Market Outlook for 2008

Alright, since my mutual fund research process has been slowed down somewhat, I will share my investment thoughts/expectations for the year.

Interest rates: I think there will be additional, albeit smaller (25bps), interest rate cuts in the future, but 2008 will NOT end with interest rates below 3%. For interest to stay that low (or lower) for that long would mean that U.S. economy would be in absolutely dire economic shape by the end of the year (which I obviously don't foresee happening) and/or that Fed will forget about its duties to monitor inflation.

Stock market: Overall stock market will rise in high single-digits or low double-digits because there are more sectors and companies with strong earnings than those going into the red in 2008. Financials sector is likely to gain a significant momentum by year since the subrime market crisis has pulled down many sound financial institutions and even punished too severely those who did deserve to be punished. Once investors will see that those companies are still making money and lots of it, they will create plenty of demand to push share of those companies up.

Attractive sectors/industries: Besides Financials, I think that Healthcare, Technology, and Consumer Staples will outperform the overall market.

• Healthcare sector tends to be independent from the overall market conditions and here is what in particular I like in Healthcare: Big Pharma and biotech stocks have been beaten down and are likely to show solid results. Companies such as AstraZeneca and Amgen have plenty of high-potential products in the pipeline and are currently selling at attractive prices. Medical equipment manufacturers should also benefit from the rising medical costs, one that I like in particular is Medtronic.


• Technology companies will benefit from renewed focus on efficiency (as always happens during economic downturns), constantly increasing demand for bandwidth and data storage put these companies in a good position: Cisco, Accenture, and EMC are the ones that I would pay attention to. Microsoft is also likely to post strong earning growth in 2008 as its Vista OS will receive wider implementation among business users.


• Consumer Staples such as Johnson & Johnson and Procter & Gamble have diversified portfolios of consumer products that people need on a daily basis regardless of the overall economic conditions. Currently, both of these companies (especially J&J) are selling at attractive prices.


• In general, large global companies who do not depend on the outside financing and have strong presence in the emerging markets should do well relatively to the overall market.

Market Down; Stock Picks Looking Better; Mutual Funds for 401(k)

With the stock market going down (especially today after the employment numbers were reported!) my stock picks keep looking better and better. Overall they're down 9%, ranging from 4.8% price increase in Medtronic to a 16.7% price decrease in Cisco. When I say "down," I mean down since I've analyzed them since that is how they're being tracked in my spreadsheet. This basically means that it was a good call not to invest in my stock picks just yet (except for Medtronic, which is actually up).

So, for now I'm holding out on investing in the stock market. This "strategy" can be called market timing, but in my opinion it may be wised to wait a bit to see how everything will get sorted out since bad news keep coming out and a number of stocks on my "final" list are dependant on the overall economy since Coach and Harley-Davidson are in the "Consumer Discretionary" category, while Bank of America is obviously in the "Financials." Of course, there is a reward for taking a risk in the turbulent times, but at this time it's not clear whether the reward is great enough to compensate for the risk. In a way, that's what investing is all about: balancing risks and rewards to maximize the rewards with minimal risks.

Jumping to a different topic. I will be looking at mutual funds (and maybe ETFs), as the time will allow, while stock market is figuring itself out. Most of the mutual funds (although not all!) have already made capital gains distributions, so it's a good time to start investing in them. Also, I will need to pick mutual funds for my new 401(k) plan, which will involve looking over 20+ mutual funds. One thing I'm not clear about is whether load/no-load mutual fund structure matters in 401(k) plans since the benefit administrator has some sort of a pricing structure worked out with the employer. I'm wondering if and whether this differs from employer to employer and how those "load" fees are passed to plan participants. This may make a significant difference in how I choose mutual funds for the 401(k) plan. Any thoughts on this?

