Fear, Uncertainty and Greed with CEG Merger Arbitrage

I must admit today’s market activity struck fear in my heart, but for a very specific reason. Constellation Energy Group’s (CEG) stock took me for a wild ride today. Thankfully, as a value investor, I knew that I had to keep my fear in check in order to profit. Let me share with you my story of fear, uncertainty and greed with this merger arbitrage opportunity.

About a week ago, I was kicking myself for missing a great arbitrage opportunity. Berkshire Hathaway’s MidAmerican Energy Holding Company announced on September 18th that it was buying out Constellation Energy Group (CEG) for $26.50 per share in cash. I follow Warren Buffett’s Berkshire Hathaway (BRKa) pretty closely, so the buyout headline stuck in my head.

The next day I once again spotted Constellation Energy Group in my feed reader, but this time it was for a blog post by Derek at Stableboy Selections. He noted that CEG was trading at 18% below the $26.50 buyout price. That caught my attention. It is very rare for a company that is being bought for cash to trade for a discount of less than 10% unless something is wrong.

I started searching around for any potential issues with the CEG deal for about a half hour. I couldn’t find anything, so I went to place an order for CEG in my Special Situations Real Money Portfolio account. As I was placing the order, CEG jumped up to $26.50 and then traded slightly above even the buyout price. I missed the 18% potential profit by just minutes. As members of Fat Pitch Financials Contributor’s Corner know from my comment to premium subscribers, I was very disappointed. I missed that fat pitch, but at least no strikes are called in investing.

Fast forward to today. After my lunch, I checked my newly created list of merger arbitrage opportunities that I’m maintaining at Contributor’s Corner. I noticed that CEG was down over 10%. I looked for news about the deal and I didn’t see anything new. Given a second chance to swing at this fat pitch, I purchase 400 shares of CEG at 23.51.

Shortly after my order was filled, I decided to check CEG again. The price dropped to 22. Then I made the mistake of refreshing my browser again. This time it showed 20, and on a subsequent quote the price was 19. The blood started draining from my head. I started to really doubt myself. Did I make a mistake? Should I quickly sell? Thankfully, I held it together.

I scrambled to find out what was going on to cause this massive price drop. I couldn’t find anything on Yahoo! Finance, MarketWatch, Bloomberg, Reuters, Google News, the Wall Street Journal or the Financial Times. The news was just dominated by today’s failed Congressional vote for the financial bailout plan. Finally, I check the Yahoo Message Board for Constellation Energy Group. There I spotted a post that caused me to panic, “Headline – Constellation seen considering Chapter 11 filing.” By this point, CEG dropped to 18, 17, and finally 15 in just moments! I quickly checked the above news sources again and then searched for the term “Constellation Chapter 11” on Google News. Nothing came up.

By this point, my senses thankfully returned. Why didn’t the author of the message board post include a link? That was suspicious. Then someone else asked for the source, but the only response included a domain name, www.sparkspread.com. The site wouldn’t load for me after several frantic attempts. Then I pulled up a cached version of the site and it didn’t appear very authoritative and no CEG headline appeared. Now, I suspected this whole bankruptcy scare was likely a hoax, to put it nicely. I hope the SEC looks into this, but given all the other market insanity I’m not counting on it.

At this point, Constellation Energy Group started to climb again back to 19 and then 20. At twenty, I decided that I should really average down my position, so I picked up more shares at $20.30. Mr. Market still seemed a bit unconvinced, so CEG dropped back below 20 briefly, but I was out of cash at this point.

The drama came to a conclusion at around 3:30 PM this afternoon when MidAmerican issued a press release confirming that the merger was still on track. Surprisingly, shares of Constellation Energy Group only ended the day at 23. I’m pretty confident that Warren Buffett’s MidAmerican subsidiary will stick to its offer. Mr. Buffett is known for being honorable and holding firm on his offers. Financing is not an issue here, since parent company Berkshire Hathaway definitely has the cash pay for this buyout.

I learned several lessons from today’s activity. First, Mr. Market can be completely irrational and lead others to do crazy and even irresponsible things. The price swings associated with CEG today were simply crazy. When no one could explain the initial price drop, a nasty rumor was posted to fill the void created by the uncertainty. Second, major market turmoil can open up opportunities in merger arbitrage for individual investors, where normally the profit margins are too slim. I normally avoid merger arbitrage, but this market crisis has caused institutional investors to sell off their holdings and some hedge funds are closing down and unwinding their positions. This basically takes the professionals in arbitrage out of the game and allows us amateurs to get a chance at bat. Finally, trust your own research and always confirm rumors before even considering acting on them. I wish I had tried to call Constellation Energy Group right away when I first learned of the rumor. A simple phone call to someone in the know could have cleared up my uncertainties immediately. I wonder if the folks who bought CEG between 15 and 16 today were in that position, or just had major cajones and bought low.

I’m just happy that I’ll likely be able to make a nice return on this relatively low risk position. The Special Situations Real Money Portfolio is likely one of the few portfolios you’ll read about that is still up 14.7% this year and generating a 25% compound rate of return since inception. Now I just need to get my value plays in the Fat Pitch Financials Portfolio to perform half as well. Fat pitches are flying and I need to start swinging.

Disclosure: I own shares of CEG. No other stocks mentioned are owned at the time of the post.

11 thoughts on “Fear, Uncertainty and Greed with CEG Merger Arbitrage

  • September 30, 2008 at 8:26 am
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    Wow good job on keeping your emotions in tact. I never really trust yahoo/google/msn message boards for information however. Anyone could register a domain name and post anything they want in a message board.

    Speaking of arbitrage, what do you think about BUD trading at a 10% discount to its tender price?

  • September 30, 2008 at 8:29 am
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    The BUD arbitrage play looks pretty good. It’s on my list of what to buy as cash frees up in my portfolio.

  • September 30, 2008 at 8:30 am
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    Do you have any thoughts as to whether CEG will entertain the EDF deal for $35/share despite agreeing with MidAmerican?

  • September 30, 2008 at 3:19 pm
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    George,

    Great job. I wish I’d been watching this play out!

  • September 30, 2008 at 7:17 pm
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    @value: I’m not banking on the EDF deal. The regulatory approval for such a deal would take too long and add lots of risk in this financial market chaos.

    @Nick: You missed one hell of a roller coaster watching CEG yesterday.

  • September 30, 2008 at 11:42 pm
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    I think you should be very clear to your readers that this buyout is still in the “due diligence” at this point, and could fall apart.

    Misleading, potentially, by omission.

    JW

  • October 2, 2008 at 2:00 pm
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    Pretty good news today regarding CEG. Do you close part of your position on the strength or do you hold for $35?

  • October 2, 2008 at 10:31 pm
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    I closed out my position in CEG today. I actually placed a limit order to sell at $26.40 yesterday. The reason I placed that limit order was because I was scheduled to be in an all day meeting today, which would prevent me from monitoring CEG. I wanted to make sure my position was sold if Mr. Market went crazy again and shot the price of CEG up to the buyout price. I’m not very confident about the EDF offer for $35, so I’m happy with my decision to sell CEG today. In addition, I want to be ready to pounce on another merger arbitrage opportunity tomorrow if the bailout is not passed by the House.

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