Arbitrage: Brown Forman A Shares and Brown Forman B Shares

It is not terribly unusual for some companies to create a dual class structure for the stock. Hershey, Google, and Ford immediately come to mind. In every example of this I have ever studied, the purpose is to keep ownership control in the hands of a select few that want to maintain control over the company by scaling back their investment in it. It’s a controversial practice—people think that investors with $500 million worth of stock should wield 10x as much influence as someone with $50 million in the firm. Others find the practice tolerable because investors have notice of the arrangement at the time they make their investment, and plus, the original founding families that own the firm through the decades may have more of a long-term orientation than some random guy that gets his hands on a large block of stock.

Brown Forman, one of the most legendary wealth creators among publicly available opportunities, is controlled by the Brown Family through such an arrangement. Like Google, however, the shares of both stock listings are publicly available. If you purchase a share of Brown Forman A (BF.A), you are entitled to the same voting rights per share that the Brown fortune heirs receive. If you buy a share of Brown Forman B (BF.B), then you receive no voting rights. But you do have an identical interest in the company.

Over the past thirty years, the B shares have often traded at a premium to the price of the A shares. This may seem unusual because you would think that people would prefer to own stock with voting rights compared to a share of the stock that gives you dividends and capital appreciation over the long haul but no actual say in the company.

The explanation has to do with liquidity. Because the Brown family so rarely sells shares, there are only 22,000 shares that get traded as part of its ten-day average. If you tried to purchase $5 million worth of the stock in a day, week, or month, you would likely cause the price to go up because you would become a meaningful amount of the market. For someone buying a few hundred shares per year, or someone buying $10 million worth of Brown Forman stock over the course of an entire year with a near 0% possibility of ever selling in a short period of time, it makes sense to buy the A shares (especially if they are trading at a discount to the no-voting B shares.)

The B shares, meanwhile, go through 680,000 shares as part of the ten-day average. It’s a market that has 30x as much money circulating in Brown Forman stock on a daily basis, and this means that $66 million is regularly exchanged in the stock (compared to around $2.3 million for the A shares). For someone that wanted to buy or sell millions of dollars of Brown Forman stock in a short period of time, the B shares are a much more attractive vehicle to do it because your singular actions won’t affect the price of the stock nearly as much.

A company with shares offering a low float like the Brown Forman A shares is a refreshing reminder that the stock market is one giant eBay for businesses and you need to find a buyer or seller on the other side that is willing to trade ownership places with you. It’s like a baseball stadium where every seat is always filled in by someone at a given time. It’s also a reminder that someone is always buying a company as it falls (for every share of Chevron that people want to get rid of at $99, there is someone on the other end that is buying the stock at $99).

The annual reports not only pay lip service to the notion that the A shares and B shares have equal economic interests to each other, but the Brown family actually does something about it. When they repurchase stock, they always repurchase shares of the stock that is currently trading at a lower price out of a desire to have a long-term parity between the two.

The reason I am about Brown Forman right now is that we are living through one of the unique periods in which the A shares are trading at a premium to the B shares. Although each share collects the same $0.315 quarterly dividend, the A shares are trading at $107 and the B shares are trading at $98. Both the A stock and the B stock represent $3.22 in earnings per share, though the A shares cost almost $10 more to purchase. Furthermore, the company is currently in the midst of a $1 billion buyback that will retire some of the float on the B shares (yet still keeping the economic interests of the two companies equal. Brown Forman is the only large company other than Google which does this).

The reason why the A shares have risen to a premium is the result of a transfer of power from fourth-generation to fifth-generation heirs that have prompted the speculation that the A shares could be sold to an activist investor if the price is high enough. The Brown family is notoriously private, so this remains speculation that is neither confirmed nor denied.

What is interesting, though, is that for at least the past thirty years, the B shares have traded at a slight premium. The adage has always been—the A shares will catch up and reach parity—eventually. That has never happened because the A shares have historically been regarded as meaningless because even if you acquired all of the available A shares, you’d still only hold sway over a third of the company and the Brown Family would still be calling the shots as they collectively own 67.6% of the company. The voting power of the A shares have historically proven to be a distinction without a difference because the controlling family has retained majority control over the majority ownership of the A shares which grants them full control over Board of Direction selection.

What is intriguing is this—for Brown Forman’s entire corporate history since at least the last time the Kansas City Royals won the World Series, the B shares have been the ones trading at a premium. Right now, due to speculation, that role is reversed and the A shares cost almost $10 more each. An enterprising could theoretically benefit from buying the B shares as the identical ownership position could come to match the A shares (and maybe even advance more to reflect the liquidity benefits of the B shares that have historically created the premium.)

The catch? There is no rule stating that the valuation of the A shares can’t come down to match the valuation of the B shares (rather than having the B shares increase to match the A shares), and the stock is currently trading at its highest P/E ratio since the dotcom bubble. It traded around 28x earnings in the late 1990s, and trades at 30x earnings now. It is an excellent business, delivering 21% annual returns over the past thirty years. If someone commits to paying a premium, there are far worse companies to choose.

The problem, though, is that during every single year between 2001 and 2010 investors could get a much better deal on the starting valuation of the stock than you can get now. It’s not just a little bit of a difference either. If we were talking about the difference between 20x earnings and 23x earnings, we could get over it. But that’s not the case here. This is a company with a historical valuation between 18x and 21x earnings that is now selling at over 30x earnings. That is a moderate, going on substantial, difference. It is likely that buying Brown Forman today will give you total returns lower than the growth rate of the company. If Brown Forman grows at 14% annually from here, the premium is tolerable. If it grows at 9%, it is much less tolerable because you’ll end up with 6% or so returns during the shift from 30x earnings down to the 20x earnings range.

There would be much more clarity evaluating Brown Forman right now if the A shares traded at 20x earnings and the B shares traded at 18x earnings. It would be a clear example of buying an excellent business at a better-than-fair price, and it would also carry the lesson of how to tilt the odds in your favor by arbitraging the difference between the B shares and A shares. You’d get a more liquid ownership position, and you’d eventually make more money for being shrewd and taking advantage of that opportunity.

But a valuation of 30x earnings is probably too rich to take advantage of this opportunity. The B shares rarely get cheap compared to the A—I can’t find any historical data indicating the last time that this happened. But on an absolute basis, the stock is price-y enough that I’m not sure there is anything you can do with this information right now.