Very much like in our last case study were we discussed the idea of international arbitrage utilizing Dual Listed Companies (DLC) and American Depositary Receipts (ADR) shares; the investment strategy of dual class stocks arbitrage present an unique opportunity for profit thanks to the mispricing between the common single vote securities and the super voting shares.
What are Dual Class Shares?
The basic structure of dual class shares is the ownership rights over cash flow and votes of a company. The main purpose of having two classes of stocks of the same company is for founders to preserve the managing control of the publicly treaded corporation. The most typical way these kinds of dual class equities are constructed is by the classification of class A-Shares and class B-Shares. The class A being the common single vote shares and the class B the super voting shares with more than one vote per single stock. The most popular example of this type of capital structure is Warren Buffet’s company Berkshire Hathaway and their BRK.A and BRK.B shares.
Berkshire is the classical example for dual class securities arbitrage; because its presents the possibility of mispricing by two means:
- The premium that higher voting shares have in the market.
- The conversion and redemption ratio from second class ownership to ordinary class A-Shares.
- Currently voting rights of BRK.A over BRK.B is 10,000 to 1; and the price conversion rate is 1,500 to 1.
Other example of dual class stocks are Facebook $FB and Google $GOOG were management establish this equities in a way were earning are divided equal, but were the majority of the voting rights are control by the founders.
How to Arbitrage Dual Class Shares
The way to establish a dual class arbitrage trade is by taking advantage of the premium spread that primary shares have over secondary shares. In one side of the position you will be short the less liquidity overprice class A-Shares while at the same time you will be long the undervalue class B-Shares. Accounting for the conversion ratio and margin cots your profit equation should be the difference between the prices of the two stocks
Case Study Time
Develop an excel spreadsheet formula that can calculate the expected total return of a dual class shares arbitrage trade.
The Bottom Line
The most critical issue with this kind of arbitrage tactic is the liquidly risk of owing super voting shares; since most retail investor don’t have enough capital to own an impactful amount of class A-shares to influence management decisions like in an event of a merger or acquisition. In real practical terms the trading price premiums of primary equities in not well deserve.
Would you rather own Berkshire Hathaway or arbitrage BRK.A & BRK.B?