A company known as Alibaba will IPO in the USA this Friday.  Trading Alibaba will be risky for a variety of reasons.  My guess is that even at a high valuation, there might be mania and the price will go up.  However, rather than guessing there might be a more “arbitrage-like” trade.  This is a copy of a letter I wrote to several friends of mine on May 9, 2014.   Some of it may apply today as well.

Fact 1:  Yahoo (YHOO) owns 22.6% of Alibaba.  That means, Yahoo is worth Yahoo + 0.226*Alibaba Market Value.

Fact 2:  YHOO must sell 40% of its stake in the IPO.  Thus, after the IPO, when Alibaba moves to the secondary market, the value of YHOO will be:  Yahoo + 0.40*IPO Market Value + 0.60*Secondary Market Value.

Speculation 1:  Alibaba values its shares for IPO at $120B.      This would give YHOO’s value at $27B.  YHOO’s current market cap is $34.83B.  Some analysts believe that Alibaba will be worth $195B.

Trade 1:  Thus, prior to the IPO, one might wish to take an outright long position in YHOO.  If the analyst projection is correct and the offering price is similar to what Alibaba believes, the return over the next month would be:  7%.  Of course, this is a risky strategy (assumes a 62% jump over the offering price), but still may be worth doing.

Trade 2:  Wait for the IPO and hope that the arbitrage between YHOO and ALIBABA is limited or difficult due to short-sale constraints.  Continue trying to sell ALIBABA until you can short Alibaba and go long YHOO in the right conversion ratio.

Step 1:  Check if P(a) > P(yahoo) x (n(yahoo)/n(a)) x (1/phi), where these are prices of alibaba and yahoo post-ipo (P) and shares outstanding (n) of the respective companies, and phi is the ownership of YHOO post-ipo (should be 0.13).

Step 2:  If it’s true, then for every share of Alibaba that you short, go long  (n(yahoo)/n(a))x(1/phi) shares of YAHOO and wait.

Of course, all of this analysis, ignores the value of YHOO that is already discounting the value of Alibaba.  However, if Trade 2 is possible, it still would be a profitable strategy.  Thus, perhaps the best strategy is to wait for the IPO and examine Trade 2.

Since I wrote this memo very quickly, feel free to comment, criticize or suggest enhancements.

Ludwig

Note:  Since I wrote this memo to my friends, the YHOO trade has done quite well (May 9, 2014 to September 16, 2014).  A strategy of long-short with the S&P 500 would have made a very pretty return of 18.97%.  A straight long position in YHOO would have made 26%.