Become Your Own Arbitrageur

Some say that when Warren Buffett decided to create his "Baby Berks" class of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) stock a decade or so ago, he did it to stop people from divvying shares up on their own.

Unit investment trusts had planned to buy Berkshire stock -- which was then trading around $33,000 a share -- and sell units to small investors who couldn't afford the Class A share price. Berkshire stock has never been split, and the Class B Baby Berks have fewer voting rights than the Class A shares. Today, the Big Berks trade in excess of $109,000 a stub while the Babies go for around one-30th of that, or about $3,300.

It's just as Buffett wanted. Holders of Class A shares can convert their stock into Class B shares at any time, thus limiting the attractiveness of a unit trust dividing up the shares. Explaining the price difference a few years ago, Buffett wrote:

"The Class B can never sell for anything more than a tiny fraction above 1/30th of the price of A. When it rises above 1/30th, arbitrage takes place in which someone -- perhaps the NYSE specialist -- buys the A and converts it into B. This pushes the prices back into a 1:30 ratio."

Arbitrage explained
Arbitrage is the ability to take advantage of discrepancies between price and value -- whether it's stocks, commodities, currencies, or other financial instruments. Billionaire financier George Soros became very wealthy playing the arbitrage available in world currencies, though he wasn't always correct and lost just as big. It has happened to Buffett, too.

Yet because an investor can convert Berkshire A shares into their B counterparts if their valuations become too skewed, it keeps equilibrium in check.

However, that's not always the case with stocks that have different classes of shares. With Motley Fool Hidden Gems recommendation Chipotle Mexican Grill (NYSE: CMG  ) (NYSE: CMG-B  ) , its A shares trade at a higher valuation than the B shares, even though the B shares carry superior terms, such as 10 times greater voting rights. When such a situation exists, it doesn't make sense to buy the lower-valued, higher-priced A shares. Rather, buying the B shares is the sensible choice, because, as Buffett has also noted, over time the market is a weighing machine that will balance out the undervalued shares.

Lightning strikes twice
It's a phenomenon being witnessed again by investors in the Class B shares of Mueller Water (NYSE: MWA  ) (NYSE: MWA-B  ) : Many of these investors got the shares as a result of owning shares in another Motley Fool Hidden Gems recommendation, Walter Industries (NYSE: WLT  ) . Last December, Walter spun off its remaining ownership interest in Mueller and issued Class B shares with superior voting rights over the A shares, which had already been trading on the market -- eight votes for every one.

By most calculations, the B shares should be trading at a premium to the A ones, but that hasn't happened. Since the spinoff, the A shares actually had earned a 5% premium to the B shares, but in recent weeks that discrepancy has widened further. The A shares recently traded as much as 22% higher than the B shares, which would suggest an arbitrage opportunity.

Free money?
The problem is that there's no guarantee that you'll ever make money arbitraging Mueller. Mueller doesn't have an automatic right of conversion, like Berkshire. And while you might want to short the A shares and go long the B shares -- figuring the two will eventually strike an equilibrium point -- you'll have trouble finding A shares to borrow for your short sale.

While each case is unique, investors should be jumping on Mueller's discounted B class. Depending on whether you hold Mueller's shares in a taxable account or not, you may want to sell A shares to buy into B shares. Not only would you get money back in your pocket, you'd also gain a much larger say in the company's future.

There's no reason Mueller's A shares must trade at less than the B ones, and perhaps even a few good reasons why they can trade higher. For example, the A shares have been on the market longer, and there's less information available to the average investor about the B shares, because they are relatively new. There are also many more B shares on the market than the A ones, so the laws of supply and demand may yet be at play here.

Still, to this Fool it creates an opportunity to capitalize on a pricing discrepancy that no efficient market theory has yet to dispel.

Berkshire Hathaway's "Baby Berks" are recommendations of Motley Fool Stock Advisor and Motley Fool Inside Value.

Fool contributor Rich Duprey owns shares of both Mueller Water and Walter Industries but does not have a financial position in any of the other stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.


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  • Report this Comment On June 13, 2008, at 10:02 AM, LarryIL wrote:

    Yep, "B" class is even further "underwater" [yuk] vis-a-vis "A" shares since I switched A-for-B soon after reading the same recommendation from Geoff Gannon on seekingalpha in April of 2007!

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