The Chipotle Mispricing Persists

The stocks of Chipotle Mexican Grill are both down today on an analyst downgrade, which is fine. The company’s price has certainly been bid up. What continues to amaze me, though, is the lack of attention to the very obvious mispricing that exists between the company’s class A and class B shares. For one thing, oftentimes the B shares aren’t even mentioned, or reports will just make reference to “shares of Chipotle,” as if they are all the same. Something very interesting has been going on here but no one seems to care.

When Chipotle was spun off of McDonalds last year in an IPO, it had only one class of publicly traded stock. McDonalds retained a majority interest in Chipotle, though, calling the shares it owned B shares and assigning ten times the voting power to them. Then, when McDonald’s sold its remaining interest in October (perhaps because it saw CMG as overvalued?) the B shares came to market.

The shares have the same economic value. That is, the B shares are identical to the A shares except for the fact that they have more voting rights. So, if anything, the B shares should trade at a small premium to the A shares. But they don’t. They have persistently traded at a 7% discount to the A shares. This is an example of investor irrationality. I read about it in various places after the phenomenon began, but it took a call to the company itself before I believed it.

Anomalies like this drive academicians nuts. How can this happen? Why aren’t arbitrageurs eliminating this discrepancy? The literature on behavioral finance contends that such anomalies can persist when there are “limits to arbitrage.” This explains why shares of 3Com traded at a discount to shares of Palm, which it owned, my favorite Wall Street anomaly of all time. Know-something investors couldn’t get their hands on shares of the overvalued stock to short, so it kept getting pushed up.

But I don’t think this can explain the persistent mispricing in this case. Both classes of stock trade several hundred thousand shares per day, and I personally have been able to buy both classes – the A’s before the B’s were around, then was able to easily sell the A’s and buy the B’s. So there is no liquidity concern here, and even if there were, I would expect the A shares to be discounted as there are slightly fewer of them outstanding (and thus they are less liquid).

So can this discrepancy be arbitraged? The short answer is yes, but it has not been profitable yet. Since the phenomenon continues to persist, those who shorted the A shares and bought the Bs have not yet realized any gain. And if it takes long enough to correct the mispricing, they may never realize a gain. I found it difficult to get historical price data for CMG.B because, again, everyone is focused on the A shares. It isn’t available on Yahoo, Google or even Ameritrade’s resources. I finally found a source for both classes on the Chipotle IR website, although I had to search for each day’s price independently. I then, painstakingly, charted the profit from an arbitrage of them by manually entering them into excel. And here it is, in all its glory:

I assume that I initiated the arbitrage trade on January 10, since this was around the time that I personally learned of the mispricing, by buying Class B shares at $52.40 and shorting Class A shares at $56.21 . The cost basis is the cost of the shares I bought, $52.40, so to date the arbitrage would have produced a gain of $2.00/$52.40, or 3.8%. If we assume the cost of shorting is 9% APR, or 4.5% over the six months we were short, then the interest on the short would completely wipe out the gain on the long. And this ignores the time value of money, the return on the market and, perhaps more importantly, the fact that a long position in either class of stock would have produced a great gain.

The analyst report that came out today also makes reference to the large short interest in CMG in the explanation of its downgrade. Couldn’t this simply be because of investors trying to arbitrage the difference?

PS - What do you suppose SocialPicks will say about this one?

FD: I have no position in any stock mentioned in this post.