Moral Arbitrage and the Inheritance Play

The thing about the rational investor hypothesis is that it assumes that investors wish to maximise a financial risk/reward function. They don’t. Investors have a utility function that includes economic considerations, but also includes many other goals important to the investor.

Some investors may refuse to invest in defense companies, especially those that produce offensive weapons. Others may avoid investing in companies based in countries who have policies that they don’t approve of. Still others may reject gambling or alcohol related companies. The list goes on.

Whilst economists discuss such issues ad nauseam, traders make money off it. A non-financially motivated seller nearly always provides an opportunity for the astute, and differently motivated, investor to make money.

The first time that I saw such a trade was on the Abu Dhabi National Hotels (ADNH) shares. In those days the market was OTC, so whilst there was no screen to see trades on, if you’re sitting in the office of a major broker, you hear a lot.

A young gentleman trained and experienced in developed markets got his first direct taste for what can happen in emerging markets. Applying basic Graham and Dodd valuation techniques to the UAE equity market, ADNH turned out to be extremely cheap and consistently so. Even better, the dividend policy, also consistent, monetised this under valuation on an annual basis.

The investor in question was not ready to invest based solely on financials and kept asking people why ADNH was undervalued. The answer was quick to emerge: Because ADNH owned hotels, which in turn served alcohol, it was shunned by a subset of the investor community that felt this was inconsistent with their values or, as the more cynical market participants pointed out, it was shunned by those who wanted to present a certain image.

What this allowed for were market participants who viewed things differently to buy a great stock, from a financial point of view, at a great price. Our budding local investor joined in.

This, however, is not the moral arbitrage that I saw. The arbitrage happened subsequently. ADNH would trade at around AED 20—21 in those days. But once in a while it would plummet to AED 16—17. Investors happy to invest in ADNH would then snap it up and it would return to 20—21 for a 25% profit inside of a week.

The first time I saw this I assumed that the massive price drop was an aberration. The second time this happened, about two months later, I realised something was up. I started asking around. I got the answer quickly as the market knew exactly what was going on. A HNWI with a large position in ADNH would pass away. The inheritors would decide that ADNH was inconsistent with their morals and they would dump ADNH into the market, driving the price down forcefully.

This inheritance play turned out not to be restricted to ADNH. It included all the conventional banks, because of the interest they charge and pay, plus any company that had more than a minimal amount of debt.

As I started paying attention to the moral arbitrage, I noticed that the associated inheritance play was not restricted to moral issues. A major issue was liquidity. The main example is real estate. Fresh inheritors seeking cash to spend, and prioritising time to receive cash over maximising the sale price, would dump real estate portfolios at 10% to 20% discounts just so that they could get their cash faster.

Two completely different goals can be rational. The difference may be financial, prioritising liquidity over price, or non-financial, prioritising some personal values over financial values. There is no judgment or right or wrong here, this is simply a reflection and an acceptance of human behaviour. An awareness of these rational differences can lead to great opportunities.

Successful investing is not based on a single philosophy. Just as you need a portfolio of investments, you also need a portfolio of investment styles. You’ve heard of value investing and growth investing. Now you know about moral (weak) arbitrage and the inheritance play.