Any discussion about the greatest investors of all time would no doubt include mention of legendary Berkshire Hathaway (BRK.A -0.39%) (BRK.B -0.56%) CEO Warren Buffett. Since taking the helm back in 1965, his stock picks have yielded compounded annual gains of roughly 20% and have collectively soared a mind-boggling 3,787,464%.
The so-called Oracle of Omaha has employed a number of different strategies over the years in order to produce Berkshire's unrivaled gains. Buffett's primary goal is to buy quality businesses at a fair price, though he occasionally employs a strategy known as "arbitrage" when the conditions are right.
In early 2022, Buffett saw one such opportunity and pounced, and it turns out it was a pretty prescient move. In doing so, he may have just booked more than $1 billion in profit in one fell swoop. Here's how Buffett did it.
Image source: The Motley Fool.
The background on the deal
In late 2021, one of Buffett's investment managers accumulated a $975 million stake in Activision Blizzard (ATVI), believing that the stock was undervalued. Coincidentally, the purchase came just months before Microsoft (MSFT -1.73%) announced its intention to buy the video game purveyor for $68.7 billion, or $95 per share.
Some investors found the timing curious, but Buffett posted a letter on Berkshire's investor relations website, making it clear that the company had no prior knowledge of the pending acquisition. He also pointed out that the stake was purchased several months before the deal was announced.
A compelling opportunity
While some investors may not be familiar with the concept of merger arbitrage, the strategy is simple enough. When one company offers to buy another, the purchase price historically includes a premium to entice investors to get on board with the deal. This results in a gap between the trading price and the buyout price. From the time of the announcement to the time the deal closes, that price gap narrows, eventually closing in on the buyout price.
Once an acquisition deal has been announced -- like the one between Microsoft and Activision -- investors who have a high degree of confidence that the deal will ultimately close can buy shares of the company being acquired at the current, lower price. As they near the closing date, investors can sell the stock at the recent -- and hopefully higher -- price, pocketing the difference as profit.
While there's no such thing as "a sure thing" in investing, for investors who are confident a deal will likely close, merger arbitrage offers the opportunity to bank the difference over the life of the deal.
After Microsoft announced its intention to buy Activision Blizzard, Buffett believed there was a high degree of probability that the merger would ultimately go through, raising his stake to as much as 9.5% of Activision stock. After numerous small sales, his stake in Activision stood at roughly 6.3% of the company, or 49.4 million shares, as of March 31, the date of Berkshire's most recent regulatory 13F filing.
What Buffett was thinking
At Berkshire Hathaway's annual shareholder meeting in early May, Buffett explained his rationale for increasing his position in Microsoft after the initial purchase by one of his portfolio managers.
"Occasionally I'll see an arbitrage deal and do it," Buffett said. "Occasionally it looks like the odds are in our favor, but absolutely we can lose money on that company, fairly large sums of money, depending on what happened if the deal blows up." He went on to point out that while he had a good chance of coming out ahead, there was still a degree of risk. "If the deal goes through, we make some money, and if the deal doesn't go through, who knows what happens," Buffett said.
The biggest wildcard to the deal closing was the reactions of the various regulatory bodies that would have to approve the acquisition. "We don't know what the Justice Department will do, we don't know what the [European Union] will do, we don't know what 30 other jurisdictions will do. One thing we do know is that Microsoft has the money," he said.
Now what
As the date of the prospective deal moved closer, there was still a great deal of uncertainty about whether Microsoft would win the regulatory approval necessary to close the deal. That may have explained why Berkshire was gradually trimming its stake in Activision. However, a court ruling this week suggests the deal could end up closing later this month, earning Buffett a well-deserved windfall.
That said, if Buffett didn't sell any of his Activision stake during the second quarter -- and that's a big if -- he could still hold more than 49.4 million shares. Buffett acquired the stock at a weighted-average of $73.95, according to Business Insider. At the market close on Wednesday, Buffett has made more than $800 million on the trade. If the deal ultimately closes at the stated price of $95 per share, Buffett will walk away from this deal with more than $1 billion in profits.
Not bad for just 18 months' work.
