The investment analysis below is our Tenth in our ongoing series of guest write-ups, and is brought to you by friend of the blog Anthony Cambeiro. Anthony is currently General Partner and Co-Director of Investments for Downtown Associates (DA), a 35 year old firm focused on building a concentrated, value-centric portfolio of small and mid cap securities. Notably, DA’s 10 year average annual return ending 12/31/2009 clocked in at 6.28% net vs. -0.95% for S&P 500 and 3.51% for Russell 2000 (impressive, to say the least). Anyhow, as longtime fans of DA and Anthony’s work, we are proud to bring our readers his most recent write-up on current AAOI Partners Fund holding/pair trade Discovery Communications.
But before we dig in to Anthony’s outstanding thesis, here’s a quick “pitch” we put together on the trade earlier this year that should provide our readers with a quick primer on what we believe is a uniquely attractive opportunity (take from our AAOI CAPS page at The Motley Fool)…
“You gotta love a relatively short duration market neutral pair trade in today’s uncertain environment, especially one with a tantalizingly attractive 15% spread and better yet, a couple of meaningful catalyst’s that should help bring about the realization of value withing a reasonable time frame. Keep in mind that the spread’s recent widening was driven by a significant amount of non-economic selling brought about by the recent Russell rebalancing and therefore should to a certain extent be naturally self-correcting (i.e., the selling pressure was not fundamentally driven and therefore the recent widening between share classes is a temporary issue that should not only correct itself naturally, but better yet, do so in relatively short order). Add to this admittedly already attractive mix an outstanding capital allocator who in addition to a decades long paper trail of success, has actually made his name by consistently exploiting exactly these type’s of “no brainers” and you have all the makings of the type of low-risk, high-return investment opportunity that we spend our days and nights searching to uncover.
By the way, the “no brainer” reference above wasn’t just some off the cuff quip, but the actual response of value creating extraordinaire John Malone after he was asked (a few months back) about his thoughts on the wisdom of initiating a buyback at some point in order to exploit/close the valuation gap between Discovery’s two share classes. Regardless, we think that the size of today’s spread is unsustainable, and will almost certainly revert back towards its historical mean at some point over the next year or so as the company buys back stock (if not close completely, assuming of course that management decides to collapse the company’s dual share structure sooner than expected). The bottom line here is that investors who put on the trade at or around current prices will very likely generate an incredibly attractive 15%+ IRR with essentially no risk – always an attractive combination in our opinion.”
We want to quickly emphasize that not very many investments in today’s “risk on/risk off” world offer investors both 1) significant protection against market declines (given the behavioral/defensive characteristics of the trade) and 2) the opportunity to generate an attractive return essentially risk free, regardless of what happens in the equity and debt markets – which we would note is no small thing given today’s depressed yields and unusually uncertain economic environment. Think of the position as a form of “super cash” if you will, that due to its cash like defensive characteristics and equity like returns makes it perfectly suited for low-return environment’s like today’s where elevated valuations and considerable macro uncertainty argue for a more cautious and prudent approach.
So again, for a variety of reasons we think its a near certainty that the current pricing gap between these two identical assets is unsustainable, and hence mean reversion is relatively imminent. Given Malone’s past, incentives, publicly stated commentary and recent follow through, we’re pretty confident that if Mr. Market doesn’t close the valuation discrepancy soon, he is more than willing to do it for him.
Risk-averse investors seeking a simple, timely and (most important of all) low-risk way to generate above average returns in both a relatively short period of time (a year, maybe two) and regardless of what happens in the general equity and debt markets, may want to give this trade a deeper look.
Enjoy!
Thesis:
Fairly simple idea. Buy DISCK and short DISCA.
DISCK 37.205
DISCA 42.76
There is a $5.50 spread between the two. 15%
There is no economic difference between the shares. The only differences are that the K shares do not have voting rights, and the K shares are less liquid than the A shares.
