UBid vs Creative Computers
Hedge funds provide sophisticated investors an alternative to traditional investment allocation strategies. Hedge funds are subject to less regulation than mutual funds and other financial institutions, so they can use leverage and both long and short positions more freely and shift between strategies frequently. These features allow hedge funds to generate returns that are uncorrelated with the market. Since exotic strategies can sometimes result in large and unexpected losses, hedge fund investment is restricted to accredited investors: wealthy individuals and institutions. The higher returns often associated with hedge funds come at a cost. Hedge fund managers generally charge a 2% management fee on all funds placed with them. In addition, they keep 20% of the profits generated. This arrangement, known as “2 and 20” is often justified by hedge funds’ abilities to implement strategies that are not readily available to other investors, or which might not be noticed by less savvy investors.
As of December 9th, 1998, Ubid sells for $35.688 per share and Creative Computers sells for $22.75 per share. Ubid is selling at a $12.98 premium over its parent company that holds 80% of the equity in Ubid. This is a clear violation of the efficient markets hypothesis, and the fundamental analysis of both company’s fundamentals show that Creative Computers is the healthier company. Both companies have large volume of sales, but CC has a growing net income ($435,000) while Ubid has yet to have positive earnings (-$1.1million). CC has a staggeringly high P/E value of 535. Ubid does not have one due to negative earnings. The Price-Book ratios favor Ubid with a value of 54 compared to CC’s of 1.63, but CC is a much larger and mature company than Ubid and the liquidation value of Ubid is very secondary to their main value in potential growth. These measures show that CC is functioning extremely well. CC’s current ratio is a healthy 1.2 while Ubid is struggling with .889.
These numbers aren’t entirely disparate, but they show why Creative Computers is a more profitable company to invest in than Ubid. Ubid’s cash flows and assets don’t support their high share price despite market expectations and high potential growth as an Internet based company. If these future cash flows don’t materialize, Ubid shares will not only converge to the CC price, but will drop drastically. Creative Computers shows solvency and has an incredible P/E ratio as well as a fair price to book ratio in case a Ubid fallout rocks the company. For these reasons, Ubid share price has to come down or CC share price has to rise in the next few quarters.
Considering the magnitude of Ubid’s overvaluation relative to Creative Computers, Elena should sell short 387,772 shares of Ubid and buy 277,606 shares of Creative Computers. This would allow Strategic Capital to profit from the likely convergence in valuation. Assuming the tax-free spinoff is completed, which we think is likely; we will receive the Ubid shares necessary to cover our short position. Our choice of how many shares to trade was driven by the ratio of shares needed to cover our short position in Ubid after the spin-off. Even if the excessive valuation premium on Ubid is not arbitraged out of the market by then, it is likely that Creative Computing shareholders will accelerate the process. When Creative Computers shareholders receive 80% of Ubid’s outstanding shares, many will be likely to sell them immediately because they will probably notice the disparity. As Ubid shares are sold, driving the price down, Strategic Capital can opportunistically use the shares received from the spinoff to cover its short position. This hedges the risk of Ubid increasing, since…