Tentative Portfolio Allocation Targets

Now I'm looking at the capital allocation between stocks, mutual funds, etc. Here is the breakdown that I'm currently considering:

• 45% - Stock Portfolio (about a dozen top stock picks)
• 30% - International Mutual Funds
• 10% - Domestic Mutual Funds
• 5% - Speculative and merger arbitrage trading10% - Cash

It is definitely on the aggressive side, but I figure that good research takes away a good portion of the risk and long-term investment outlook (well, with the exception of speculative and merger arbitrage trading) further mitigates the risk. I feel pretty comfortable researching stocks and I think I'm not too bad at researching mutual funds either. I've researched and picked a handful of mutual funds last fall and they have all performed well even though their focus is varied.

Domestic mutual funds are meant to complement the stock portfolio, which represents a mostly domestic exposure. Domestic mutual funds that I'll be looking at will most likely have a relatively concentrated portfolio of mid-caps and small-caps with unorthodox investing strategy since I don't want a fund following the small-cap index, which isn't expected to perform too well now.

International mutual funds will diversify the overall portfolio to make sure I'm exposed to the global market gains. This is somewhat of a hedge against the U.S. economic slowdown.
Speculative and merger arbitrage trading are meant to ennhance the overall portfolio performance. It is to take up only 5% of the portfolio because it is risky and it is also meant to teach me more about markets as I make these trades. You could a call it a "play money" portfolio segment, but money is money and money involved in the speculative trading are just as valuable to me as money in the mutual funds or the stock portfolio.

And cash is there as the backup funding for additional market opportunities. For example, if Bank of America were to tank on the news that it will writing off gazillions of dollars at the end of the fourth quarter, I could use that backup money to pick up the pieces being 100% sure that the company will rebound soon enough.

I might replace some mutual funds with ETFs, depending on how long-term I will be choosing the mutual funds for. We'll see about that. With a 100 free trades from Firstrade, it is that much more tempting to use ETFs.

Signing up for Firstrade / Trading Plan Update

So, I've signed up for the Firstrade individual trading account yesterday. It will a few days before I can do any trading since it takes about 5 days for ACH bank transfer to complete. I think it's a good idea sign up for an account sooner rather than later if you're expecting to make trades in the near future even if not necessarily today or tomorrow because it does take a while for account to become active. Also, if you choose to go with the Firstrade, and sign up before the end of 2007, you will get 100 free trades. That is only $695 worth of trades ($6.95/trade x 100). If it wasn't for the promotion, I was strongly considering signing up with Tradeking which has $4.95 trades.

I have not explored the account options in detail yet, but I was pretty happy to see the S&P stock and fund reports and various market commentaries/analysis. Those additional research sources will work well in conjunction with the Morningstar analyst reports.

Once the account is set up, I will check S&P reports on my top picks so far and if I find any interesting and/or significant points, I will post them here.

So far, I have not been punished for my delay in buying the top picks. Most of those picks lost a few percentage points in price and only Medtronic and Coach are making an effort to upset me a little by their gain of 6-8%. I'm not worried about those two too much though: if you look at it short-term, there is a good chance that they'll go down again and I'll buy them at same low price that I analyzed them at; or, if you look at it long-term, they're still a large upside to both of them, so there is still plenty of gains to be made.

Final Stock Picks and What I Plan On Doing With Them

So, at last I have a handful of companies that can be invested in. Eleven, to be exact. Well, more like eight actual "investment grade" stocks + two strong candidates + one speculative play.

Capital One is the speculative play, which as tempting as it may seem I will probably pass on. After reading a Fortune article pointing out that UK has been ahead of us by about 18 months for the past several year as far as the economic conditions go and besides the subprime mortgage that they've experienced two years ago, they've also had a problem with credit card default rates afterwards. When I thought that Capital One's stock was beaten down because of its subprime exposure, I figured that extent of the downward pricing pressure on the stock was uncalled for, but now it almost seems justified if U.S. economy will keep on following UK's behavior as it has so far.

Having said what I said above about potential credit card problems, I'm still bullish on Bank of America. It'd be a shame not to snag one of the financial companies at these beaten down share prices and this company seems to be in the better position than others with an excellent balance sheet and a limited exposure to the subprime mortage mess.

