I have been fascinated with arbitrage opportunities for decades. In cases where the same asset is traded in multiple markets or very similar assets are traded in the same market, opportunities can arise to earn profits at relatively low risk, at least in theory. As computer algorithms get more sophisticated, it is logical to think that arbitrage opportunities should become inaccessible to ordinary investors. For the most part, I think this is true but there are certain occasions where it pays to remain alert.
One of the first series of articles I wrote on The Rational Walk was related to a potential arbitrage opportunity in Berkshire Hathaway shares that emerged in February 2009 and remained intact for about a month before disappearing toward the end of March 2009. At the time, I simply observed the situation but did not act on it.
Recently, a similar opportunity emerged in Berkshire stock and I was able to take advantage of it. In this article, I will provide background information and some historical data to illustrate the situation and I will describe a recent transaction where I profited from the Class B discount. As always, I am not making any investment recommendations in this article and the approach I took could involve risk of loss and potentially unfavorable tax consequences.
Background
In May 1996, Berkshire’s existing common stock was renamed as Class A and Class B stock was issued. Initially, each share of Class B stock had economic rights equivalent to 1/30th of one share of Class A stock and voting rights equivalent to 1/200th of one share of Class A stock. Each share of Class A stock was convertible at any time into 30 shares of Class B stock. However, Class B stock cannot convert into Class A stock.1
Following a fifty-for-one split of the Class B stock in 2010, each share of Class B stock has economic rights equivalent to 1/1500th of one share of Class A stock and voting rights equivalent to 1/10,000th of a share of Class A stock. Each share of Class A stock may be converted to 1,500 shares of Class B stock.
Warren Buffett wrote a memo regarding the comparative rights and relative prices of Berkshire’s common stock, from which I have taken this excerpt:
“The Class B can never sell for anything more than a tiny fraction above 1/1,500th of the price of A. When it rises above 1/1,500th, 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 1:1,500 ratio.
On the other hand, the B can sell for less than 1/1,500th the price of the A since conversion doesn’t go in the reverse direction. All of this was spelled out in the prospectus that accompanied the issuance of the Class B.
When there is more demand for the B (relative to supply) than for the A, the B will sell at roughly 1/1,500th of the price of A. When there’s a lesser demand, it will fall to a discount.”
Mr. Buffett believes that Class B stock should usually trade at about 1/1,500th of the price of Class A stock. However, it is possible for Class B stock to trade at a discount. This is because Class B stock cannot be converted to Class A stock. If the relative demand for Class A stock is greater than for Class B, then the Class B stock can fall to a discount. Mr. Buffett writes in the memo that it makes sense to favor buying Class B stock when the discount is more than 1%.
Why would a situation emerge where the relative demand for Class A stock exceeds the demand for Class B? The sole difference between the two share classes is that Class A stock has full voting power while Class B stock has diminished voting power. Therefore, if large buyers of Berkshire stock value the voting rights greatly, they might be willing to pay a premium price.
As Berkshire’s stock price has advanced in recent decades, demand for Class A stock is likely to come mostly from institutional investors rather than individuals. Although Mr. Buffett has effective control of Berkshire today, perhaps some institutions are looking ahead to a time when this will no longer be the case.2
Recent Class B Discount Trends
Calculating the Class B discount is very straight forward. Let’s take the closing prices on Thursday, April 27, 2023 as an example:
BRKA Closing Price: $499,700
BRKB Closing Price: $326.23
BRKB Discount = 1 - [(326.23 * 1500) / 499,700]
BRKB Discount = 2.07%To look at this in another way, if the Class B stock was trading at no discount, it should trade at 1/1500th of the Class A price. In the case of the close on April 27, the Class B stock would trade at $333.13 if there was no discount at all.
I have data on the Class A/Class B relationship since 2000, but to show greater recent detail, I start the following chart in 2020:
One thing to keep in mind when looking at this exhibit is that I am using closing prices and there are times, particularly during significant market volatility, when Class A shares don’t trade for several minutes prior to the close while Class B shares are actively trading, usually right up to the close. Class A stock is much less liquid than Class B stock due to the nearly half million dollar stock price.
Also note that there are days when Class B shares appear to trade at a premium to Class A at the close, but this is due to an absence of Class A trades in the minutes leading up to the close while Class B shares continue trading. As Mr. Buffett says in his memo, it is not possible for Class B shares to trade at a premium, so consider values in the chart below 0% to be noise that is best disregarded.
With these caveats in mind, we can see that Class B stock rarely trades at a discount of over the 1% level where Mr. Buffett believes that investors might favor Class B over Class A. In fact, there are many times when the discount approaches zero and I have been able to purchase Class A stock at times when there was no premium attached to the enhanced voting rights.
The rest of this article, limited to paying subscribers, discusses some approaches to profiting from the Class B discount and provides an example based on recent transactions in my own portfolio.
Arbitrage Possibilities
I recently profited from the wider than usual Class B discount. Although I do not normally like to discuss personal transactions, I am making an exception in this case to illustrate that possibilities to profit actually exist in the real world.3
Copyright, Disclosures, and Privacy Information
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Long Berkshire Hathaway.
- At the time, Berkshire Hathaway stock traded around $33,000 per share. This relatively high price made Berkshire’s stock inaccessible for many individual investors. Promoters of unit trusts emerged who proposed to give small investors the ability to buy units that would simply hold Berkshire stock. Of course, the promoters would charge a hefty fee. Warren Buffett did not want to split Berkshire’s stock but disliked the unit trust concept. His introduction of Class B shares, which initially traded around $1,100 per share at the original 30-for-1 ratio, made Berkshire accessible to smaller investors. The conversion right also allowed Class A shareholders to create their own “stock split” if they wished to give away shares under the gift tax exclusion or avoid paying capital gains tax on the sale of a full A share. Originally, Class A shareholders also had the additional privilege of participating in Berkshire’s charitable giving program. However, that program was terminated in 2003. The introduction of the Class B stock has also had the effect of allowing Warren Buffett to retain effective control of the company even after giving away over half of his stock. [↩]
- As I wrote recently, Mr. Buffett owns shares representing 15.6% of Berkshire’s economic interest but the concentration of his holdings in Class A stock means that he controls 31.6% of the vote. I would argue that controlling nearly a third of Berkshire’s vote directly gives Mr. Buffett effective control considering the large number of Berkshire shareholders who will vote based on Mr. Buffett’s recommendations. This is almost certain to persist for the duration of Mr. Buffett’s tenure as Chairman and CEO. However, following Mr. Buffett’s death, his Class A stock will be converted to Class B stock and given to charities over the subsequent decade. Could institutions be looking that far ahead and accumulating Class A stock today in anticipation of controlling Berkshire in 2040 or 2050? It is possible. [↩]
- I never short stocks, but I should point out that investors who are willing to open short positions could buy Class B shares when the discount appears to be particularly wide while shorting Class A stock. The trade could be closed out when the Class B discount narrows or disappears. For example, using April 27, 2023 closing prices, an investor could purchase 1,500 Class B shares for $489,345 and short 1 Class A share for $499,700. Assuming the discount is eventually eliminated, the value of these positions would roughly match and could be closed out. The investor would pocket $10,355. Of course, there is no law that says the Class B discount will narrow or close — and it could increase resulting in losses. I cannot comment on the feasibility of shorting Class A stock since I’ve never done it. [↩]