Nov. 2021: See a Penny (or a Million of Them) - Pick it Up
Updated: Nov 14, 2022
November 5, 2021
By Mark Oelschlager, CFA
Most publicly traded companies have just one class of shares. But sometimes a corporation’s management decides to issue multiple share classes. There are different reasons for this, but one common one is to concentrate voting power in the hands of certain shareholders. When Google (now Alphabet) went public in 2004 it created three classes of shares: A, B, and C. The B shares, which carry far more votes than the A and C shares, were kept by management so that they maintained voting control of the entity. The A (GOOGL) and C (GOOG) shares were both issued to the public, with the A shares having one vote per share and the C shares having no votes attached.
The A and C shares possess an equal claim on the company’s earnings, so economically they are equivalent. As such, they traded at roughly the same price as each other since they were issued, though generally the A shares traded at a slight premium to the C shares, given A’s superior voting rights. But in 2020 things got interesting.
In the second half of 2020, Alphabet began buying back C shares, which caused C to regularly trade at a slight premium to A, a reversal of the historical norm. This premium was generally less than half a percent for many months but then eclipsed 0.5% in the spring of 2021. In April 2021 the board authorized another buyback of C shares, which caused the premium on the C shares to expand dramatically, reaching 2.4% in late April and a whopping 4.5% in June. In actual dollars, this meant the C shares traded at $2,511 while the A shares were $2,402. Remember, the only fundamental difference between the A and C shares is that the A shares carry voting rights. It’s difficult to quantify the value of such rights, and the value may be de minimis given the fact that management maintains voting control through its B shares, but it is clear that such rights aren’t negative. Yet the A shares were trading as if they were in fact negative.
This didn’t make any sense and was essentially an opportunity for free money for holders of Alphabet C to sell their shares and buy the A shares. All they had to do was to be paying attention and be willing to act. We know (and it is public knowledge) that the A shares are intrinsically worth no less than the C shares, yet they were trading at a 4.5% discount for technical reasons - namely the fact that the company was focusing its buyback on the C shares. It was reasonable to assume that this short-term factor would eventually fade and cause the share prices to converge, restoring a more sensible relationship between the two classes of stock.
Many years ago, I covered the aerospace and defense stocks and can recall a head-scratching discrepancy between Raytheon’s A and B shares. The class that was fundamentally more valuable traded at a discount. If memory serves, this was because the other shares were included in the S&P 500 index while the more fundamentally valuable ones were not. It took a long time, but eventually the prices of the respective shares moved to a more logical relationship. I can remember a similar thing happening with Fox’s multiple share classes as well. This experience was valuable in handling the Alphabet situation.
When a divergence like this occurs, the trading costs need to be small enough relative to the size of the opportunity for it to be worth swapping share classes. In the case of Alphabet, unless we are talking about a firm with billions of dollars in Alphabet stock, this was most definitely the case. Alphabet is highly liquid, so with reasonable commissions we could expect the trading costs to be minor compared to the 4.5% opportunity. Oelschlager Investments had owned both the A and C shares, having bought when the prices were more in line with each other. But as the C shares spiked in relation to the A, we took advantage and sold all the C shares in all our accounts, simultaneously purchasing the same amount of A shares. We didn’t know when it would happen, but we were confident the price gap would eventually close. In essence it was free money. We just took the time to reach down and pick it up.
Interestingly, one didn’t need to be that quick to take advantage of the opportunity. From mid-June to late July, the C shares generally maintained a premium in the 3% to 4.5% range. In late July, the company announced that it would begin buying back A shares (a smart strategy given the discount), and the gap suddenly closed. As we type this, A and C are still trading at close to parity with each other. This means that the A shares have risen by about 4 ½ percentage points more than have the C shares since the gap opened up in June. This return differential represents real money.
The scenario that played out with Alphabet is relatively rare. Our investment strategy and long-term returns are not built on trades like this. But it was free money for those aware and willing to take action, and it was a profitable opportunity for our clients and shareholders.
One note: this analysis does not necessarily apply to taxable separately managed accounts, as the benefits from implementing such a strategy would be impacted by the tax consequences of selling one share class and buying another.
Mark Oelschlager, CFA Oelschlager Investments
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