Description

Executive Summary

This is a spread play, capturing the significantly wide but unwarranted price differential which has occurred between the Ordinary shares and Preferred shares of Volkswagen AG (VW).  For reasons described below, the prices of the two securities have been driven dramatically apart over the past several days, setting up an attractive arbitrage opportunity.

The trade is to simply go long VWAPY (ADR for VW’s Preferred Shares) and short VWAGY (ADR for VW’s Ordinary Shares) in equal dollar amounts and capture the return as the price differential between the two securities returns to normal levels (<10% spread).  As of the close on 3/18, the price of VWAGY is $35.95 whereas the price of VWAPY is $25.95, a 38% spread.

Please note that while I have chosen to construct the trade using the US-listed ADRs, it can also be constructed using VW’s DAX-listed Preferred shares (VOW3 GY) and Ordinary shares (VOW GY).

Company Description

With annual production of ~11mm vehicles per year, VW is one of the world’s largest automotive OEMs.  Brands include Volkswagen, Porsche, Audi, SCODA, SEAT, Bentley and Scania.

Similar to other automotive OEMs, VW is in the process of converting its existing brands and platforms from internal combustion engines to fully electric vehicles.

Ordinary Shares vs. Preferred Shares

There are really only two main differences between VW’s Ordinary shares and the Preferred shares.  First, the Ordinary shares have voting rights, while the Preferred shares do not.  Second, to compensate the holders of the Preferred shares for lack of voting rights, the Preferred shares have a slightly higher annual dividend payout of €0.06/share (€4.80 for the Ordinary vs. €4.86 for the Preferred).

As there is no preferential treatment between the Ordinary shares and the Preferred shares in the ownership of VW’s equity, the two types of stock have usually traded at close to price parity, with rarely more than a 10% differential.

Interestingly, voting rights are usually valuable to the holder, but in the case of the VW Ordinaries, the voting rights really aren’t worth anything to the regular retail or institutional owner.  This is because 3 shareholders control 90% of the Ordinary shares:

• Porsche and the Piech family - 53%
• The German state of Lower Saxony - 20%
• Qatar - 17%

Accordingly, if you’re a shareholder of the Ordinaries, your voting rights are essentially worthless because you’ll always get out voted by the 3 main shareholders.

Importantly, as 3 shareholders own 90% of the Ordinary shares, the free float of the Ordinary shares is quite limited at <10% of shares outstanding.  This is one of the contributing factors in the dramatic rise in the price of the Ordinary shares vs. the Preferred shares, as described below.

Recent Events

Without question, one of the biggest stories for investing in 2020 was the ~10-fold rise in TSLA’s stock during the year.  Market participants have been looking for “the next TSLA” and VW appears to be one of the front-runners in developing EVs.

Below is a timeline of recent events which have caused the dramatic increase in investor interest in VW and the corresponding rise in the price of VW’s Ordinary shares vs. the Preferred shares:

• On March 9 VW’s CEO announced that the Company would be hosting a “Power Day” to showcase its battery technology, one of the central components of an effective EV.  The event was akin to the “Battery Day” TSLA hosted in September 2020.
• On March 10 in the trading post the announcement, VW’s Ordinary shares (VWAGY) rose 7.4% while the Preferred shares (VWAPY) rose only 2.1%.  News articles indicated that social media volume about VW had tripled.  While there’s not a definitive way to tell this, the speculation is that US-investors wanted to “get in on the VW action” and were buying VW Ordinary shares because they either (i) didn’t know about the Preferred or (ii) thought the VW Preferred shares were some sort of preferred stock, higher in the capital structure and not having the same upside as typical common stock.  The limited free float of the Ordinary shares also helped fuel the rally.
• On March 16, VW announced 4Q20 earnings.  VW had already issued a preliminary summary of 4Q20 earnings on 1/22/21 and then provided additional 4Q20 earnings detail on 2/26/21, so the earnings results themselves were well known.  While there were many pieces of new information that management issued in the earnings release and associated conference call, there were two main items that caught the market’s attention.  First, VW stated its intention to be the world’s leading manufacturer of EV’s by 2025 at the latest, overtaking TSLA.  Second, VW guided to a 2025 EBIT margin of 7-8%, up from VW’s guidance of 5.0-6.5% for 2021.  This positively addressed a key concern by investors that the transition to EV’s would be margin dilutive whereas VW management is indicating it will be margin accretive.  Again, social media volume on VW soared.  In the trading that followed during March 16-18, the price of VW’s Ordinary shares (VWAGY) rose ~21% while the price of VW Preferred shares (VWAPY) rose only 10%.

All in, from the close on 3/9 to the close on 3/18, the price of VW’s Ordinary shares (VWAGY) has risen ~35% while the price of VW’s Preferred shares (VWAPY) has only risen ~13%.  For two securities which normally trade at close to parity, this is an extremely wide differential and presents an attractive arbitrage opportunity.

Key Risks and Path Forward

The key risks with this trade are (i) the price spread between the two securities could continue to widen and (ii) there’s not a clear catalyst to drive the price of the securities together.  These risks are very real and should not be taken lightly.  The only way to address these risks are through keeping one’s exposure at a level commensurate with one’s tolerance for risk.

While there isn’t a clear catalyst to get the security prices to converge, it does appear that the price differential between the two is being driven by “quick acting investors” who aren’t fully informed of the difference between the Ordinary shares and the Preferred shares.  As more investors become interested in the Volkswagen story, there should be enough communication out there (brokers, chat rooms, social media, etc.), that investors start to realize that its more advantageous to buy the Preferred than the Ordinary – same exposure to VW, just at a cheaper price.  This should cause the price spread between the two securities to return to a more normal level.

Catalyst

As more investors become interested in the Volkswagen story, there should be enough communication out there (brokers, chat rooms, social media, etc.), that investors start to realize that its more advantageous to buy the Preferred than the Ordinary – same exposure to VW, just at a cheaper price.  This should cause the price spread between the two securities to return to a more normal level.