Study: Arbitrage Middlesex Preferred Shares

Preface: Met with a friend who recently made $2.2m on $450k in 3 months.

The Arbitrage Story

Many people think that Warren Buffett had the advantage of slow information during his younger days that allowed his diligence to turn into high returns.

But he said in the 2018 shareholders’ meeting:

I gaurantee that I could make 50% annual return if I started out with $1 million today.

Oh, really?

We believe this is true if you are determined to go through every small listed company. There are probably tens of thousands of them. But you will definitely find irregularities that shouldn’t exist.

We sat down with a friend who discovered one of these mispricings in 2024.

He made about +500% returns in a few months with virtually no risk at all. The story starts with this company: Middlesex Water Company.

Middlesex is a very old company, founded in 1869 and currently operates in New Jersey and Delaware.

It issued 7% preferred shares dating back to at least 1912. These preferred shares have no par value and pay a dividend of $7 annually.

Since 1912, the preferred shares have paid dividends without fail. That’s 112 years long, not bad for a stable cash flow.

There was another detail, the most important one: the preferred shares were convertible. You could exchange 1 preferred for 12 common shares.

The conversion feature of the no par $7.00 Series Cumulative and Convertible Preferred Stock allows the security holders to exchange one convertible preferred share for twelve shares of the Company’s common stock.

Middlesex annual report, 2023

So there are 2 ticker symbols: MSEXP (preferred) and MSEX (common).

In June 2024, MSEXP was trading at $95/share and our friend scooped up 4,800 preferred shares.

Guess what was the price of MSEX common shares?

They were $50/share!

So if 1 preferred = 12 common shares, it is equivalent to saying 1 preferred share should be worth $600 (12*$50) at that time.

Our friend just bought them at $95 each when they could be immediately converted and sold for $600.

Impossible, Free Money!?

You’d be thinking… money doesn’t grow on trees, there must be a catch right?

First, we convert the preferred price into common denominator: $95/12 = $7.91 per common share.

At end of 2023, there were 18 million fully diluted common shares. Therefore, if you imagine that our friend bought the whole company, the market value of his position would be $142m ($7.91*18m shares).

Now compare this $142m to the fundamentals of Middlesex:

• Revenues 2023: $166m, 2022: $162m

• EBIT 2023: $39m, 2022: $32m

• Net income 2023: $32m, 2022: $37m

• Common equity 2023: $423m

Our friend was paying 4.4x earnings and 0.34x book value.

Just so you know, Middlesex never had a year of loss since 1912 and paid dividends every single year for more than a century. Operating margins have averaged 25% for basically their entire existence.

This is an unbelievable margin of safety; as far as we are concerned, he took virtually zero risk for this arbitrage.

End Result

Why the seller of preferred shares agree to this?

Well, they probably didn’t know the details of what they owned! Because if they knew, this arbitrage wouldn’t have existed for years.

This is proof that inefficiencies exist in public markets whereas such scenarios will never happen in private transactions.

From time to time such moments happen, every scenario is different and there is no modern internet screener to help you spot them.

You have to go through painstakingly page by page.

In Q3 2024, the preferred shares got converted and the price jumped from $50 to $670. The arbitrage has closed the mispricing.

Our friend walked away with $2.28m on his $456k initial investment, a cool +500% in less than 3 months.

To be fair, the trade was very illiquid and there was no trading volume for the preferred shares with a tiny public float of under $1m. Even today, the market value of these shares is only $1.4m.

We don’t know how our friend got his hands on so many shares. He won’t tell us, but rightfully so as he probably called up the seller and tried his luck.

As a side note: Buffett actually did similar in his Union Street Railway trade. He was buying shares at 30 cents on a dollar and had to run advertisements to find sellers for the tiny $1m market cap.

Conclusion

Buffett is correct. The small retail investor today has the same opportunity set as he did back in the 1960s.

The amount of work required to find treasures like this is actually abit easier, because we can pull reports from the internet rather than buying physical copies and writing numbers on paper.

So for those who claim that it is impossible to invest like early Buffett… this story makes a real case against that type of thinking.