QBE share purchase plan arbitrage

After the former market darling announced the latest in a string of profit downgrades, the share price of QBE Insurance has risen 32% since hitting a nadir of $9.88 on 12 Jan 12, a figure last seen on 28 October 2003.

The company largely shook off the worst manmade financial disaster since the Great Depression in 2009. Then it fell victim to the costliest year of natural disasters on record in 2011. According to Munich Re, the total economic cost of the various floods and tsunamis and other catastrophes was US$380bn.

That hasn’t dissuaded QBE from continuing with its acquisition-led strategy. With its balance sheet stretched (see Shoptalk), large investors recently coughed up $450m via an institutional placement. Now eligible retail shareholders have the opportunity to buy up to $15,000 of QBE shares priced at $10.70 via a Share Purchase Plan (SPP).

The Investor’s College review How to profit from a share purchase plan highlights how to appraise such offers. In short, even if you have a full weighting to QBE shares and don’t want to own any more, you should still consider participating in the offer.

Your options

Let’s analyse your options. First, if you own some QBE shares and want to own more, the SPP is a great and cheap way to add to an existing holding. Please keep in mind our suggested portfolio weighting of 7% for most members, though.

Second, even if you don’t want to increase the number of shares you own, the next step is to consider an arbitrage. The process is simple enough but, for reasons we’ll explain, might not prove very effective on this occasion. Here’s the theory.

Though the QBE share purchase plan only lets you purchase shares in specific dollar amounts, let’s assume you can sell 1,400 shares of QBE on market at yesterday’s closing price of $13.00 for a sum of $18,200.  You can then use some of the proceeds to subscribe for 1,400 shares through the share purchase plan at the lower price of $10.70.

The difference of $3,220 (1,400 x (13.00–10.70)) is your potential arbitrage profit. You’ll still own the same number of shares and you’ve locked in a nice, guaranteed profit. Most shareholders would have also crystallised a tax-saving capital loss in the process, adding to the overall benefit.

Nice in theory and, although your stake in the company will be diluted slightly due to the extra shares on issue following the capital raising, you’ll still own the same number of shares.

In a perfect world, we’d suggest that if you have a 7% or otherwise appropriate allocation to QBE, the arbitrage means you can lock in some risk-free gains. Unfortunately, the world is imperfect.

QBE has around 160,000 small shareholders, most of whom are considering this same tempting opportunity. As QBE only wants to raise $150m (about $1,000 per eligible applicant), applications will probably be scaled back, perhaps severely so.

Investors with large shareholdings and those with multiple holdings at the same address are expected to be scaled back first. Many others won’t bother to respond. And perhaps QBE will increase the amount it accepts. But it seems very likely that all applicants will be trimmed. If so, the attempted arbitrage could leave you with fewer shares than you originally owned and a refund cheque.

Intelligent speculation

The alternative is to participate in the share purchase plan and then sell the required number of shares after they’ve been allotted on 5 April, hopefully at a higher price than you’ve paid.

The share price has recovered from its January lows and is now 21% above the share purchase plan price. That means participating in the plan and then selling part or all of your acquired shares on market is likely to be profitable. We’d call it ‘intelligent speculation’.

This isn’t a classic arbitrage play because there’s a risk of the share price falling substantially prior to the allocation of your shares (and before you’re able to sell them on market), so your final profit/loss will fluctuate depending on the QBE share price on the day of sale. On the other hand, the strategy does guarantee that you won’t be left owning fewer shares than you started with.

If you’ve been following our advice to hold some cash, then this is an intelligent way to deploy some of it, even if only for a short-term capital gain with some risk attached. We also recommend seeking professional tax advice if you’re unsure of the potential tax consequences of these strategies.

Please bear in mind that applications need to be received by 5pm on 26 March. If you’re planning to participate, you need to move fast.

As for our recommendation on the stock itself, with the share price up 11% since Clouds clearing at QBE from 29 Feb 12 (Strong Buy - $11.70), we’re downgrading a notch to BUY.

Note: The model Income and Growth portfolios will apply for $15,000 worth of shares via the share purchase plan, and redress the portfolio limits following the final allocation.

Note: Staff will also be applying for shares through the share purchase plan, and will potentially sell shares following the final allocation to achieve their desired portfolio weighting.