Profit From Panic With This Arb Pair Trade
By Sham Gad

In today’s markets, valuations simply do not matter. If you are a value investor, you see this firsthand as high-quality, cheap businesses seem to get cheaper by the day. With no end in sight, the notion of a business being “too cheap not to own” seems to take a backseat to “too risky to own anything.” Yet during periods of extreme volatility and uncertainty, one channel of market activity that is usually nonexistent opens up: stock arbitrage.

Arbitrage is basically an investment opportunity that is not dependent on the general performance of the market to yield a positive return. Value investors salivate around such opportunities because they can offer complete safety with virtually risk-free upside. Arbitrage exists in many forms. The most common is merger arbitrage, but in today’s market I wouldn’t count on many deals going through unless the government or Berkshire Hathaway is buying.

Another type of arbitrage involves businesses with two classes of stock that both trade simultaneously and should have stock prices that reflect the economic value of the shares. One such company today offers one of the best and safest arbitrage pair trades out there.

That company is Mueller Water Products and , a pure-play water infrastructure company that was spun off from Walter Industries a couple of years ago. Since this arbitrage opportunity has nothing to do with the business and everything to do with the price of the shares, I won’t get into the business details here.

The Trade
As an ultimate result of the spinoff, Mueller has two classes of stock, A and B, both of which trade on the NYSE. The A shares were issued by the company. The B shares were issued to the shareholders of Walter Industries as part of the spinoff.

The two classes of shares have identical economic rights, but the B shares have superior voting rights. In fact, B shareholders are entitled to 8 votes per share vs. 1 vote per share for Class A holders. As such, one would think that the B shares would theoretically be worth more than the A shares, but at a very minimum they should be equal to the A shares. There are no differences between the two classes besides voting rights.

As of the close yesterday, the A shares traded at a premium of more than 30% to the B shares! The B shares were trading around $6, while the A shares were trading at a penny under $8. This is an awfully wide spread and should not exist in the long run. I can only blame the panic-stricken market for allowing this to happen.

So the arbitrage trade is simply to short the A shares and buy an equal number of the B shares. Using prices from the close yesterday, the trade would be:

Short 1,000 shares MWA at $8.00 a share: -$8,000
Long 1,000 shares MWA.B at $6.00: $6,000
This spread will converge either through an appreciation in the B shares, a decline in the A shares, or a combination of both. As of late last week, the spread was more than 65%, so the spread has closed rapidly, but it’s still wide enough to warrant action.

Why the pair trade? Why not simply go long the B shares? You don’t know how the convergence will take place. It could be that the A shares decline while the B shares sit still, or both classes could slowly converge toward each other. By employing the pair trade, you hedge your losses and capture a gain, which is the essence of a pure arbitrage play.

A Note of Caution
Historically, the A shares have typically traded at a 5% premium to the B shares. There’s no logical explanation to this except to say that of the 116 million outstanding shares, 86 million are B shares and 29 million are A shares, so it could simply be a supply/demand issue. Yet there have been periods when the shares were trading equally.

Still, I would be looking for at least a 20% to 25% spread before thinking about making the trade. At last week’s prices, this trade was like stealing candy from a baby. At today’s prices of $6 for the B shares and $8 for the A, there is still room for a tidy profit.

Understand, however, that the spread could actually widen in the short-term, but over the years there has been a tendency for it to hover around 5% or so. And because there are no conversion rights from the B shares to A, there is no guarantee for a complete convergence.

Nonetheless, panicky markets distort prices beyond rationality. And this trade has nothing to do with the Dow rising or plunging 500 points. That’s the beauty of stock arbitrage and why value investors love it so much.