Alcon Agrees Novartis Deal in Consensus Hedge Fund Arbitrage Trade

Alcon (ACL) has reached an agreement to sell the remaining 23% of the company to Swiss drug maker, Novartis (NVS). Novartis is offering 2.8 shares of NVS for each share of ACL, the equivalent of $168 for each ACL share. The deal is supposed to close in the first half of 2011, pending shareholder approval.

While Novartis' offer comes in at $168 per share, ACL is currently trading just above $164. The deal is contingent upon shareholder approval and if you examine the list of shareholders, it's littered with prominent hedge funds. Back in the second quarter issue of our Hedge Fund Wisdom newsletter, we flagged Alcon (ACL) as a 'consensus buy' due to numerous hedge funds starting and accumulating positions in the company. You can check out a full free sample issue here.

Then in our new third quarter issue, we singled out Alcon as a featured hedge fund merger arbitrage play three weeks ago. To understand the hedge fund investment thesis, here's some of our commentary from our newsletter:

"Alcon was purchased by Nestle in 1977. Nestle floated to the public a 25% stake in the company in 2002. In April 2008, Novartis (NVS) purchased from Nestle a 25% stake in Alcon for $143 per share. And in August of 2010, Novartis exercised its call option to acquire Nestle’s remaining stake at a price of $181 per share.

In January 2010, Novartis made an offer of 2.8 shares of Novartis stock for each share of Alcon for the stake owned by the public (which currently values Alcon at $156 per share). Still, Alcon is trading at $163 because the offer has been rebuffed so far and investors are looking for a more equitable offer to the Nestle stake takeout that was done at $181. Arbitrageurs are betting that Novartis will increase the effective exchange ratio, so they buy Alcon and short Novartis in order to hedge out the risk that Novartis shares may go down by the time the deal closes.

Novartis closed its acquisition of Nestlé’s stake in 3Q, which increased investors’ confidence that a buyout of the public shares will happen sooner rather than later. In addition, Alcon’s share price is tied to the value implied by the exchange ratio offered by Novartis. So, as Novartis’ shares dropped in late 2Q / early 3Q, so did Alcon shares. At $135, the spread to the Nestle takeout at $181 was seen as too wide and the value of Alcon’s franchise was under-appreciated by the market.

This combination motivated some new funds to add Alcon to their portfolio. Magnetar Capital started a new position in Alcon and made it its top portfolio holding with a 12% weight. Steven Cohen’s SAC Capital maintained Alcon as its #1 position and increased its exposure during the quarter by 20%. John Paulson’s hedge fund Paulson & Co increased its exposure by 30%. Highbridge Capital doubled its position while Jamie Dinan’s York Capital and Thomas Steyer’s Farallon Capital also added shares of ACL. And while some funds are obviously short Novartis as part of the arbitrage pair (though they don’t disclose it), other funds have elected to purchase puts on Novartis to round out the merger-arb trade."

Given the quantity and quality of hedge funds involved in this trade, it will be very interesting to see if they approve the current deal valued at $168 per each ACL share or if they push for the same $181 per share that Novartis paid Nestle. With shares still trading slightly below the deal price, it will be interesting to follow.

The above is the type of research and analysis we cover in our Hedge Fund Wisdom newsletter. Be sure to click here for a free sample issue as we examine the investment theses behind hedge fund trades.

Jeremy Grantham Favors High Quality US Stocks: Market Commentary

Today we're doing a bit of 'market-strategy-Monday' here on Market Folly and will kick things off with the often-read missive of GMO's Jeremy Grantham. He is now a deflationista as he thinks it has trumped inflation as the biggest concern in the near-term. While Grantham doesn't seem too anxious to be a buyer of many asset classes, there are three areas he has deemed compelling. GMO's asset allocation portfolios are built on a seven-year forecast and here are his thoughts:

Firstly, Grantham sees value in high quality large cap US companies. The main argument? Valuation. Just last week, we highlighted hedge fund T2 Partners' bullish presentation on 3 large cap stocks. The 'buy high quality large cap' theme has been long underway in hedge fund land as a plethora of managers have now sung the praises of this opportunity. Pershing Square's Bill Ackman went long Kraft (KFT) on this notion (among other reasons) and East Coast Asset Management likes quality names as well. Grantham's GMO colleague Edward Chancellor echoes these thoughts. He says,

"When we look through the various classes of equities, we find in the U.S. that companies that are so-called quality have high expected returns relative to the market; in other words, companies that tend not to go bust, and tend to maintain their positions—the sorts of businesses that Warren Buffett made his fortune investing in and are trading at a P/E of about 14. Johnson & Johnson (JNJ) and Pfizer (PFE) are key companies—the sort that your grandmother had in her portfolio or are typically owned by trust companies. Normally they trade at premiums to market, but right now they’re not."

