Sunday, September 21, 2014

Alibaba (BABA) Underwriting

To understand what is happening in Alibaba (BABA), you need to have a feel for how underwritings of IPOs are supposed to work and how they are sold.

Let me give you the benefit of my experience trading and underwriting IPOs.

When a company wants to go public, they naturally want the best possible price for their stock.

If it is a large deal, if it is a hot deal, several underwriters will compete for the deal and they do this by offering better terms. 

Therefore, IPO prices tend to be on the high side. In fact, it is said that 80% of IPOs trade below their issue price in one year.

In order to get the stock sold, the underwriter will have to whip up strong demand for the stock.

The underwriter will create more demand then just enough demand to place the issue if it wants the stock to trade well in the aftermarket.

This means the underwriter will have to sell 120% or more of the amount filed with the SEC.

If 10 million shares are filed, the underwriter will sell 12 million.

The remaining two million shares will provide buying in the aftermarket so the stock will trade above the issue price.

Underwriters whose stocks trade above the issue price are popular and have an easy time selling their deals. Underwriters whose stocks crash after the issue starts trading not only lose their investors and syndicate partners, they can be sued by disappointed investors.

Another dynamic here is that if the issue is going to trade at a premium to the issue price, the underwriter will have to ration the stock. Naturally, the underwriter will give the stock to those who will benefit it in some way in the future or who have been friendly to it in the past.

If the stock is sold at $10 and trades at $12 to start, the underwriter has made a gift of $2 to the underwriter's clients.

A third element in the equation is scarcity. The hotter the deal, the more the demand, the less stock can be allocated to a particular client. This is why any smart underwriter will always tell you that for any deal, he has huge demand, whether that is true or not.

Now let us apply this to the recent IPO of Alibaba. The stock hit the market at a strong price. Concerns about the negative aspects of the company were buried in the sales push. You may have noted several smart investors passing on the issue, saying that while it may make a good fast trade, they did not see the long term potential or at least saying that they would wait until the initial enthusiasm has died down.

The underwriters, having a lot at stake, made a huge sales push, emphasizing the positive aspects. They were successful in this and several large investors demanded $1 billion each of the deal. This created a scarcity of stock and the other interested investors bid the stock up to almost $100 on the first day. This means that the investment bankers gave their large accounts a huge profit to start with.

We are not so bold as to predict what will happen in one year with Alibaba. We have our suspicions about any company that is so strongly hyped but we are still investigating. Suffice it to say that if you can get in at the offering price, you were fortunate, but buying it at prices near $100 or anything close does not seem to me to be a smart move.

Consider this, if you want 100% on your money in one year, do you believe that in one year BABA will sell near $200? I think even the most optimistic BABA supporter would find that hard to imagine. Rather, it seems more likely that the initial demand will be tempered as time wears on and the stock will see prices below its current level, even if the long term positive forecast for the company plays out. 













Monday, August 25, 2014

Stock Market Strategy: Random Stock Prices

Years ago, when I was Vice President of Trading for a Wall Street investment bank, I got a resume from a promising young man who wanted to work as a trader.

And what a great resume it was! Ivy league finance MBA, top of class, interned at the best Wall Street investment bank, etc.

I told this young man that I was always interested in the latest financial theories from the universities and asked him what the latest and greatest was.

He told me that the best thing was the Random Walk Theory: all stock prices are random and you cannot predict stock prices.

Therefore, I asked him how he was going to make money trading stocks if he could not predict prices.

He had a very good answer, "Ahhh....uhhh..........I... ahhh....., um.........."

That pretty much ended the interview.

I have now come to find out that there are actually several versions of the random walk school of thought.

The most severe of these geniuses believe that even if you have inside information, you cannot predict stock prices. This leaves me speechless.

However, this school of thought is very useful to portfolio managers who do not know what they are doing and those who want to take advantage of them.

The inept portfolio manager can always claim that he cannot predict prices and so it is not his fault you lost money.

However, if you want to make money, I suggest you stay tuned to this blog.

We do believe we can predict which stocks are likely to appreciate.