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Berkshire Hathaway Arbitrage Opportunity Eliminated

March 25, 2009 | About:
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Ravi Nagarajan

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Over the past month, I wrote a few posts regarding potential arbitrage opportunities available due to discrepancies between the relative valuations of Berkshire Hathaway’s Class A and Class B shares. The arbitrage opportunity identified in these posts has now been entirely eliminated as a more “normal” relationship between the Class A and Class B shares returned. Let’s revisit what took place over the past month and the implications for the notion that the market for Berkshire Hathaway shares is “efficient”.

Relationship Between Class A and Class B

As I wrote on February 20, each Class B share carries 1/30 of the economic rights and 1/200 of the voting rights of a single Class A share. During normal times, the Class B shares trade at roughly 1/30 of the price of a Class A share reflecting the difference in economic rights. It is logical for the Class B shares to sometimes trade at a small discount relative to the 1:30 ratio given the lower voting rights. However, in the case of Berkshire Hathaway, voting rights are not as relevant given Warren Buffett’s ownership interests as well as the legions of loyal shareholders who will always vote with Buffett which gives him effective majority control. All of the details related to the differences in Class A and Class B shares are listed in this memo written by Warren Buffett.

Record Spread Develops on February 20

Based on my research, on February 20, a record high spread developed between Class A and Class B shares. On that day at the close of trading, it was possible to purchase 32.26 B shares for the same price as a single A share. Any A shareholder was free to sell a single A share and purchase 32 B shares plus pocket the change represented by the fractional 0.26 B share. By doing so, the A shareholder would effectively increase his economic interest in the company by 7.53% (including the retention of the cash equivalent of the fractional share). Granted, the A shareholder would now only have a fraction of his prior voting rights, but that appears to be the only downside, aside from potential tax implications related to the A sale which could be significant. A long position would be maintained with a significant addition to the shareholder’s economic position.

It would also have been possible to make a move that would not bet on the direction of Berkshire’s stock price but only on the eventual narrowing of the historically wide A/B spread. By shorting one A and purchasing 30 Bs, an investor could effectively bet on an eventual closing of the historic spread. Regardless of the direction in which Berkshire shares trade, the investor could profit when the spread returns to more typical levels. At that time, the A share would be repurchased with the proceeds of selling the 30 B shares. The main risk here would be if the spread widens further and does not narrow again in the future.

Spread Persists But Narrows in Mid March

I revisited the situation on March 9 and noted that the spread had narrowed briefly but then became quite wide again. On March 9, an investor could purchase 31.69 B shares for the same price as one A share. During this timeframe, Berkshire continued flirting with multi-year lows. On March 10, Class A shares advanced 15.9% and Class B shares advanced 19.3% which narrowed the spread significantly but did not eliminate it.

Spread Eliminated on March 25

Over the past several days, the spread continued to decline gradually and it was entirely eliminated on March 25 when Class A shares closed at 86,850 and Class B shares closed at 2,900. At these levels, the Class B shares actually traded at a small premium over the typical 1:30 ratio. The chart below shows the behavior of the A/B ratio between my March 9 post and March 25:

brk_ab_march9to25_2009.jpg


What Does This Prove?

The point of this post is not to claim any special knowledge of the absolute price movements in Berkshire Hathaway shares. On February 20, I had no idea whether Berkshire Hathaway shares would trade higher or lower over the next month. However, anyone could see that the relative valuation between Class A and Class B was not behaving normally.

It was possible to take advantage of this in at least two ways:

Scenario 1: On February 20, any existing A shareholder could have sold his A share and used the proceeds to purchase 32 B shares and kept the cash equivalent of 0.29 B shares for reinvestment elsewhere. He would have sacrificed some voting rights, but this is not material for nearly all shareholders. Today, that same shareholder could have reversed this transaction and sold his 32 B shares and purchased one A (or alternatively, he could have sold 30 Bs and purchased 1 A, keeping the extra 2 B shares). This investor would have had a long position in Berkshire throughout this timeframe.

Scenario 2: On February 20, an investor could have sold short one A share and used the proceeds to purchase 32 B shares. Today, that investor could have sold 30 B shares and covered the short of the one A share. The investor could either keep the 2 additional B shares or sell them. In either case, he would have profited from the narrowing of the spread. Note that the success or failure of this operation would not have depended on the direction of Berkshire’s share price movement but only on the narrowing of the spread between A and B shares.

Is the Market for Berkshire Shares “Efficient”

It is very difficult to make the case that the market for Berkshire Class A and Class B shares is “efficient” as defined by the efficient market hypothesis when an investor could exploit conditions like what I have described here. There were numerous other investors pointing out the situation in February yet the wide spread persisted for months. If an efficient market is supposed to reflect all public information in the pricing of securities, surely this market did not display efficiency over the past month.

It is fair to ask whether I personally traded on this arbitrage opportunity over the past month. Unfortunately, I did not act quickly enough. All of my holdings in Berkshire Hathaway are B shares purchased in small quantities over a period of close to a decade. I did not have any A shares to sell in exchange for Bs as noted in Scenario 1. I also have not made it a practice to engage in short selling of any kind in the past and did not have a brokerage account set up to execute Scenario 2. While I do not believe in un-hedged short selling for many reasons, I plan to set up my brokerage account to permit short selling for arbitrage opportunities like this in the future.

