Citigroup and Berkshire Pricing Anomalies

Both Citigroup (C, C.P) and Berkshire Hathaway (BRK.A, BRK.B) continue to violate the law of one price.

Citigroup

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):

• Simple $2,880
• Preferred $2,517
• Synthetic $2,650

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 Hathaway

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.

Comments

[Anthony B:]

another good one is CMG and CMG.B

Jul 06 01:52 PM

[jimmy46:]

For C you don't give your methodolgy, so others can't spot your errors, but I'm sure they're there.

Jul 06 02:16 PM

[U338129:]

If Buffett's gift is impacting the stock in a negative way then shame on him (I doubt the gift is what's causing the mediocre pricing of the stock). Philanthropy is great, and we should all be so lucky one day to partake in it, but if the CEO of a company is partaking in an action that is decreasing shareholder value (however short-term it may be) then he/she should be called out for it; regardless of who it is. We all know about his arrangement and it's very noble. However, he still owes it to his shareholders to increase shareholder value. He already forces shareholders to sit through these downturns without so much as a mild dividend to hold us over. We're also left in the dark about the transition plan (it is not unfair to ask for details when the man that holds the key to the kingdom is nearly 80 years old). I believe he's been one of the best at managing retained earnings; but, the stock sure isn't reflecting that greatness lately. Still holding on to the stock but I can't say that I'm ecstatic about its performance over the last 18 months.

Jul 06 04:33 PM

[KIT:]

Warren is protecting the shareholder from his eventual death were all his shares will be deemed sold. The resulting tax can only be met by a massive selloff, this selloff would decimate the current shareholders. This donation prevents a single day wipeout.

Ford foundation, Carnegy, and many others have done the same for the same reason


On Jul 06 04:33 PM U338129 wrote:

> If Buffett's gift is impacting the stock in a negative way then shame
> on him (I doubt the gift is what's causing the mediocre pricing of
> the stock). Philanthropy is great, and we should all be so lucky
> one day to partake in it, but if the CEO of a company is partaking
> in an action that is decreasing shareholder value (however short-term
> it may be) then he/she should be called out for it; regardless of
> who it is. We all know about his arrangement and it's very noble.
> However, he still owes it to his shareholders to increase shareholder
> value. He already forces shareholders to sit through these downturns
> without so much as a mild dividend to hold us over. We're also left
> in the dark about the transition plan (it is not unfair to ask for
> details when the man that holds the key to the kingdom is nearly
> 80 years old). I believe he's been one of the best at managing retained
> earnings; but, the stock sure isn't reflecting that greatness lately.
> Still holding on to the stock but I can't say that I'm ecstatic about
> its performance over the last 18 months.

Jul 06 11:34 PM

[Nicholas Wa...:]

Last I heard from my stock loan buddies... it had been costing 100% per annum to borrow Citigroup whereas it was 0.35% pre-Lehman. So, that should answer almost all of your questions.

Jul 06 11:34 PM

[Nicholas Wa...:]

On your query wrt to Berkshire... These class A/B trades come in and out of vogue over time. We used to trade Viacom A/B at Salomon Brothers all the time... In any case, as arbitrage capital shrinks, these spreads tend to widen. Plus, with normal companies the A/B spread might be enough to pressure management to make changes, but that certainly won't be the case with Buffett. Please read my post on his wild foray into equity index derivatives, which Berkshire continues to downplay. Regards, Nick.

Jul 06 11:40 PM

[U338129:]

I don't buy the "protecting the shareholder" bit. Back when Berkshire was small that may have held more weight. Same thing goes with the dividend policy. However, times have changed and Berkshire has become more important than one single person (or two if you throw in Charlie). At this point, Buffett would be "protecting shareholders" by providing more in the way of transition information (he's almost 80, I think we deserve the info) and actually giving something back to shareholders now that the magical returns of the past are a thing of the past. He can't match what he did in the past, and he admits that, so isn't it about time for a dividend and dare I say a buyback? We've all read his lectures and the books on his ways. However, 18 months of nothing but mediocre performance would get most money managers fired. I'll continue to hold my stake in hopes of brighter days, but there's a heck of a lot more Buffett can do to "protect shareholders."

On Jul 06 11:34 PM KIT wrote:

> Warren is protecting the shareholder from his eventual death were
> all his shares will be deemed sold. The resulting tax can only be
> met by a massive selloff, this selloff would decimate the current
> shareholders. This donation prevents a single day wipeout.
>
> Ford foundation, Carnegy, and many others have done the same for
> the same reason

Jul 07 10:09 AM

[BerkeleyBob:]

I have been puzzled by the disparity in PLD common and PLD preferred F. I am long both (small positions) but the PLD preferred has almost doubled in a short time. PLD has taken several steps to deleverage and reduce debt, but the preferred makes me nervous...

Jul 07 12:10 PM

[long_on_oil:]

In Berkshires case the market is setting the B share price because it is the affordable share. According to Berkshire you can convert 30 B shares to one A share but the reverse is not true. Also, if you follow Berkshire you will find that this disparity does not last long, so you have to be a good timer to capitalize on the difference.

Jul 07 12:56 PM

[MIKETRADER:]

ON CITI theres an ARB spread that will narrow while we get closer to expiration date, but the reason of the discount on the Public Pref. vs Citi Common is the repo rate also, example:

If you buy C.PRI @ 31.00 and sell 13.07 C @ 2.70 = 35.28

and on July 24 you convert your preffers you will gain on the spread minus the repo rate on shorting C with is like 60 to 100% anually so thats the catch!.

What I personally recomend is buy CITI ETRUPs: CPRF, CPRO especially if C goes to $3 you can shorT it and lock in a 3.5 dlls gain on each share, participating in the exchange.... and if you dont, your getting a hefty yield and large TCE as cushion.

Jul 07 02:15 PM

[EttU:]

Why complicate when you can simplify. I can afford to buy BRKB, once in awhile however I can not buy BRKA, ever at any time.
I assume you still believe that the market puts everything in its proper place, you must have been sleeping during the last two years, when the Mr. Market got itself in the ringer, thanks to the quants and greed on wall street.

Jul 07 08:19 PM

[Ricard:]

On Jul 07 08:19 PM EttU wrote:

> Why complicate when you can simplify. I can afford to buy BRKB,
> once in awhile however I can not buy BRKA, ever at any time. <br/>I
> assume you still believe that the market puts everything in its proper
> place, you must have been sleeping during the last two years, when
> the Mr. Market got itself in the ringer, thanks to the quants and
> greed on wall street.

By this logic, BRKB should be more expensive than BRKA due to higher demand, but the opposite is true.

Jul 09 07:41 PM

[Tushar Patel:]

According to an article in this weeks Barrons,

Berkshire's class B shares (BRK-B), worth 1/30th of the A shares, fetch about $2,750 each. The B shares look like a better buy than the A shares, because they sell at a 3% discount to their theoretical value. But the discount has persisted for some time, and could continue, as the B shares can't be converted into A shares.

Full article at
online.barrons.com/art...

Jul 16 05:11 PM