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Overview

While markets are mostly efficient, every once in a while for no discernible reason, share prices get distorted. Together, the general efficiency of markets and the occasional distortion in prices allows value investors to profit. The investor can buy/short the shares at the distorted price with the assumption that the market will correct for itself.

Most arbitrage opportunities are complex and involve extraneous risks that have to be hedged for. For example, when arbitraging ADRs over exchanges one has to hedge for currency risk in order to make the arbitrage complete. Merger arbitrage also opens the investor up to risk because not all deals actually go through.

Class Structure

The current market conditions have opened up a pure arbitrage opportunity on Brown-Forman Class A (NYSE:BF.A) and Brown-Forman Class B (NYSE:BF.B) shares. Brown-Forman is a large producer of high-end spirits and owns and markets a diverse portfolio of brands including Jack Daniels, Southern Comfort, Woodford Reserve, and Finlandia. The company has historically traded at a high P/E, which accounts for its solid historical growth and stability. The company has been family-controlled and managed since the pre-prohibition era. While many companies, which centralized control such as Facebook (NASDAQ:FB), underperform, history demonstrates that that is not the case with Brown-Forman.

Share Classes

The way the Brown family maintains control over the company is via a dual-class share structure. The family holds Class A shares, which each carry 1 vote while the float primarily consists of Class B shares, which do not have voting rights. In terms of dividends and debt structure the shares are equal. Assuming the voting rights are relatively insignificant when the Brown family controls the entire corporation, the shares should trade at the exact same value. In reality, the additional Class A shares should trade at a small premium to the Class B shares since the votes do have value in case of future corporate action.

Arbitrage

Since the Class A shares are senior to the Class B shares they should trade equally or at a premium to the Class B shares. As you can see by the chart below (of price movements), that is typically the case.


(Click to enlarge)

But if you look closely, over the past few months a spread has opened up and the Class B shares are trading at a premium to the Class A shares.


(Click to enlarge)

On June 27, 2013 the Class B shares closed at $68.43 while the Class A shares closed at $67.68. The surefire way to profit from a situation like this is to short the Class B shares while entering a long position in the Class A shares. The subsequent trading day the spread closed, but today it has opened once again. When the spread closes the investor will profit the spread. Assuming markets are mostly efficient, the spread must close. The only question is when the markets will correct for this.

Opportunities like these are rare, and are interesting to observe. They also serve as a refutation to the efficient market theorists who inhabit the ivory tower. Finally, before acting on this, investors must be aware that the Class A shares are not quite as liquid as the Class B shares. This seems to be the reason as to why the spread opened up in the first place. Nonetheless, the Class A shares will always have more value than the Class B shares and the market will eventually correct for the spread.

Source: Pure Arbitrage In Brown-Forman's Class Structure