Two stocks that I'm undecided about right now are Walgreen (WAG) and 3M (MMM). I've only done financial analysis on them and not the full analysis, have not really looked at their 10-K statement yet. Walgreen has a higher margin of safety and a solid track records of revenue and profit growth. 3M, on other hand, seems to have these cyclical declines all the time and although the margin of safety is only 18%, the company, it seems to me, is likely to bounce back up quicker than Walgreen if previous stock price history is any indication. So, I might take a position in both, with 3M being the smaller investment.

Out of the remaining eight picks, only two have margin of safety (MOS) under 30%: Medtronic (MDT) at 27% and Coach (COH) at 22%. Medtronic is close enough to the 30% benchmark, while a good price for a position in Coach might be worth waiting for. Coach went up 12% since I analyzed it three weeks ago, but I'm sure it will go down before keep on going back up.

So, with the exception of Coach, other seven picks (including MDT) can be invested in. What I'm waiting for right now is the Fed meeting on December 11th, which will determine what my actual final pick will end up being and the size of positions I will take in each of those stocks. What I'm concerned about is Fed's seeming unwillingness to cut the interest rate further. If the rate is not cut once again, there is a strong belief among reputable economists, such as Ed Yardeni, that such action (or rather inaction!) will induce a recession with a significant economic downturn. I figure it's worth waiting another two weeks to see what's happening, but I would prefer to make the trades before the end of the year, this way I'd have an option of taking long-term capital gains by the end of 2008 if my tax situation will be suitable for such a move. Obviously, the trades are not made for tax reasons alone and I will most likely buy those stocks anyway, but might as well do it at the time that might be tax-advantageous in the future as well.

Here is a list of stocks listed in the spreadsheet above linked to their analysis pages:

• Johnson & Johnson (JNJ)
• Cisco (CSCO)
  
• Medtronic (MDT)
  
• Capital One Financial (COF)
  
• Bank of America (BOC)
  
• Coach (COH)
  
• McGraw-Hill Companies (MHP)
  
• Progressive Insurance (PGR)
  
• Walgreen (WAG) - no analysis
  
• 3M (MMM) - no analysis
  
• Harley-Davidson (HOG)
  

Morningstar StockInvestor: Seven Different Investing Perspectives

Recently, Paul Larson, an equities strategist with Morningstar, had described seven ways in which his investment strategy differs from the conventional wisdom and academia ("Seven Different Investing Perspectives"). If I were to make such a list myself, it would look identical to the one compiled by Paul Larson. Brief version of his "seven investing perspectives" is included below.

1. Focus on the next decade, not the next quarter.

Most Wall Street analysts who publish research for public consumption spend a lot of their energy focusing on near-term tax rates, weekly inventory trends, and so on, which really do not matter in the long term.

The army of analysts on Wall Street are then serving an exploding number of hedge funds, entities whose investors demand performance - and demand it now - given the exorbitant fees usually being paid. Many hedge funds cannot afford to think about the long term, because if they suffer even a little in the short term, they might not be around for the long term.

Luckily, those willing and able to take a long-term perspective can gain an edge in this short-term-focused world, and that's exactly what I and our analysts do here at Morningstar. We spend a lot of our time thinking about where a company is going to be many years from now, because this is what drives intrinsic value. We try to minimize the short-term noise to pick out the secular trends that will really matter.

2. Price volatility does not equal risk.

If you go to business school, you are likely to be taught that risk in the stock market can be defined as the historical volatility in a stock's price. Risk is usually thought of and measured in terms of beta, a statistical measure that represents a stock's past volatility relative to an index. Frankly, I just do not understand the relevance of beta when thinking about ways I might lose money. Not only is it backward-looking, but its connection to intrinsic business value is tenuous at best.

When thinking about a stock's risk rating, Morningstar analysts do not focus on the past stock price movements of a company. Rather, we focus on the fundamental business factors - competition, litigation, financial leverage, and so on - to try to figure out what sort of margin of safety to apply to a company before buying it.

