Tuesday, September 14, 2010

A Stock To Short For Value Investors

Most value investors don't short stocks, and with good reason. The science behind buying undervalued stocks is not as easily applied to selling overvalued stocks. An overpriced company can rise for years, constantly requiring margin injections. (An undervalued, languishing stock requires no such cash infusion.) A company with poor fundamentals can also be bought out for more than it's worth, resulting in a loss to short-sellers. But very rarely, a situation can come along that eliminates many of the risks of shorting, while at the same time offering strong potential for upside for the investor. One such opportunity may involve going short Xing Resources (XING) and going long Qiao Mobile (QXM).

Xing has made an offer to acquire each share of QXM in exchange for 1.9 shares of Xing and 80 cents in cash. Today, that adds up to $3.75. But each share of QXM currently trades for just $3.35, resulting in an arbitrage opportunity of 11%. But the risk of this transaction falling apart has to be considered low, as Xing already owns more than 60% of QXM's shares, and therefore controls the company.

In this arbitrage play, however, owning the target (QXM) is not enough to guarantee success. Because the offer is share-based, if Xing shares were to fall, the gain for QXM investors could easily disappear or go negative. But by shorting 1.9 shares of Xing for every share of QXM that the investor is long, an arbitrage profit will be made as long as the transaction goes through. (Even if the transaction does not go through, the investor is still somewhat hedged as Xing's 60% ownership of QXM makes the fortunes of the two companies.)

Before making their investment decision with respect to QXM and Xing, however, investors may wish to wait until QXM's independent board committee responds to the offer.

Long-time readers may recall a similar situation to this one occurring last April, when TATT offered to buy up the shares of Limco that it did not already own.

Disclosure: Author has a long position in shares of QXM


Anonymous said...

Interesting article. How does the math work out where you would make money as long as the transaction goes through? (I am very much a novice to arbitrage)

Mike Robey said...


Here's the letter of intent for everyone to review:


Anonymous said...

I am also curious about the mathematics. I understand the simple valuation of QXM using the XING shares but I do not know how the ~11% profit # is derived and I have a hard time wrapping my brain around the long 1 position, short another concept.

Paul said...

the math goes like this.

XING is trading around $1.55 or so. $1.55 * 1.9 = $2.945 + $.80 = $3.75 (rounded).

When Saj wrote this, QXM was at $3.35, now at about $3.44.

So, the $.40 profit divided by $3.35 is about 11-12%.

Make sense?

Anonymous said...

So, how does going short Xing and long QXM guarantee that you make money as long as the transaction goes through?

Saj Karsan said...

Hi Anons,

Building on what Paul said, (1.9*XING + .8) has to equal QXM when the transaction goes through, because one will be exchanged for the other. But whether QXM will go up, or XING will go down to make that equation equal is not known. So going long QXM could net you nothing if XING comes down such that (1.9*XING + .8) equals QXM's current price.

But by going short 1.9 shares of XING at the same time as going long 1 share of QXM, you make money when the two sides of the equation converge. If QXM goes up and XING stays where it is or goes up as well, you make money on the long and lose a little on the short. If QXM goes down or stays where it is and XING goes down, you lose a little on the long but make a lot on the short. If QXM rises a little and XING falls a little, you make a little on both.

In all cases, you make the 40 cent profit Paul alluded to, except in the case where the prices don't meet (i.e. the transaction didn't go through)

Make sense?

Anonymous said...

Is Gushan Environmental Energy Limited (GU)in the same situation as QXM? The company has a lot of cash on hand, almost no debt and shares are traded at a ridiculously low price.

Saj Karsan said...

Hi Anon,

I don't know GU very well. Do they have a plan to stop losing all that money? That's a lot of red ink.

Brandon Chu said...


As a retail investor I have a limit on the dollar vlue of a stock which allows me to short it. How can I get around this? Is it a mere broker-specific policy?


Simon's Thoughts In London Fall '07 said...

At the current levels- XING at $1.46 and QXM at 3.35 (and holding steady) do you still see opportunity?

I calculated the reward to be somewhere along the lines of 6% at these levels.

Saj Karsan said...

Hi Brandon,

It must a broker issue, but I have no knowledge of what your problem could be beyond that.

Hi Simon,

I think the spread is now back to where you would earn 10%. However, I can't really answer whether it's a good deal for you. I'm just putting the info out there.

Anonymous said...

While the spread in price differences is roughly 10% at current levels (QXM: 3.31 XING: 1.51) when comparing the conversion offer for QXM and XING, it's important to keep in mind that the true return is closer to 7.4%, as an investment in both companies is required to secure the arbitrage play. This is because an investment of $4.82 (QXM x 1 + XING x 1.9) per "share" is required to realize the current $0.36 spread.

All before commission fees! ;)

PS: Thanks for the quality site!

Saj Karsan said...

Thanks Anon,

But remember, when you short a stock, you don't pay cash, you receive it. So you don't have to put up all of that. That being said, you likely can't use all the proceeds from your short to fund your long position, as some is likely to be restricted, depending on your arrangement with your broker etc.