Mining BHP's great share arbitrage

For more than a decade, ever since BHP became a dual listed stock, it has been one of the ultimate fantasies for an investor.

How to capitalise on the arbitrage opportunity thrown up by the starkly different prices the separately listed companies command?

In 2002, mainstream newspapers carried yarns about the incredible riches to be made by simultaneously trading both stocks.

“Easy 10 pc on BHP Arbitrage”, screamed one headline in the Sydney Morning Herald. I have to confess, I was business editor back then, so I’m to blame as much as anyone.

For the simple fact remains, if it was easy to arbitrage the position there would never be a 10% gap in the first place.

Clearly though, there is something there, for that story went on to detail how the US-based Capital Group – at one stage the biggest shareholder in the Australian domiciled company – had ceased being a substantial shareholder but had increased its stake in the UK listed entity.

On paper, the difference should be marginal. Both companies own the same set of assets and liabilities. They have equal voting rights. They have the same boards of directors. They pay the same dividends.

But, for the entire time the dual listed structure has been in place, the Australian entity has traded at a premium.

In recent weeks, the gap has widened further. The Big Australian ended last week at $33.43 on the ASX. In London, it closed at $28.24 after converting to Australian currency.

The discrepancy exists primarily because the shares are not interchangeable. Shares in the London-listed company cannot be traded on the ASX and vice versa. But that still doesn’t explain the enormous gap.

Some proffer that it is an exchange rate play and that this somehow has a bearing on the varying share prices. But that doesn’t wash.

Consider that both securities can be traded on the New York Stock Exchange via American Depository Receipts or ADRs.

BHP Billiton Ltd finished last Friday at $US69.94. But BHP Billiton PLC ended the week at $US59.21.

Perhaps a more likely reason for the difference is that Australian investors and institutions are entitled to franking credits on dividends, boosting demand for the Australian entity. Another possibility is the tax on share trades in the UK.

On a simple level, buying stock in the UK entity is essentially acquiring the same assets and business on a large discount.

Despite their commonality of ownership, management and board, the two companies are separate legal entities trading on different exchanges, and for that reason an easy arbitrage is out of the question.

For those with a taste for the exotic, however, there is a way to exploit the spread in the share prices.

For it should be noted that, stripping out the effect of exchange rates, there have been wide variations in the spread between the two companies.

At times such as now, the spread appears quite wide. But it is in fact close to average. The UK vehicle is valued at just 84% of the Australian company. It has been as close as 96%, and in recent years as low as 77%, with an average of around 86% according to some studies.

The way to trade the spread, on a currency hedged basis, is to trade the ADRs on the New York Stock Exchange. By buying one BHP entity and selling the other, both in US dollars, you effectively are trading the gap in the prices between the two companies.

The best time to do this is when the BHP share price is slammed. During periods of uncertainty, the Australian company tends to take a greater hit and therefore the spread narrows. As conditions normalise, the average spread tends to reassert itself, allowing traders to capitalise on the relative movements between the two companies.

The change in spread can be quite dramatic during these periods. But this is not a trade for the faint hearted. It conceivably could be a better trade to simply buy stock in the Australian company on a downturn hoping for a capital gain, with the added bonus that you are acquiring a reasonable yielding stock with franking credits.