3. Price volatility is a good thing.

Not only do I think stock price volatility is a silly way to measure risk, but I actually like volatility. When stock prices whip around, it creates more opportunities to buy things when they go on sale. Moreover, volatility can fling stocks well above their intrinsic values, creating selling opportunities.

I think two of the more famous Warren Buffett nuggets of wisdom apply here. (Though Buffett is as mainstream now as he has ever been, he is still seen as a heretic in many academic circles.) According to Buffett, one of the cornerstones of his strategy is, "Be fearful when others are greedy, and greedy when others are fearful." The other Buffett quote that backs up my favorable opinion of volatility is: "Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

4. Concentration has its benefits, overdiversity its downfalls.

It seems that whenever I hear financial advisors speak, they are always preaching the benefits of diversity. While I agree every portfolio should have some level of diversity to prevent any single mistake from causing financial doom, I do not think the downside of diversity gets enough attention. Specifically, the wider you spread your portfolio around, the less you will know about any single investment, and the greater the chance you will miss something that is wrong. Call it the risk of ignorance.

In other words, I agree that it is good advice to not put all your eggs in one basket, but do not forget about the risks of trying to carry too many baskets. Or, to use our "fat pitch" metaphor, don't swing at the marginally decent pitches, because then your swings at the truly fat pitches will be diluted.

5. Bottom-up is better than top-down.

There are two basic ways to look at stocks. The first way (and what we do here at Morningstar) is to look at an individual company - its competitive positioning, profitability, growth prospects, and so on - to come up with an intrinsic value estimate for the business. We then compare this fair value estimate with the current stock price to come up with our Morningstar Rating for stocks (the star rating).

The other way is to try to pick out macroeconomic trends and generate investment ideas from these trends. Some examples might include ideas regarding the aging population, interest-rate movements, global-warming regulations, changes in consumer-spending patterns, and so forth. Some investors might choose to overweight or underweight their portfolios in certain sectors based upon their views of some of these trends.

The problem I see is that there are often too many logical links between the ideas and the actual stock investments. Even if your idea is correct, you could still select the wrong stock for that idea. Another pitfall of looking top-down is forgetting the importance of valuation and paying too much for a stock.

I also do not try to "fill the box" when managing the [stock portfolio]. What I mean by this is deciding on some sort of asset allocation - either by sector or stock style - and then picking stocks to try to fit my target allocation. To me, this is putting the cart before the horse.

What I do instead is look at each stock on a case-by-case basis, and I then let the cards fall where they may with respect to the sectors and styles of my holdings. Only at the extremes might I get worried (such as having more than half a portfolio invested in a single narrow industry).

6. Increased portfolio activity does not create higher returns.

In the real world, the more activity you have in a given area, the greater the return in that area, in general. For example, the more you exercise, the more weight you lose. The more you play golf, the better your swing will get and the lower your handicap will go, and so on. But when trading stocks, the exact opposite is true. In general, the more you trade, the lower your returns will be.

There are the frictional costs of taxes, trading spreads, and commissions that will eat into your capital every time you trade. Of even greater importance in my mind is the amount of thought that goes into each trading decision. It seems that the greater the thought-per-transaction ratio, the better our results should be, all else equal. I spend hours upon hours considering each transaction in the Tortoise and Hare, but spend mere minutes interacting with our broker doing the mechanical transactions, worrying about nickels and dimes. I get the impression that too many investors have this ratio reversed.

7. Focus on value, not price.

It strikes me that many in the market know the price of everything and the value of nothing. I will admit that there are scores of companies for which I know what the stock price has done, but have no clue about the value of the underlying business. But before I invest in something, there is no way I would put a single penny in without having some idea what the underlying business is worth. Knowing price without knowing value means knowing nothing.

I recently was asked if I had in place any stop-loss orders for positions in the Tortoise and Hare. The answer is a resounding "no." Making decisions based on historical prices makes no sense to me. Moreover, assuming that the intrinsic value of a business is unchanged, when its stock price goes down, that is the time to get more excited and consider buying more, not time to cut bait.

