When Genius Failed (Roger Lowenstein) #3

By 1997, Long-Term was under immediate pressure to park its capital somewhere, and equities loomed as a far larger and more tantalizing new frontier. It was an open frontier because most traders with Long-Term’s mathematical bent had naturally left equities alone. Although pricing a bond can largely be reduced to mathematics, valuing a stock is far more subjective. Wall Street and academe had devised many a formula to forecast the market, but none, no matter how esoteric or rigorous, had worked. Over the short run, stocks are subject to the whim of often emotional traders. Over the long run, they vary with business performance, which is subject to great uncertainty and is notoriously hard to forecast. It requires judgment—not merely math—of the sort that no computer has ever mastered. As the economist Burton Malkiel once observed, “God Almighty does not know the proper price-earning multiple for a common stock.”

Haghani had been researching equities, particularly in Europe, and he thought the field was ripe for a firm with the necessary quantitative skills. Rosenfeld, too, had been thinking about equity arbitrage since his days at Salomon. One attractive point was that equity arbitrage would (he supposed) be uncorrelated with bond arbitrage. Rosenfeld wanted random investment dice, and equities seemed of a different world apart from bonds.

Haghani focused his research on so-called paired shares. Various European stocks were doubly listed. Volkswagen, for instance, listed an ordinary share and a “preference” share, the latter with superior voting rights. BMW was another. Haghani also looked at pairs of stocks with related (but not identical) assets, such as Telecom Italia, the Italian phone company, and Telecom Italia Mobile, its subsidiary, or Louis Vuitton and Dior. For various reasons, one side of a given pair often traded at a discount to its partner. Hence, Haghani spotted the potential for arbitrage.

The paired-share trades weren’t perfect arbitrages, because the two sides of each trace were never precisely equivalent. A preference share of Volkswagen was worth a premium over an ordinary share, especially as, in Germany and elsewhere in Europe, managements did not feel the same obligation as in the United States to treat all stock-holders fairly. No one could say precisely what the “right” premium was, only that the 40 percent premium in VW’s case, for example, seemed excessive. But the spread could persist or even widen—the models be damned.

Haghani found about fifteen paired-share trades, and Haghani bet on them in staggering size. His favorite was Royal Dutch/Shell was owned by two listed companies, Royal Dutch Petroleum of the Netherlands and Shell Transport of England. Although Royal Dutch and Shell got their income from the same source—that is from dividends on Royal Dutch/Shell—the English firm had historically traded at an 8 percent or so discount to its Dutch cousin. The stocks were owned by distinct pools of investors, and the Dutch stock was typically more liquid. But there was no good reason for the price differential. With Europe becoming a single economic unit, Haghani reckoned that national differences would matter less and less, and the spread between Royal Dutch and Shell would contract. This was a popular view.

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