Here in the U.S., it is the time of year when madness is about to begin. For those outside America, perhaps I should explain. A national college basketball tournament, known colloquially as “March Madness,” will begin in earnest tomorrow. This is an event that grips the nation, perhaps because of the last second winning shots, the high quality of play, or the chance of an unheralded team getting hot at the right time and making unlikely progress in the tournament, the so-called Cinderella story. Or it could be that the obsession with the tournament is more about the fact that, with the proliferation of pools predicting each game, it is the only time the most Americans are allowed to gamble openly, but that may be a touch too cynical.
Anyway, the fact that madness is in the air makes it an ideal time to suggest a trade that qualifies as madness on two fronts. First it involves buying a stock that is just about to see the largest lockout period expiry in history and is dependent upon the Chinese economy, which, talking heads everywhere agree, is tanking. Secondly, it involves a common trader’s technique that seems crazy to most retail investors – selling something to buy it.
In case you haven’t guessed already, I am talking about Alibaba (BABA). Six months ago, when the stock IPO’d, I predicted an initial pop on the first day, followed by a period of losses and then a recovery. The chart confirms that pattern up to a point, but once evidence emerged of slowing Chinese growth at the end of last year, all of the gains were erased.
First, with reference to the chart, let’s make the case for the madness that is buying BABA. The actual IPO price back in September was $78, and after all of the gyrations the stock is now trading at around $83, around 6.4% higher. When a company goes public, some of the finest minds in the world arrive at a valuation based on current performance, prospects and what the market can bear. They arrived at that $78 price as the right one at the time, and were proven correct by the subsequent price action.
The initial jump followed by a gradual decline suggests that the investment bankers priced the offering where it would be oversubscribed, but without undervaluing the company. If that was the right price six months ago, then 6.4% higher now looks about right for a company that has an estimated 14% annual growth rate. Of course “fairly valued” is not a reason to buy a stock, but if we look at the assumptions underlying that valuation, then it could be argued that BABA is cheap at the current price.
Traders and analysts both tend to suffer from the same disease: extremism. That explains why Alibaba may be undervalued right now. Six months ago, nothing could be more in vogue than an e-commerce company in the world’s fastest growing economy. At the end of last year, however, e-commerce lost its luster; Amazon (AMZN), for example, fell around 20% in September and October. That change in sentiment coincided with a change of heart about China. The growth that was once seen as inevitable was now seen as unsustainable. Faced with a double whammy like that BABA stood no chance.
As usual, though, the pendulum has swung too far the other way. Chinese growth may be slowing, but it is still growth. Most CEOs would kill to be in an environment where 6-7% was disappointing. Despite that the last few months have seen major banks falling over themselves to cut their estimates and ratings for BABA. Those that remained bullish all the way down from $120 are now turning, a sure sign that the stock will turn soon.
In that case, then, why not just buy BABA? Why bother to trade into a position? Well, there is the little matter of that lockup expiry and the proximity to the low and the offering price. All of that will no doubt create some nervousness among holders of the stock. It means that, while BABA may not break through $80 and fall further it definitely could, but the chances of a jump up in the next few days are negligible. Selling here with an order to buy twice as much on a break of $88, or at $75 if the stock falls would leave you long at $93 in the worst case scenario and at $67 if it all works out perfectly.
Either way, given the overdone pessimism, you would own a stock with good growth potential in a market where the leaders have just committed, ECB-like, to do “whatever it takes” to re-stimulate growth. What at first glance looked like March Madness now looks like a March moneymaker.
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