Of course, the key phrase is "assuming the intrinsic value of a business is unchanged." We are continually questioning our theses and projections for the companies we cover, always digging deeper for pieces of confirming or contradictory evidence. These fundamental factors - not stock prices or ideas about future market sentiment - are what drive our fair value estimates.

Miscellaneous Stock Tips: Issue #1

1. As one fund manager has noted, there is a reason to not like companies with a very low tax rates: because it's a sign that IRS will eventually catch up with them or that the company is possibly manipulating the earnings. With an average corporate tax rate of 35%, companies with a tax rate of 15-20% seem suspicious.


2. Avoid homebuilding stocks as they are difficult to value: it is not always clear whether the gains come from the business growth or from the higher valuation of their land assets.


3. Bank stocks are still not a good buy since global credit boom is most likely in its last days and even good banks are likely to suffer or trade sideways. (Having said that, if you have a long-term investing outlook you can find a few financial giants that may rock your world, such as Bank of America (BAC) and Capital One Financial (COF), which I've recently reviewed).
   


4. Gold is considered as a hedge investment (or insurance) against an equity market slowdownsince it usually goes up when the stock market goes down.

Morningstar's Investing Strategy

I whole-heartedly agree with the investing strategies suggested by Morningstar and outlined below. This is definitely part of a value-investing approach, particularly as manifested by Warren Buffet's investing style.

This strategy fits in well with Morningstar's 20 Stock-Investing Tips.

1. Look for Wide-Moat Companies.

The fat-pitch approach is best described as buying above-average (wide-moat) companies at prices that provide a margin of safety to your fair value estimate.

Companies with wide economic moats reside in profitable industries and have long-term structural advantages versus competitors. These companies are fat pitches with predictable earnings, returns on capital higher than the cost of capital, and long-term staying power.

The beauty of a wide-moat company is that the odds are pretty high that the actual intrinsic value of the firm will increase over time, leading to higher shareholder value. In other words, time is on your side with these companies.

We recommend maintaining a watch list of wide-moat companies that you consistently monitor for any opportunities.

2. Always Have a Margin of Safety

Buy a stock only when it's selling at a decent margin of safety to your estimate of its fair value. Don't even think about the overall direction of the stock market, because that's impossible to predict with any consistency. By doing this, you'll need to exercise a lot of discipline and wrestle with the fear of missing out on a market rally. Patience is indeed a virtue when using this approach because oftentimes it may take many months, or longer, before a fat-pitch opportunity presents itself.

Think only about individual wide-moat companies; if you find one where the price is irrationally low relative to its long-term intrinsic value, consider buying it. If not, hold off for a fatter pitch.

Also, you must determine how much of a margin of safety you'll require before buying a stock. If the firm is not very risky, you could be content with a 15%-20% discount to its fair value. If the firm is riskier than average, you may demand a 30%-40% discount. Ultimately, it's your decision.

The beauty of fat-pitch investing is that it has two built-in factors that help offset the risk that your fair value estimate is wrong. First, by requiring a margin of safety, you've given yourself some "error cushion," just in case your estimate was too high. Second, by purchasing wide-moat companies, chances are high that the firm will increase in value over time. Thus, even if your estimates were way off, the firm--and its stock price--will likely appreciate in value, eventually catching up to your fair value estimate. In effect, by buying wide-moat companies, you have another margin of safety built into your investment.

3. Don't Be Afraid to Hold Cash

For instance, many professionals getting paid to invest other people's money feel they are actually required to stay fully invested even if there's a lack of fat-pitch opportunities. Thus, when the market drops, they often can't do anything but watch (or worse, sell out near the bottom).

So if the market isn't throwing you fat pitches, just hold on to your cash and wait until it does, because fat-pitch investments are much more likely to provide strong absolute returns over time.

4. Don't Be Afraid to Hold Relatively Few Stocks

Remember, it takes great patience to be a fat-pitch investor, but when opportunities present themselves (nice fat pitches right down the middle), you should buy boldly (swing away).