Here is how I am thinking of these two factors:
Voting Rights – I don’t care. A vote in this company is irrelevant. The Class B shares are super voting and the Newhouse family has an additional override vote on any takeover potential. The value of a vote in A shares is dubious.
Liquidity – K shares trade 700,000 per day, A shares trade 1,700,000 shares per day. So maybe that deserves a discount, but not 15%!
The company has been buying back stock, and they’re only buying back K shares.
From August 3 2010 to Sept 30th 2010, they bought back 1.1mm K shares at an average price of 33.61 (over that time the spread between K and A was only $4.00 or 12%)
As many of you probably are, I think you need to watch where John Malone puts his money. Greenblatt did an outstanding job discussing the Liberty Media Rights trade years ago. So I think it is important to see where John Malone’s incentives are.
John Malone owns 1.7 million shares of Class A, while he owns 5.5 million shares of K.
So this spread is costing him $27mm in value!! I can’t imagine he is going to want to leave that on the table forever…despite how wealthy he already is.
If you have some extra cash lying around, this would seem to be a decent use of capital while you wait for better ideas. The borrow on DISCA is very easy and the cost is only like 40bps annually (according to my broker).
Risks:
Depending on who else has this spread trade on, you could see the spread blow out further if they are forced to ‘unwind’ during a period of duress. I’ve not looked into this, but I know there are some others putting this trade on today.
And if you’re looking at this as an alternative to cash, during a period when this spread would blow out (due to some dislocation in the market), it is probably the exact time you would want to use that cash to scoop up other opportunities in the marketplace.
So the spread is going to close overtime. The catalyst? Hard to know for sure, but the company buying back K shares should help overtime. It is a nice tailwind to have.
I suspect that the company will not do something to immediately cause the discount to close (like change the status of K shares, or convert K to A shares, since I suspect they intend to buy back more stock and prefer to buy at the 15% discount!
However, 2 years out, hard to imagine this discount remains if the company keeps buying back stock. So even if you wait 2 years, you earn 15% nearly risk free. In this interest rate environment, seems like a pretty good alternative to cash. And if you can lever that up, even more.
Q&A
Q: Interesting write-up. I have previously invested successfully in dual share class arbitrage situations (Chipotle, Mueller, SunPower). These companies were spin-offs and the Parent could not collapse the share classes until a specified date without being subject to sizeable tax penalties. Once the date passed, these Companies (with exception of SunPower but spread there has narrowed significantly) summarily collapsed their dual share class structure. Having said that, do you have any color / perspective if the Company is looking to collapse its dual share class structure going forward? Also, you are assuming two years out that the spread collapses to zero (thereby earning the 15% return) without the existing share structure collapsing. How realistic is this? Without a clear catalyst, these trades don’t work. Just my opinion from prior experience.
A: Thanks for your comments. I agree the spread won’t narrow to zero unless they collapse the shares structure, but I don’t forsee that happening.
As I noted, I don’t think the company has an incentive to close the gap with an immediate corporate action while they’re interested in buying back shares at a discount. I think the buying back of shares should help narrow the gap overtime, but it is not a sudden thing.
Given the economics are identical and the value of the voting rights in DISCA, I think is nil, the spread that exists should be a result of liquidity. (DISCA is 3x more liquid)
(As a reference CMCSA and CMCSK trade at a 5.6% spread today and CMCSA is 4x more liquid. The spread was as low as 0% from 2006 – 2008 and increased to 8% during the crisis in 2008)
At the end of 2008 to the beginning of Feb 2009 the spread was between 0 and 5%. In Feb 2009, DISCA was added to some indicies and I think that drove demand for DISCA vs. DISCK.
So I think what is most likely is that the spread narrows to 4-5% overtime, short of the company collapsing the dual classes.
Finally, some people have put the trade on 1 for 1, but to do that you’re taking a view on where the stock will go. If it goes down, you’ll make money even if the spread doesnt close. If it goes up, you’ll lose money even if the spread doesnt close.
I did it dollar weighted instead. So 1.15 shares DISCK for 1 share DISCA based on the prices yesterday.
