An exercise in real-life arbitrage

By DAVID MOON, Moon Capital Management, LLC
May 4, 2008

At the appropriate price, almost any asset can be an attractive investment. Even a house on the wrong side of town, if priced cheaply enough or offered on the right terms, would warrant the interest of an astute real estate investor.

Never mind that every PTA, neighborhood group or realtor has a different definition of the 'wrong' side of town.

The best investment is when you can buy an asset for 70 cents after already arranging to sell the asset for $1. After you buy the asset, you immediately sell it (sometimes without even taking possession), then pocket your easy money.

This is known as a form of arbitrage, or (relatively) riskless profit.

Arbitrage opportunities can exist anywhere, but usually not for long. Investors see the opportunity to buy $1 assets for 70 cents, and they bid up the price of the underpriced asset until the arbitrage opportunity is gone.

That's why what I'm about to tell you could mess up a sweet deal.

One of the qualities necessary to succeed as an investor is an almost unnatural passion for seeking out investment opportunities. A young analyst in our company certainly has that. He also apparently has some time on his hands, which will become evident.

Silver currently trades on the New York Mercantile Exchange (NYMEX) for about $17 an ounce. My budding silver tycoon has discovered that broken silver trinkets can occasionally be purchased on eBay at the equivalent of under $12 an ounce.

To prove his point, he showed me a plastic bag full of just-delivered miniature sterling heart pendants and a broken baby spoon. I felt like I was holding the booty from a drug deal.

He sent this first shipment of silver stuff to a smelter in Michigan this past week, where the metal will be melted, weighed and turned into cash for the benefit of this would-be Hunt brother.

If you don't know who the Hunt brothers were, look it up. I'm betting my guy has a much better outcome.

How much money does he expect to make?

Including shipping, he's paid a total of $480 for goodies. He hopes, of course, that he actually bought silver, and not some soft spray-painted rock.

Assuming $17 an ounce for silver, after the smelter is finished smelting and taking its 12 percent cut, the gross profit should be $158. Then there will be $8 in shipping costs.

All in, he expects to make 31 percent (pre-tax) over 15 days. On a percentage basis, this is an annualized return of about 75,000 percent.

In dollar terms, he might clear $150. Again, before sending Washington their fair share.

Of course, he didn't purchase all of that silver stuff in one single eBay auction. It took four purchases to accumulate enough for him to send to the smelter. And it took 150 failed auctions for him to have four successful ones.

I may need to check his Internet usage at work.

Our entire business is about identifying profitable investments while minimizing risks. The ideal situation is, obviously, to be able to completely eliminate risk. Of course, we can't compete in this silver arbitrage; we may not have Warren Buffett levels of cash, but we need investment opportunities a bit larger than $480.

But I'm anxious to see how this little exercise in real-life arbitrage works out. I'll let you know.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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