Swatch share class arb
- 1. 12/13/2012 Swatch Group has two share classes that trade in Zurich; “Bearer” shares and “Registered” shares. Both shares have 1 vote each and bearer shares have 5x the economic interest. There are about 4x as many registered shares outstanding. However, since the controlling family owns 53% of the registered shares and another large holder owns 9%, the registered shares are significantly less liquid (average daily volume of the registered shares is about Fr 8M vs. 67M for the bearer shares.). The registered shares offer greater voting power, but given the Hayek family controls 42% of the votes, its unclear how valuable voting rights are here. Otherwise the shares are exactly the same, so any price difference should be determined only by the differences in voting rights and liquidity. From 1993 until mid-2009 the registered shares traded at a slight premium to the bearer shares implying that the market ascribed a small value to the additional voting rights offered by the registered shares. However, in mid-2009 this began to change and now the registered shares trade at a significant discount to the bearer shares. Since there were no changes to the share classes or relative liquidity profiles, the only explanation for this is that the market suddenly placed a much higher value on the additional liquidity offered by the bearer shares. The company has no additional explanation for this discount. Currently, the spread between the price of a bearer share and 5 registered shares is at an all-time high of Fr 64 - more than 3.5 standard deviations from the 19-year mean of 2.99. Now, if you purchase the bearer shares you’re paying 16.0x estimated 2012 earnings for Swatch vs. only 13.7x for the registered shares. This spread is much greater than any reasonable liquidity premium would justify – especially since the registered shares are hardly illiquid in an absolute sense. As such, I recommend shorting Swatch bearer shares and going long the registered shares in order to profit when this spread narrows. Since this trade involves being both long and short fundamentally identical securities there is no business or market risk. Difference between the price of a bearer share and 5x an ordinary share 70 60 50 40 30 20 10 0 -10 -20
- 2. Share price difference vs. liquidity difference 65 55 Ratio of 30 average trading volume Bearer share price - 5x ordinary share price 45 35 25 15 5 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 -5 Just as there is no economic justification for this disconnect in the two share classes, there is also no catalyst for it to reverse. However, it appears that the spread between the share classes is strongly positively correlated with share price (ie. as the share price rises, the discount of the registered shares also rises). A simple regression shows a positive correlation with a 99% confidence interval and an r- squared of 0.722. One possible explanation for this robust relationship is that price movements are driven by large institutions who require the liquidity provided by the bearer shares. As such, a fall in the share price could be a catalyst for this discount to narrow. Share price vs. Registered share discount 85 Bearer share price divided by 5 75 Bearer share price - 5x ordinary share price 65 55 45 35 25 15 5 -5 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Regression output of bearer share price vs. share class spread X Variable Line Fit Plot 70 Bearer share price - 5x registered shares 60 50 40 30 Bearer share price 20 Predicted Share Price 10 0 100 150 200 250 300 350 400 450 500 -10 -20 Bearer share price
- 3. I don’t have a directional view on Swatch shares, however there are any number of factors that could cause shares to fall. Swiss watches are highly discretionary purchases, so Swatch is obviously exposed to global consumer health. Furthermore, China accounts for about 40% of Swatch’s sales (and likely a higher % of profits), so anything that impacts the Chinese consumer or discourages “gifts” in China (see article below) would clearly impact the company. http://www.nytimes.com/2012/09/25/business/global/as-beijing-clamps-down-on-gift-giving-luxury- goods-losing-their-appeal.html Of course, shares could continue to rise. However, since Swatch pays a divided the yield spread between the two classes should prevent price spread from widening much more. As such, its hard for me to envision a situation in which this position results in a permanent loss of capital. Despite minimal risks, the potential upside is significant. For example, if the share class relationship were to return to its 19-year average, the return would be almost 16%. While if the spread went to 30 – the level it touched during the last market downturn in late-2011 the return would be about 9%. The potential returns at various spreads are shown below: If spread goes to… … Profit as % of Long capital Fr 0 16.5% Fr 10 13.9% Fr 20 11.3% Fr 30 8.7% Fr 40 6.1% Fr 50 3.5% Fr 2.99 (19-year avg) 15.7%