Empirical Finance Newsletter, July 2009 (plus Stock Screen Results)
Our partners Wesley R. Gray of the University of Chicago and Andrew E. Kern of the University of Missouri present:
July 2009 — Empirical Finance Newsletter on Mispricing of Dual-Class Shares: Profit Opportunities, Arbitrage, and Trading, a paper by Paul H. Schultz and Sophie Shive
Abstract: Dual-classes of shares with equal cash flow rights often trade at significantly different prices. Buying underpriced shares and shorting overpriced shares provides large and significant abnormal returns, hence differences in voting rights or liquidity do not explain the mispricing. Unmargined long positions in the underpriced class earn significant abnormal returns after transactions costs, so short sale restrictions do not prevent traders from exploiting the mispricing. An examination of the trades reveals that investors shift their trading patterns to take advantage of mispricing. One-sided trades are more important for bringing prices into line than long/short arbitrage trades.
Conclusions: This paper documents a very important and useful anomaly in the stock market. From this work we can conclude that exploiting the mispricings of dual-class companies is significantly profitable. However there is likely much more potential to this anomaly than the paper suggests. Because the authors neglect any opportunities on the short side, the 8.8% alpha they find would likely be much larger for the investor that implements pair trades involving both the undervalued and overvalued share classes. Such an approach would not only take advantage of the mispricing in both directions, but would also allow the investor to hedge the portfolio by taking a market-neutral approach.