We caution you, however, that it's risky to hold a concentrated portfolio (few positions) unless you do three things:
1. Buy only wide-moat companies, which will increase in intrinsic value over time.
2. Buy them only at a significant discount to fair value (a margin of safety).
3. Have a time horizon of at least three years on each pick you make. It may take this long (or longer) for the market to recognize the value of a company.

5. Don't Trade Very Often

Think of it this way: Investing is nothing more than a game of probabilities. No matter how diligent you are, your fair value estimate for a stock will never be exactly right. It's really just an estimate of what a stock is worth under the most likely scenario for future earnings growth and profitability. Thus, there's always less than a 100% probability that you'll be right about a stock pick. Given that the odds are below 100%, there's little point in trading from one stock to another frequently; your odds of being "right" on the new pick are probably only a little higher than the odds of being wrong on the current pick.

Add to this the costs of trading--including taxes, bid-ask spreads, and commissions--and the odds of generating higher returns by trading frequently are worse than simply buying great stocks at good prices and holding them for three years or more.

Additional resources:

• Morningstar's 20 Stock-Investing Tips
  

• Morningstar's Investing Classrom (Free)
  

Forget About Investing Into Mutual Funds (for now, that is)

If you're considering to start investing into mutual funds, it may be a good idea to delay that decision for a few months. Many mutual funds make capital gains distributions at the end of the year and what that means for new investors is that they will pay taxes on gains they didn't receive if they invest into a fund shortly before the distributions are made. Since distributions are often made during the months of November, December, and January, it may make sense to wait a while.

Of course, the size and frequency of distributions vary from fund to fund, so you'd need to research the particular mutual fund you're interested in. What I would do in this situation is:

1. Find the mutual funds you're interested in


2. Research the capital gain distributions policy: how frequently distributions are made, what's the expected amount of distributions this year, and when they expect to make these distributions


3. If this information isn't readily available on their web site or you simply don't seem to be able to find it, then just e-mail the fund adviser and inquire about it (e-mail addresses, or contact forms, should be easily found on their web sites)


4. Once you know the date of the distribution, mark it on your calendar and invest into the fund you chose after that date

Additional information:

• Morningstar: Watch Out for Distributions
  

Morningstar Stock Rating Performance Revisited

Morningstar has recently released its regular update on how well their stock rating system has been performing. If you were to buy their 5-star stocks and sell them at Fair Value, you would have trailed S&P 500 for the past year (11.2% vs 18.4%), but if you had followed this strategy since the inception of their stock rating system in 2001 you would have outperformed S&P 500 by 2.3% (7.9% vs. 5.6%).

They compare different strategies of using their rating system in comparison to S&P 500 performance in the full article: Stock Star Rating Performance Update.

Even though I wouldn't call these results mind-boggling, they did outperform the overall market in the long-term comparison. I also believe that this proves that Morningstar ratings are a great starting point for finding great stocks: if you can outperform the market by simply basing your buy/sell decisions on their star ratings, think how well you can do if you also apply your own analytical skills.

Will the Financial Sector Rebound Again?

Financial sector has tumbled once again in this post-subprime-mess era. What I'm wondering right now is whether it will make another come back after the Fed meeting on October 31st. It has rallied after the discount rate was cut in August and kept going up even faster after the Fed has cut the prime rate by 50 basis points at the September 18th meeting.

Fed is widely expected to cut the interest rate again at the next Fed meeting on October 31st. Although this time it will probably be cut by 25 basis points. Will the cut motivate the markets to surge ahead despite the deep problems a number of large financial firms face? Will the 25 basis points cut be enough? I don't know and I doubt anybody else knows either. But no matter which way the market will go, further development will definitely be interesting to watch.


One company I've been watching is Bank of America (BAC). It has a very solid business model, robust earnings, and is the only truly nationwide bank in the U.S. I'm wondering how low the stock will go, but, as we all know, trying to time the market and trying to get the lowest bargain price before the stock rebounds is more of a gamble than a prudent investing strategy. Either way, I'd prefer to wait out and get in at the beginning of an uptrend than at the end of a downtrend.

