My research sometimes takes me into the nooks and crannies of finance.  I know it is wonky, but I actually enjoy tearing into complex prospectuses in order get a sense of where value is.

One of my current projects is on large companies that have more than one share class.  Some easy questions:

• How many companies are there in the US with more than $1.5 billion in market cap? 1,045.
• How many of them have have more than one common share class?  103, or roughly 10%.
• How many of the 103 companies extra share classes trade more than one thousand dollars worth of volume per day?  28.
• How many of the 103 companies extra share classes trade more than one million dollars worth of volume per day?  11.

Why are there dual share classes?  Usually, it is because a founder that prized control had a financing need for which equity was the right choice, but he decided that he did not want to give up control.  So, he issued equity with lesser voting rights at a discount to the shares with greater voting rights.

In most cases, there are covenants that protect dividend rights and liquidation rights of the lesser voting shares.  The difference in the share prices of different classes of stock often boils down to the value of what a vote is worth.

Now what of those 11 companies where liquidity is adequate in the dual shares?  There is the opportunity for arbitrage in synthetically buying votes cheap and selling them dear.

Now, this is not a large trade.  Indeed, this is not big enough to begin a hedge fund around.  But it could be of value to enhanced indexers that are trying to outperform their benchmarks by a small amount.  The lesser voting shares, particularly at an extreme discount offer higher yields, and a better return in a change of control.  The loss is a lesser degree of control — you are on the back of the bus and other investors

This presumes that there are covenants on the various share classes for equal treatment in a change of control, and/or that there are rules to govern dividend policy, giving the same or superior treatment to those with a lesser voice.  That is normally the case, but when I was younger, I ran into a case with a micro-cap stock (Cerbco, aptly named for the mythic three-headed dog of hell) where the supervoting share class received a higher price in an asset sale.

This isn’t going to be too much use to the average investor, except to say when you look at buying a company with dual share classes, do this:

• Review the EDGAR filings to see the benefits of each share class.  Be wary of situations where lesser voting shares lack protection.
• See whether the classes trade adequate volume (or at all) for the size of the position you want to have.
• Review the price series for each share class, and review how wide or narrow the differential can be.  When near extremes in the values, shift to the class that is undervalued.  Sell votes dear, buy them cheap.  This works better in a tax sheltered account.

Where this has the most punch is for tax-sheltered index investors that want to enhance their indexing.  It won’t shoot the lights out, but using this on the 11 companies with decent volume, it would likely offer 5 basis points of outperformance versus a pure index portfolio, and more, if your trader is good.  My clients do/will get more specific advice on the eleven companies, but I put this out to my blog readers to give them a general idea of what to do as small investors when faced with multiple share classes.

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One final note: Berkshire Hathaway was an exception (isn’t it always?) with respect to why it has a second share class.  Buffett didn’t need more financing when he created the “B” shares.  He noticed that a small cottage industry grew up to allow investors to buy fractional shares of Berky.  What annoyed him was that the providers were taking a significant annual cut off of the fractional shares.  So, Buffett outcompeted them by creating a second class with lesser voting rights than the “A” shares, and 1/30th of the economic value of an “A” share.

This also allowed Berky investors to be able to gift shares under the gift tax limit.  (Thanks Dr. Bob, I did not know that, but it makes perfect sense.)

Now, for index investors, that doesn’t help, because Berky is not in any of the indexes (though I think it should be), aside from the NYSE Composite (no one follows that).  There’s still a smallish noisy arb there for those who want to play it.  Thanks, Climateer.

So it goes.  On to review some deal arbitrage…. enhanced indexing can be fun.

Full disclosure: no positions in companies mentioned.

Since I met him at a Baltimore CFA Society meeting in 2001, I have  appreciated the intelligence of Mike Mauboussin.  (My old boss was his roommate in college, so I was told, the name is pronounced “MOE-bus-son.”)  He was early to pick up on the value of behavioral economics and nonlinear dynamics (“chaos theory”).

Think Twice is an effort to get all decisionmakers to take a step back and ask whether they are making decisions from shorthand rules, or from carefully analyzed data.  The book is full of examples of how people are easily fooled by irrelevant data.  Most of the examples I was aware of, becauseI have studied this stuff intensively.  There were a few surprises for me, though.

Did you know that at the craps tables in Las Vegas, on average, when someone wants a higher number, they throw the dice hard, and when they want a low number, they give it a gentle toss?  I found that to be an amusing example of the illusion of control in  a case where humans have no control.

This book helps answer a number of tough questions:

• When are crowds better than experts, and vice-versa?
• Why don’t we go get data, rather than listening to anecdotes?
• Why does an initial estimate play such a large role in estimating the final value?  (Why don’t people ignore the estimates, and start from scratch?  It’s too much work!  Never underestimate the power of laziness.)
• Can subliminal cues lead people to make different decisions?
• Do I have to understand the whole system to understand the piece of the system that I am interested in?
• When can you outsource production, and when does it not make sense?
• When do catastrophic events occur, and why?
• How does one sort out happenstance (so-called “luck”) versus skill?

The clear message of the book is don’t be lazy; do your homework on any task.  Try to be objective as possible, ignoring the opinions of others, and using as much data and cold logic as one possesses to confront the problem.  Be aware of the mental shortcuts that hinder good decisonmaking.

I recommend this book, but with a quibble.  It is not written in a truly user-friendly way.  There are technical terms used and not defined that many average people will blink at, and maybe get part of the meaning through context, but not get it in full.  If we Flesch-tested the book, it would come up at “college level” for reading.  (As for me, I am to be understood at a high school level.)

Who can benefit from this book?  Anyone who makes economic decisions could benefit.  It would help them be more self aware of the pitfalls involved in decisionmaking.  I found it to be a breezy read at 143 pages of main text, and the writing style is entertaining.

You can buy the book here: Think Twice: Harnessing the Power of Counterintuition.

Full Disclosure: Anyone entering Amazon through a link on my site, and buying something — I get a small commission.  Your costs remain the same.

To my readers, if you want me to review Mauboussin’s other book, Expectations Investing, I would be more than happy to, because I read it five years ago.  If you have other books you would like me to review, let me know… my time is limited, but if I get a lot of people asking for the same book, I will give it a shot.

PS — look at the book cover — what is the hidden message? (which never gets mentioned once in the book…)