Summary: Both Citigroup and Berkshire Hathaway continue to violate the law of one price.
In previous posts (this is the most recent), I’ve pointed out that there are three ways you can purchase common shares of Citigroup:
Simple: Buy shares of common stock.
Preferred: Buy shares of preferred stock that will convert into common.
Synthetic: Use call and put options to replicate the financial returns of owning common stock.
In a perfect world, these three approaches would give nearly identical prices. That’s the law of one price.
Over the past few months, however, Citi securities have been breaking that law. Investors who have been buying common shares have been significantly overpaying relative to the values implied by the prices of the preferred stock and options.
Those pricing differences have declined somewhat over time as the likelihood of the preferred conversion has risen and as the closing date has gotten closer (the offer expires July 24 and closes the following week).
Nevertheless, the spread in prices remains substantial. At Thursday’s closing prices you could have bought 1,000 shares of Citigroup for three different prices (using price quotes from Yahoo and ignoring transaction costs):
Note: The preferred calculation is based on the Series F, while the synthetic is based on options that mature in September 2009 with a strike price of $3.
In other words, investors in the common stock appear to be overpaying by as much as 14% relative to investors in the preferred. That’s down from the 18% I calculated in my previous post, but it is still much wider than normal for these kinds of deals.
As best as I can tell, the only explanation for this anomaly is the difficulty of shorting Citigroup common stock, coupled with some clientele effect that leads certain investors (presumably not the “smart money”) to buy only the common.
Berkshire’s pricing anomaly is small compared to Citi’s, but still interesting. As I discussed in my original post, the source of the anomaly is that Berkshire Hathaway has two classes of shares: A and B. The B shares receive 1/30 the economic payoff of the A shares (there are also some differences in voting rights).
As a result, you might expect that the price of an A share should be about 30 times the value of a B share — the law of one price in action. And you would be right; the prices have often traded around a 30:1 ratio since the class B shares were introduced. But not always.
In recent months, for example, the ratio has increased noticeably, with Class A shares trading at a notable premium to the Class B:
On Thursday, the ratio finished the day at 30.8. The A shares closed at $89,384, while the B shares closed at $2,893. At that price, 30 B shares would cost you $86,790, almost $2,600 less than a single A share. If you think that the prices will converge, you might be able to profit by shorting an A share and buying 30 B shares (that’s not a recommendation, and no I haven’t tried).
I originally thought the Berkshire anomaly might be a sign of stress in the financial markets; notice, for example, how the spread widened in the summer of 2007 and the fall of 2008. More recently, however, the wide spread has persisted despite calmer financial conditions. That suggests that the spread is being driven by Berkshire specific factors. A leading hypothesis — as suggested in several emails from readers — is that it may be related to Warren Buffett’s donation of Class B shares to the Gates Foundation.
Disclosure: As research, I am currently long a small amount of Citigroup preferred and short some call options on the common. I have no positions in Berkshire securities.