to Buffett, a moat is a sustaining Dhandho arbitrage.
The author further explains the Dhandho arbitrage spreads of different businesses. Few have spreads of just a few months, while others have spreads that stretch for decades. While he asserts that the "Dhandho arbitrage spreads" of all businesses will ultimately be eroded, two vital factors can allow investors to earn outstanding returns in the interim: the most or the size of the spread, and its timespan.
In the end, he portrays a couple of businesses owned by Warren Buffett that don't have moats any longer, Blue Chip Stamps and World Book. However, the "arbitrage spread" obtained by these companies over the years has helped Buffett make a lot of money. For example, his purchase of See's Candy was partly bought by money reaped from Blue Chip. The author recommends investors looking for exceptional returns should invest in companies with wide and lasting Dhandho arbitrage spreads.
