Tuesday, March 29, 2011

Mispricing of Dual-Class Shares: Profit Opportunities, Arbitrage, and Trading

One of the authors, Prof. Schultz, co-authored a paper back in 1994 that led to this 1996 DoJ headline,


Compliance wonks may know it as "In re Nasdaq Market-Makers Antitrust Litigation".
The market makers settled for a bit over $1 Billion and swore to find other ways to make money.

Anywho, here's the headline story from the Σmpirical Finance blog:
  • Paul H. Schultz and Sophia Shive
  • A version of the paper can be found here.
  • We maintain live datasets for this strategy and can pipe customized products via our Data site infrastructure. If interested, contact us here.
“This is the first paper to examine the microstructure of how mispricing is created and resolved. We study dual class-shares with equal cash-flow rights, and show that a simple trading strategy exploiting gaps between their prices appears to create abnormal profits after transactions costs. Trade data from TAQ shows that investors shift their trading patterns to take advantage of gaps. Contrary to common perception, long-short arbitrage plays a minor part in eliminating gaps, and one-sided trades correct most of them. We also show that the more liquid share class is usually responsible for the price discrepancies. Our findings have implications for the literature on risky arbitrage and asset pricing more generally.”
Data Sources:
The authors compile a list of companies with two classes of stock using CRSP/Compustat during the period 1993-2006. Next, they verify that cash flow rights are equivalent and determine how voting rights differ. Their sample ends up being exactly 100 companies.
Dual-shares can mean a lot of things to a lot of people, but in the context of arbitrage trading, these shares are defined as shares with equal cash flow rights, but different voting rights (sometimes the cash-flow rights are not on a 1 for 1 basis, but this can be accounted for in the trading strategy). Here is an example discussed on Chipotle: click here or here. And below is a live spread of LEN and LEN.B:

Data Source: Capital IQ.
Why would there be a divergence in price for an asset that has matching cash-flows?
There are a few “rational” reasons for divergence:
  • Liquidity premium–one class of stock is a day-trader’s dream; the other class is only loved by widows and penny-stock newsletter authors.
  • Voting rights–in certain cases, voting rights may actually have real effects on the net present value of the cash flows between shares.
  • Limits of arbitrage–short-selling constraints, bid/ask spreads, impact costs, and so forth.
So how do these concepts hold up against the data?
A “duh” test to see if rational reasons explain all divergence between shares is easy: look at spreads over time....MORE
HT: Simoleon Sense