Chancellor also sees opportunities in the European high quality equivalent. In particular, he mentions Nestle (NSRGY), Novartis (NVS), and Unilever (UN). Last week we also pointed out how hedge fund Viking Global has a large stake in Unilever as well.

Secondly, Grantham believes that emerging market equities are the next best play. This is mainly attributable to the fact that the fundamentals in these countries are so much better than our own markets. While EAGE equities are slightly expensive, they are a much better option than say, fixed income.

Lastly, Grantham remains staunch on his view of forestry (i.e. timber). He has long advocated a place in portfolios for timber as it serves as a good diversification tool during the good times. And, during periods of uncertainty, it is a "brilliant store of value should inflation unexpectedly run away, and a historically excellent defensive investment should the economy unravel."

Embedded below is Jeremy Grantham's latest market commentary from GMO:



You can download a .pdf copy here.

For more excellent commentary be sure to head to the latest hedge fund letters where prominent managers share their thoughts on the markets.

Consensus Versus Variant Perception in the Markets: East Coast's Q2 Letter

We're pleased to present the second quarter 2010 commentary from East Coast Asset Management. The letter, penned by Chief Investment Officer Christopher Begg, touches on a number of intriguing and hotly debated topics, including inflation. Some of you will recall that we featured some past commentary from East Coast where they examined the deflation-reflation continuum.

East Coast is decisively in the inflationist camp. They believe that central banks armed with printing presses can only lead to one outcome. Their portfolio is positioned to mitigate the effects of any tail risk events such as hyperinflation, a bond bubble, a spike in interest rates, paper currency debasement, and a double dip recession. You'll recall that Baupost Group's Seth Klarman has also protected his portfolio from tail risk events as a form of cheap insurance.

Summarizing East Coast's stance, Begg writes, "The greatest opportunities to compound capital come from periods where dislocations are being driven more by 'what ifs' than the 'what is'. Fundamentals trump hypotheticals and facts weigh heavier than emotions."

Maybe the most intriguing aspect of their commentary though is the list of consensus views they've compiled. They've outlined 10 areas where there are currently consensus views in the market; areas where East Coast has strafed away from the crowd and into an opportunity with a perceived edge. They see these variant opportunities as a means to mitigate risk away from the consensus. This is a topic we've very briefly touched on in our piece where we examined the hedge fund herd mentality.

Below is East Coast Asset Management's list of 10 consensus views and their corresponding variant perception:

1. Consensus: Everyone is a macro-economist. Variant Perception: Fundamental/value investing and focusing on micro themes is the key.

2. Consensus: Binary extreme outcomes of inflation/deflation. Variant Perception: Individual investment merits based on expected return.

3. Consensus: Flood to fixed income as individual investors chase yield. Variant Perception: Bond bubble. Attractive equity total return expectations.

4. Consensus: Inflation protection via TIPS. Variant Perception: Owning businesses with pricing power.

5. Consensus: Gold - speculators are weak holders. Variant Perception: Own gold for mid-long term as paper currencies are debased. John Paulson started his gold fund for the exact same reason: as a bet against the US dollar.

6. Consensus: Overly bearish. Variant Perception: Bullish on fundamentals.

7. Consensus: Short-term time horizons. Variant Perception: Mid-to-Long term time horizons.

8. Consensus: Low rates will be the norm. Variant Perception: Interest rates will dramatically rise across the curve. (Legendary hedge fund manager Julian Robertson had previously placed a bet on sharply rising interest rates).

9. Consensus: Inferior companies can thrive. Variant Perception: High quality companies have a competitive advantage. East Coast specifically highlights Nestle (NSRGY), Waste Management (WM), Colgate (CL), Coca Cola (KO), Novartis (NVS), and Express Scripts (ESRX). We've seen numerous hedge funds become bullish on high quality companies as well. In particular, Andreas Halvorsen's hedge fund Viking Global favors ESRX. Additionally, we earlier today highlighted East Coast's bullish stance on Beckton Dickinson (BDX).

10. Consensus: Complexity. Variant Perception: Simplicity.

Begg examines each of the ten above listed views in-depth in his most recent letter and ends his commentary by giving us a view of their most recent portfolio construction. We highly recommend reading the entire East Coast second quarter letter embedded below:



You can download a .pdf copy here.

For more from East Coast Asset Management, be sure to check out their recent bullish presentation on Becton Dickinson (BDX) that we posted earlier today. Additionally, those intrigued by the inflation/deflation debate should head to their past piece on the deflation-reflation continuum. For more great investment commentary we posted up Perry Capital's latest letter yesterday as well.