Also, depending on your broker, the margin required can range, but my broker requires 30% for each leg. I was unsuccessful in convincing them to combine the two trades and thus have a lower capital requirement. The return on equity, even if it takes 2-3 years is still quite good.
DISCK ARB Graph’s
DISCK ARB - Bloomberg Graphs
But before we dig in to Anthony’s outstanding thesis, here’s a quick “pitch” we put together on the trade earlier this year that should provide our readers with a quick primer on what we believe is a uniquely attractive opportunity (take from our AAOI CAPS page at The Motley Fool)…
“You gotta love a relatively short duration market neutral pair trade in today’s uncertain environment, especially one with a tantalizingly attractive 15% spread and better yet, a couple of meaningful catalyst’s that should help bring about the realization of value withing a reasonable time frame. Keep in mind that the spread’s recent widening was driven by a significant amount of non-economic selling brought about by the recent Russell rebalancing and therefore should to a certain extent be naturally self-correcting (i.e., the selling pressure was not fundamentally driven and therefore the recent widening between share classes is a temporary issue that should not only correct itself naturally, but better yet, do so in relatively short order). Add to this admittedly already attractive mix an outstanding capital allocator who in addition to a decades long paper trail of success, has actually made his name by consistently exploiting exactly these type’s of “no brainers” and you have all the makings of the type of low-risk, high-return investment opportunity that we spend our days and nights searching to uncover.
By the way, the “no brainer” reference above wasn’t just some off the cuff quip, but the actual response of value creating extraordinaire John Malone after he was asked (a few months back) about his thoughts on the wisdom of initiating a buyback at some point in order to exploit/close the valuation gap between Discovery’s two share classes. Regardless, we think that the size of today’s spread is unsustainable, and will almost certainly revert back towards its historical mean at some point over the next year or so as the company buys back stock (if not close completely, assuming of course that management decides to collapse the company’s dual share structure sooner than expected). The bottom line here is that investors who put on the trade at or around current prices will very likely generate an incredibly attractive 15%+ IRR with essentially no risk – always an attractive combination in our opinion.”
We want to quickly emphasize that not very many investments in today’s “risk on/risk off” world offer investors both 1) significant protection against market declines (given the behavioral/defensive characteristics of the trade) and 2) the opportunity to generate an attractive return essentially risk free, regardless of what happens in the equity and debt markets – which we would note is no small thing given today’s depressed yields and unusually uncertain economic environment. Think of the position as a form of “super cash” if you will, that due to its cash like defensive characteristics and equity like returns makes it perfectly suited for low-return environment’s like today’s where elevated valuations and considerable macro uncertainty argue for a more cautious and prudent approach.
So again, for a variety of reasons we think its a near certainty that the current pricing gap between these two identical assets is unsustainable, and hence mean reversion is relatively imminent. Given Malone’s past, incentives, publicly stated commentary and recent follow through, we’re pretty confident that if Mr. Market doesn’t close the valuation discrepancy soon, he is more than willing to do it for him.
Risk-averse investors seeking a simple, timely and (most important of all) low-risk way to generate above average returns in both a relatively short period of time (a year, maybe two) and regardless of what happens in the general equity and debt markets, may want to give this trade a deeper look.
Enjoy!
Thesis:
Fairly simple idea. Buy DISCK and short DISCA.
DISCK 37.205
DISCA 42.76
There is a $5.50 spread between the two. 15%
There is no economic difference between the shares. The only differences are that the K shares do not have voting rights, and the K shares are less liquid than the A shares.
Here is how I am thinking of these two factors:
Voting Rights – I don’t care. A vote in this company is irrelevant. The Class B shares are super voting and the Newhouse family has an additional override vote on any takeover potential. The value of a vote in A shares is dubious.
Liquidity – K shares trade 700,000 per day, A shares trade 1,700,000 shares per day. So maybe that deserves a discount, but not 15%!
The company has been buying back stock, and they’re only buying back K shares.