Ravi Nagarajan

www.rationalwalk.com


Rating: 4.3/5 (7 votes)

Comments

kfh227
Kfh227 premium member - 5 years ago
I always wonder the wording of "efficient market hypothesis". When I was in school, all you had to do to disprove a law or hypothesis is prove it to be false once, under any scenario. The spreads we saw at times with A/B stock by the rules of the scientific method should no longer allow the word hypothesis to be used. It should be called the "efficient market myth". And it's not. It really irks me. I'm no English grammar expert, but seriously.... hypothesis has a specific meaning. How about the "inefficient market hypothesis"?
kfh227
Kfh227 premium member - 5 years ago
Also, my assumption was that the spread was caused by quick selling of various funds as investors panicked. Funds couldn't pick and choose what they sold. They just had to unload anything in what must have been a nightmare in their offices.
rnagarajan
Rnagarajan - 5 years ago
At least for Berkshire, the market is often very inefficient. The A/B situation is just one example. The actual price movement of Berkshire shares sometimes makes little sense to me. However, the A/B situation of the past month is the best "proof" of inefficiency that I can think of.

The efficient market theory, the Capital Asset Pricing Model, and other theories are mathematically elegant but do not account for behavioral factors that influence market movements and the fundamental flaw is that the key variable used to determine expected returns is expected volatility relative to the market as a whole rather than the long term business risks involved.

As for the A/B situation, I suspect it will reappear the next time the market has a meltdown since the Bs seem to be under greater pressure during declines. If we get a 5% discount or greater on the Bs, I'm going to try out the Short one A, buy 30 Bs approach. It's real money out there on the table - why not profit from it.
brian4160
Brian4160 - 5 years ago
I'm not sure what it was at the time, but you have to give consideration to the bid/ask spread when determining the profitability of an arbitrage strategy. If the Class A volume was very low and the bid/ask spread increased, it's possible that you wouldn't make nearly as much as you expected to. Let's say a round trip (buy, sell) on an A share cost you $1000 (spread) + $20 (commissions) and the same on your B trade cost you $30 ($1 spread times 30 shares) + $20 in commissions. You're at $1070 in costs to execute the trade. This would take a chunk out of your profits. I'm guessing at the bid-ask spread on the A share. Try to find out what it was at the time the arbitrage opportunity emerged and I bet you'll find that it was pretty wide, making a great opportunity look less great.
cm1750
Cm1750 premium member - 5 years ago
Thanks to Ravi, I was able to do this arb at a 6.5% spread and cover at a 3% spread and made some nice money after a little more than a week when there was heavy BRKB shorting a few weeks ago.

I agree with Brian that a 5% spread is the effective minimum spread to make it worth one's time.

I am sure others (and myself) would appreciate it if the more eagle-eyed among us posts when the spread is wide.
fk
Fk - 5 years ago
CM,

What kind of margin requirements in your trading account were needed to pull off that arbitrage transaction?

With BRKA trading at around 90k, did that doing a short sell of that BRKA require 30k or so of margin to pull it off?


cm1750
Cm1750 premium member - 5 years ago
I am not sure the exact details - you have to check with your own broker.

I think that the BRKB I bought was on margin for the amount above excess cash, and I had to pay interest on it even though the shorted BRKA brought in more than enough proceeds to cover it. Given I thought it would narrow within a week or two, a couple hundred bucks in margin interest was not a huge issue given the 6.5% BRKA/BRKB spread when I initiated the trade.

batbeer2
Batbeer2 premium member - 5 years ago
>> It should be called the "efficient market myth". And it's not. It really irks me.

As much as the mere existence of these situations disproves the hypothesis, engaging in these trades depends on markets being efficient within a reasonable timeframe.

I think the hypothesis is a perfect and simple model. The real world just doesn't behave according to perfect and simple models.

Newton had a perfect model (they are called laws !). The fact that they apply in many cases does not mean scientistst can safely ignore the exceptions.

Does the fact that Newtons simple, incorrect, models are called laws irk you ?
rnagarajan
Rnagarajan - 5 years ago
Regarding trading volume - looking at the data, trading volume in both A and B shares appears to be higher than average during much of the timeframe in question - and it was dramatically higher on February 20 when the record high spread appeared at close to 17.6 million B and 550,900 A shares trading. This is well higher than average daily volume. I'm pulling the volume figures from yahoo finance.

I certainly agree that the bid/ask spread and availability of A shares to short is a factor but the volumes during the height of the opportunity seem to indicate that it could have been done. As I mentioned, I didn't do this myself so I cannot claim first hand experience with it. I did not have a margin account set up in which I could short stock due to my general policy against shorting. However, there is obviously a distinction between a directional short bet and an arbitrage operation so I will be looking into doing this the next time an opp. arises.
rnagarajan
Rnagarajan - 5 years ago
"As much as the mere existence of these situations disproves the hypothesis, engaging in these trades depends on markets being efficient within a reasonable timeframe."

Yeah, this is absolutely right. We rely on the market becomming "efficient" at some point to unwind such trades. In fairness to the academics, I think that MOST securities are priced "efficiently" MOST of the time, but when you get into the kind of market meltdowns we have seen recently, it seems that opportunities to safely make high single digit returns on arbitrage are not considered worthwhile. I guess it is similar to people running out of a burning theater not stopping to pick up a dollar bill on the ground on the way to the exits.

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