When 1 + 1 = 3

Arbitrage: Attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. The ideal version is riskless arbitrage.

There are many different ways to approach this technique and most are not appropriate for the long term small retail investor (i.e. us).

The 2 special situations that are relatively safe and lower maintenance include:

1. buying holding companies that own equities whose market values, when added together, far exceed the current share price of the holding company. Another way to say this is that it is trading at a deep discount to NAV.
2. exploiting corporate "spin-off" opportunities: a large company breaks itself up into a number of smaller companies to unlock value unappreciated by the market prior to the breakup.

3 current examples of #1 are Power Corp (POW.TO), Investor AB (IVSBF.pk) and Toyota Industries (TYIDF.pk). A brief explanation of the Power Corp play can be read here. A very clever analysis of an example of #2's strategy on AHC (a large newspaper conglomerate)'s spin off should definitely be read here.

It's unbelievable to me that these situations can actually exist when there is so much "smart money" floating around-- you'd think the opportunity would come up and disappear within seconds as there are so many professional money managers scouring the market 24/7 looking for this kind of stuff.

Peter Lynch explains in his book "One up on Wall St." that institutional money is highly constrained from taking advantage of special situations that put the odds heavily in favour of the small indpendent investor:

1. The "window dressing" effect-- in order to make their performance numbers match the market and the competition come RRSP/401K time each year (you better believe their job relies on that) the money managers purposely sell stocks with remarkable long term potential but have suffered a short term set back and buy stocks that have momentum i.e. buying high and selling low or buying expensive and selling cheap
2. Brokerage/Company rules requiring at least 2 analysts to give a favourable report on the company AFTER the spin off. This is like assuming that the spun off companies are like brand new public companies... complete unknowns even though they often function exactly like they did before with the same clients and the same management as pre-spin-off. Garnering analyst attention and a published analysis usually takes months.
3. Most money managers will choose a mediocre return or even a loss in popular (= expensive, usually!) house hold name companies than a superior return over the long term in an initially obscure company. This way when they defend their investment choices to their clients (particularly the professional ones), the blame can be attributed to external forces.
4. Most pension funds have rules preventing investment in small cap stocks or in any equity that does not come from a committee approved list. As everyone knows, nothing good has EVER come from committee (unless one or two people do all the work and everyone else lets them)
5. Last but not least, when a bear market sets in, investors often panic and this leads to large and rapid redemptions from mutual funds, hedge funds and even pension funds. Unless the fund is sitting on a large wad of cash, it MUST sell stocks immediately to fund those redemptions no matter what the price currently is and no matter what brilliant strategy the manager has in place.
   

The notable exceptions to 1-4 include the vital few who make up the gurus with long term market beating performance. The vast majority of these gurus use value oriented methodologies despite often having remarkably different portfolios. Clearly there are many ways to skin the investment feline.

Take comfort that for once, you have an advantage over the "big guys" on Wall and Bay St.

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