Rule number 1 in investing – there’s no free lunch for investors. Rule number 2 – don’t always believe rule number 1. While rule number 1 stems from the proponents of the efficient market hypothesis which argues that all stock prices fully reflect all public and privately held information available on the company and no one can take advantage of any mispricing, many investors and academics have argued that markets are not always efficient, and the inefficiencies does bring opportunity to make real investment profit.
There are numerous examples of market inefficiencies in literature but last week, one showed up on the Nigerian Stock Exchange. According to a recent investor note by EUA Intelligence, Seplat’s dual listing provided an arbitrage opportunity that could easily have passed the test for “free lunch” status.
The Nigerian indigenous E&P giants was listed on both the London and Nigerian Stock exchanges at £1.24 and N619 respectively at the opening of markets on Wednesday, 6, March 2019. This put the market capitalization of the company at £722.11 million (N343.17 billion) and N359.023 billion (£755.46 million) on the London and Nigerian Stock Exchanges respectively. Thus, there was a price parity discrepancy of about N15.84 billion (£33.35 million) which calls into question the validity of the efficient market theory.
The publication stated that “an arbitrage opportunity is created when a company listed in two exchanges trades at different prices. Prices ought to converge rapidly on both exchanges to eliminate the arbitrage opportunity and allow the companies fully reflect an identical market valuation on both exchanges. While a frequent price divergence is not abnormal since transaction cost and exchange rate volatility must be considered, a price divergence of as much as 3 percent which we observed in Seplat is material enough to present a profit windfall to arbitrageurs.”
Theoretically, the stock price of a dual-listed company should be approximately the same in both jurisdictions, after taking currency differences and transaction costs into account. Otherwise arbitrageurs would step in and exploit the price differences. However, price divergences do occur from time to time, especially when trading hours do not overlap and there has been a significant price move in one market.
In simple terms, the arbitrage opportunity can be best described through a hypothetic case of an investor who borrowed 1 million shares from a shareholder in Nigeria and sold on the bourse at N619 with the promise of the return of a share certificate amounting to 1 million shares at a certain period plus a prorated interest of 17.5 percent per annum (2.2 percent risk premium on 12 months Nigerian T-Bills) for that period. The investor will have N609 million in cash after adjusting for the 1.52 percent average trading cost when selling shares in Nigeria.
Converted at the BDC pound exchange rate of N470, a total of £1.29 million will be realized and transferred into an online UK brokerage account at no cost. At £1.25 per share, 1 million shares could be bought on LSE and a profit of £40,000 less £72 buying cost and 0.05% tax on shares bought will lead to realized profit of £36,923 or N17.35 million. However, analysts say in the real world, the 3 percent arbitrage opportunity is only available if the Nigerian Stock exchange was a sophisticated market and had a functioning derivative market where risks of possible change in currency and stock prices could be hedged.
“While we agree that the arbitrage opportunity is real, exploiting it could be very difficult as a 3 percent change in the price of the stock on any of the exchanges during the transaction could lead to heavy losses for the investor. There are too many moving parts and the Nigerian market is not sophisticated enough to hedge risks against said parts,” according to the equity research firm, EUA Intelligence.
The Nigerian Stock Exchange, NSE, is on track to introduce guidelines for creation, listing and trading of derivative products on its platform. It noted that the creation would facilitate hedging of investment risks and diversification of asset portfolios within the market.
The Exchange disclosed, in a notice signed by Tinu Awe, General Counsel/Head Regulation of the NSE, that “In the cash markets, investors are typically exposed to asset price risk. In the absence of short selling and the supportive securities lending options, investors are highly susceptible to significant diminution in portfolio values once there is a reversal of a bull trend.”
As at the close of trading on Thursday, March 7, 2019, the market prices had converged and the opportunity for arbitrage lost. The prices had corrected to £1.28 and N596.9 with market capitalization of £744.38 million (N351.24 billion) and N350.84 billion (745.21 million). It is expected that investors may now be observing the stock for the next price divergence which offers possibility of yet another free lunch.