Last Wednesday, I wrote about Constellation Energy (NYSE: CEG) being bought by Warren Buffett’s MidAmerican Energy. I gave you a heads up that the market was severely undervaluing CEG at a price of $23.75, well below the buyout price of $26.50. And we didn’t have to wait long for the correction…

Thursday, the price jumped to $27.40, and by Friday it reached a high of $28.99 – a one-day gain of 15.37%, or two-day return of 22.06% for those lucky enough to sell at the peak.

But these moves aren’t uncommon in arbitrage opportunities.

• Arbitrage is where you attempt to profit by exploiting price differences of identical or similar financial instruments.
• Arbitrage opportunities are simply short-term times to profit from the differences in the current and expected price.
• In Constellation’s case, it was the difference between the offer price of $26.50 and the market price of $23.75.

When the market is confused and volatile – like it is right now – its efficient pricing mechanism can be thrown out of alignment. In this environment, there are an increased number of arbitrage opportunities to pick up undervalued companies. Which is why, for the past few months, I’ve been talking about "deep value investing" and picking up good companies at a discount.

Arbitrage Opportunities – While Rare Are Extremely Profitable

Arbitrage opportunities are generally rare, but there are a number of these profitable arbitrage situations out there right now. Here are three of the most interesting arbitrage opportunities…

• Arbitrage Opportunity #1: Anheuser-Busch

  The spread (price difference) on the Anheuser-Busch (NYSE: BUD)-InBev (EBR: INB) merger has grown because of concerns that InBev could have trouble securing the financing needed to close the deal.

  The credit crisis and the strengthening dollar are impacting the Bud/InBev takeover. Every day the dollar increases in value, the cost to InBev goes up. Earlier this year, foreign buyers saw an abundance of cheap American assets. But things have changed, and the strengthening dollar is costing foreign buyers dearly.

  But the Belgium-based InBev is standing by the deal. Here’s a recent company statement.

  "InBev has fully committed financing in place with signed credit facilities from a group of leading financial institutions and has already successfully completed the primary syndication phase of the committed financing. 

  "The [Mandated Lead Arranger] group represents a very diversified group of strong banks, giving InBev access to all significant capital markets. We are confident in our financing and are on track to close the transaction by the end of the year."

  Because this merger is being funded by 10 of Europe’s largest banks, I believe the deal will eventually be completed. InBev’s purchase offer was for $70 a share. With BUD shares trading near $62, you could stand to make over 12% before year’s end, when this deal is expected to close.

• Arbitrage Opportunity #2: Wachovia
  
  Another arbitrage opportunity is the Wachovia Bank (NYSE: WB) takeover – now being fought over by Wells Fargo & Company (NYSE: WFC) and Citigroup (NYSE: C).

  Under the terms of Wells’ agreement, Wachovia shareholders will receive 0.1991 shares of Wells Fargo common stock in exchange for each share of Wachovia common stock. The transaction, based on Wells Fargo’s closing stock price of $35.16 on October 2, 2008, is valued at $7 per Wachovia common share for a total transaction value of approximately $15.1 billion. Wachovia has almost 2.2 billion common shares outstanding.

  Before the Wells/Wachovia merger agreement was announced, Wachovia had been the subject of a Citi/FDIC arranged takeover plan. Citigroup is pushing regulators to try to force its earlier deal, and CEO Vikram Pandit has already brought a suit on New York State for damages.

  Wells Fargo opened up today at almost $33.00, this price values Wachovia at $6.57. WB opened up at $5.30 – this $1.27 difference equates to a return of almost 24% for investors.

  Wells Fargo Chairman Dick Kovacevich said, "This agreement makes compelling business and strategic sense and is simply an incredible fit that will result in an immensely strong, stable financial services company that will carry on Wachovia’s proud tradition of being one of the very best financial institutions in the world." The combined company will be one of North America’s most extensive financial services distribution networks.

  The battle for Wachovia is far from over, and its assets are an attractive prize for any large bank. Which means the outlook is getting rosier for WB shareholders. Citibank may have to sweeten the deal, which could result in a bidding war between it and Wells Fargo.

  Right now it looks like Wells Fargo and Citigroup will divide Wachovia’s assets as opposed to an outright sale to either. But stay tuned – this deal seems to change by the day. The bottom line, this merger has lots of uncertainty and that translates into arbitrage opportunity.

  It should be noted, too, that Berkshire Hathaway is the largest shareholder of Wells Fargo. Warren Buffett has been on a spending spree lately. To find our what else he’s been buying, go here.

• Arbitrage Opportunity #3: UST

  The credit crisis is also creating an 11.74% spread between Altria Group’s (NYSE: MO) offer for UST Inc. (NYSE: UST) at $69.50 and the market price of $62.20. The credit uncertainty forced the companies to announce an amended merger agreement. This extended the closing date for the deal, but it also strengthened the deal’s ultimate outcome.

  The announcement says, "While Altria currently has fully committed financing to complete the transaction, Altria’s lenders advised that it would be preferable to close the transaction in 2009. The parties also agreed to increase the "reverse termination fee" from $200 million to $300 million under certain circumstances, which are detailed in the amendment. In addition to the regulatory review process, completion of the transaction remains subject to UST shareholder approval and certain other customary closing conditions."

  By increasing the breakup fee, these companies have given us a strong indication that the deal will go through, even if it takes a bit longer than originally expected.

  UST shares pay a dividend of almost 4%. By adding the dividend to the price spread, you have a relatively risk-free opportunity to pocket a gain of almost 16% – even if this deal takes a year to close.

Arbitrage Opportunities Involves More Risk Than Average Purchases

Arbitrage opportunities involves substantially more risk than an average stock purchase because you are betting against the market’s pricing mechanism. But isn’t this what contrarian investors do all the time?

Use extra caution if you’re considering profiting from arbitrage opportunities or situations, and perhaps use tighter trailing stops to protect yourself. Keep an eye out for differences in the prices between a publicized buyout and the current price – it creates great opportunities for short-term profits.

And with all the panic and fear, there might be an arbitrage situation right under your nose.

Good investing,

Floyd G. Brown
Investment U