From August 3 2010 to Sept 30th 2010, they bought back 1.1mm K shares at an average price of 33.61 (over that time the spread between K and A was only $4.00 or 12%)
As many of you probably are, I think you need to watch where John Malone puts his money. Greenblatt did an outstanding job discussing the Liberty Media Rights trade years ago. So I think it is important to see where John Malone’s incentives are.
John Malone owns 1.7 million shares of Class A, while he owns 5.5 million shares of K.
So this spread is costing him $27mm in value!! I can’t imagine he is going to want to leave that on the table forever…despite how wealthy he already is.
If you have some extra cash lying around, this would seem to be a decent use of capital while you wait for better ideas. The borrow on DISCA is very easy and the cost is only like 40bps annually (according to my broker).
Risks:
Depending on who else has this spread trade on, you could see the spread blow out further if they are forced to ‘unwind’ during a period of duress. I’ve not looked into this, but I know there are some others putting this trade on today.
And if you’re looking at this as an alternative to cash, during a period when this spread would blow out (due to some dislocation in the market), it is probably the exact time you would want to use that cash to scoop up other opportunities in the marketplace.
So the spread is going to close overtime. The catalyst? Hard to know for sure, but the company buying back K shares should help overtime. It is a nice tailwind to have.
I suspect that the company will not do something to immediately cause the discount to close (like change the status of K shares, or convert K to A shares, since I suspect they intend to buy back more stock and prefer to buy at the 15% discount!
However, 2 years out, hard to imagine this discount remains if the company keeps buying back stock. So even if you wait 2 years, you earn 15% nearly risk free. In this interest rate environment, seems like a pretty good alternative to cash. And if you can lever that up, even more.
Q&A
Q: Interesting write-up. I have previously invested successfully in dual share class arbitrage situations (Chipotle, Mueller, SunPower). These companies were spin-offs and the Parent could not collapse the share classes until a specified date without being subject to sizeable tax penalties. Once the date passed, these Companies (with exception of SunPower but spread there has narrowed significantly) summarily collapsed their dual share class structure. Having said that, do you have any color / perspective if the Company is looking to collapse its dual share class structure going forward? Also, you are assuming two years out that the spread collapses to zero (thereby earning the 15% return) without the existing share structure collapsing. How realistic is this? Without a clear catalyst, these trades don’t work. Just my opinion from prior experience.
A: Thanks for your comments. I agree the spread won’t narrow to zero unless they collapse the shares structure, but I don’t forsee that happening.
As I noted, I don’t think the company has an incentive to close the gap with an immediate corporate action while they’re interested in buying back shares at a discount. I think the buying back of shares should help narrow the gap overtime, but it is not a sudden thing.
Given the economics are identical and the value of the voting rights in DISCA, I think is nil, the spread that exists should be a result of liquidity. (DISCA is 3x more liquid)
(As a reference CMCSA and CMCSK trade at a 5.6% spread today and CMCSA is 4x more liquid. The spread was as low as 0% from 2006 – 2008 and increased to 8% during the crisis in 2008)
At the end of 2008 to the beginning of Feb 2009 the spread was between 0 and 5%. In Feb 2009, DISCA was added to some indicies and I think that drove demand for DISCA vs. DISCK.
So I think what is most likely is that the spread narrows to 4-5% overtime, short of the company collapsing the dual classes.
Finally, some people have put the trade on 1 for 1, but to do that you’re taking a view on where the stock will go. If it goes down, you’ll make money even if the spread doesnt close. If it goes up, you’ll lose money even if the spread doesnt close.
I did it dollar weighted instead. So 1.15 shares DISCK for 1 share DISCA based on the prices yesterday.
Also, depending on your broker, the margin required can range, but my broker requires 30% for each leg. I was unsuccessful in convincing them to combine the two trades and thus have a lower capital requirement. The return on equity, even if it takes 2-3 years is still quite good.
DISCK ARB Graph’s
DISCK ARB - Bloomberg Graphs