How to Make Money from Merger Arbitrage

When a public company is acquired there is a potential to make money on the difference between the offered price and the current market price. If the company trades for $10/share and a suitor offers its shareholders $15/share, obviously someone is going to make money on the difference.

The basic risks involved are:

• Whether the takeover will be completed as planned or delayed or even canceled


• If it's a stock-only deal (where shareholders of the company being acquired are offered shares of a company that is taking over), then there is a risk that the merger will not as successful as expected and new company's stock decreases

There are typically three possible options that can be presented to the shareholders of a target company (a company being taken over): stock-only, stock-and-cash, and cash-only. Usually cash-only is the best option since its more straightforward and you only need to be concerned with valuating the target company.

The ideal deal is when the merger is cash-only, there is a very high likelihood of the successful takeover, and the whole deal is expected to complete very quickly. The sooner the deal closes the quicker you can take your profits and look for other arbitrage options on the market. The problem with such an "ideal deal," though, is that it is very difficult to buy shares of the target company before they're bid up to the takeover price. If the company trades at $10/share and offer price is $15/share, the share will most likely reach the offer price of $15/share on the announcement date. Unless you're sitting in front of a terminal all day long and monitor merger activity, you will miss out on a buying opportunity that day.

So, the most likely scenario is when a merger takes 4-8 months to complete and there are persistent rumors about different ways that a deal could fall through. After several months many investors grow wary and start selling the stock lower than the offer price. If you're patient and your research tells you that the deal will certainly happen, you can start buying during that slight price dip - the prices aren't likely to fall by much unless the deal is really shaky, but even if you make 7-15% over the course of 2-4 months, those returns will add up to a sizable annual rate of return for you if you can find deal after deal after deal throughout the year. To quote ArbitrageView:

"One of the best ways to reduce the risk in merger arbitrage is to participate in multiple deals simultaneously. Diversifying across several deals without being overweight in any particular one will ensure that if one of the deals fails it will have only limited impact on the portfolio as a whole."

So, here is how I would approach a merger arbitrage investing process:

• Find a list of mergers currently underway


• Choose highest-yielding arbitrage opportunities and focus on them first


• Research the target company:


• Determine its fair value


• Evaluate whether this company will be a good long-term investment at the current price if the merger falls through


• Research merger terms:


• Evaluate the risks involved


• Quantify the likelihood of the merger deal falling through


• Finally, carefully consider all the risks and yields involved and made a decision whether to participate in the arbitrage of this deal or not
  

You can use Benjamin Graham's risk arbitrage formula to determine what your reward would be once you account for risk involved in the deal. Here is how it works:

Annual Return= (C*G-L(100%-C)) / (Y*P)

or

Annual Return = (0.70*0.15-0.20(1-0.70)) / (0.5*1) = 0.09 = 9%

Where:
• C is the expected chance of success (%) or 70% in the example
• P is the current price of the security or 1 in the example
• L is the expected loss in the event of a failure (usually original price) or 20% in the example
• Y is the expected holding time in years (usually the time until the merger takes place) or 0.5 (6 months) in the example
• G is the expected gain in the event of a success (usually takeover price) or 15% in the example

Additional resources:

Arbitrage opportunities in pending merger deals in the U.S. market:

• ArbitrageView: click here
• MergerInvesting: click here
• The Online Investor: click here
  

Articles about merger/risk arbitrage:

• Investopedia: Trading the Odds with Arbitrage
• Risk Glossary: Event Driven Trading Strategy
• Morningstar: The Basics of a Buyout
• American Venture Magazine: Merger Arbitrage
  

Other web sites focused on mergers/acquisitions and arbitrage strategies:

• Mergers & Acquisitions DealBook (by New York Times): click here
• Deal Journal (blog by Wall Street Journal): click here
• FocusInvestor.com (Tons of information on Buffett-style investing and arbitrage): click here