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It’s not often when so many great lessons of the market come together in one trade. The dispute over ownership between Alibaba (OTC:ALBCF) and Yahoo (NASDAQ:YHOO) of Alipay and the action in Yahoo’s stock surrounding it provides several critical lessons to market operators. Although this trade hasn’t completely played out yet, and the dispute is far from being resolved, we can already take away so much. There are lessons in technical analysis, how the market sets valuation multiples, how the market discounts information over a period of time, and business risk. Let’s take a look at each of these.

Technical Analysis

You won’t find many traders who operate on the position to longer term trading time frames relying solely on technical analysis. Why? Because fundamental analysis allows us to focus in on only the list of prospects we believe have the opportunity to be excellent candidates to trade on more than just an intraday to 1 week time frame. When your strategy calls for taking big bites out of trends, you need to have conviction in the companies that you are trading, and allow yourself to hold through 5-10% pullbacks.

For these types of traders, technical analysis is used primarily to time entries and exits, it is not used to scan for setups. Yahoo is a perfect example of a company that many had widely believed was “cheap” based on valuation multiples. But the stock had been lagging for quite some time while the rest of the tech sector was on fire. Good technical analysts knew to stay away from this “value trap” and thus their opportunity cost of watching Yahoo was minimal, while those value players who believed it was cheap had their capital tied up while the stock languished. Technical analysis allows us to determine when the odds are in our favor to commit capital, and Yahoo was a great example.

(Click charts to expand)

Yahoo had been bumping up against major long term resistance on this weekly chart at around $18 for quite some time. But during the period of October 2010, to late April 2011, you can see that the pattern had become less volatile. The stock was consolidating on low volume underneath that major resistance level while major long term moving averages were starting to turn up. This should have been a clue that the stock was being accumulated by large fish, the dips were less violent and were bough quickly.

The larger weekly pattern represented a classic inverse head and shoulders. Looking at the price by volume chart, a long term $28 target was rational given the location of the most action in this stock prior to its schellacking in 2008. Based on support and resistance levels a first target was $23, that was also the measured move from the inverse head and shoulders pattern.

Moving to the daily chart, Yahoo began to break shorter term resistance around $17.30 in late April on increasing volume. This was your entry opportunity to the trade from a technical perspective with stops below the recent lows around $15.75. At this point in time, those who believed that Yahoo was trading at a value should have triggered into long positions. The stock then broke that large resistance level at $18, spent a few days above it, and got crushed on disappointing fundamental news.

Remember, technical analysis is in no way a perfect predictor of the future, it is there to increase odds based on historical patterns and market psychology. A technically beautiful stock can at any time announce accounting fraud and be down 60% the next day. It’s just odds.

Valuation Multiples

If you can easily predict the earnings and revenue growth of a company over the next 1-2 years, the valuation multiple of that company is going to get hit. Businesses that are relatively static, or which are very transparent, will not fetch high multiples, that’s a fact. Why? Because the market gives high multiples to companies that are either growing ridiculously fast, or which it does not have enough information yet upon which to value the company longer term. You will hear bad traders say often, but this company is trading at a P/E of 8 and it is such a great company producing a lot of free cash flow, blah blah blah blah. Companies that produce a lot of free cash flow and are not growing revenue by over 20% quarter over quarter do not receive high valuation multiples.

Why? Because if a company isn’t growing quickly now, what are the chances that it is suddenly going to be growing extremely quickly a quarter or two from now, and have a completely different financial picture 2 years from now? Very little. Valuation multiples are determined by opacity. Young biotech companies with little revenue or earnings are often valued at huge multiples because of their future promise. Once those companies begin to produce their product, and have a steady flow of sales, the market will drastically reduce their valuation multiple because analysts can predict future earnings and revenue much easier. Tech or consumer companies are no different.

Let’s take everyone’s favorite company Apple (NASDAQ:AAPL) as an example.

Why is a company growing as fast as Apple, making as much money as Apple, seeing its price to earnings and price to sales rations fall so quickly? Simple, because the market has a more transparent view of its earnings, or at least it believes that it does. The market understands that Apple’s business model is not going to drastically shift over the course of the next few quarters, thus it gets a lower multiple. That doesn’t mean its not a stock you should own, it just means you aren’t going to get any help from the momentum traders who thrive on opacity, the only help you’re going to get is from Apple itself, you are making a bet on the company, not the market for the stock.

But there is also the other side of this equation, when all of the sudden the market realizes that a company is fundamentally changing, that analysts’ ability to forecast earnings and revenue over the long run have become diminished. If the market senses that the company is moving into a higher growth business model, or something else inside or outside the company is going to drastically effect its fundamentals down the road, it will change the valuation multiple.

Case in point, TravelZoo (NASDAQ:TZOO).

As the market realized that TravelZoo was getting into the daily deals business heavily right around September of 2010, it began to revalue both the earnings and revenue multiples. As you can see from the charts above, even as Travelzoo has gone from a $15 stock to a $104 dollar stock, its price to earnings and price to revenue multiples have skyrocketed from 25 to 50 and 2 to 9 respectively. TravelZoo’s future earnings and revenue potential is extremely opaque, the analysts have no clue how to value this new business model. They have no clue how to value the incredible growth in revenue that TravelZoo is seeing, thus, the company gets higher multiples. When analysts can better predict or the market believes it can better predict the growth of TravelZoo, those multiples will come down.

Now let’s get to the real company in question, Yahoo.

Something interesting began to take place at the end of 2010. Yahoo’s valuation multiples began to increase. But it certainly wasn’t because of a rapid increase in revenues, just look at that last chart, it is falling off a cliff. And it certainly wasn’t because Yahoo’s business model was changing, there has been no hint from inside or outside the company that this is the case. Yahoo’s domestic business is dead in the water, it is hemorrhaging market share in search. Since 2007, investors had written this off as a dead company, the charts don’t lie.

But something else had changed underneath at Yahoo. While its revenues were plummeting, its valuation multiples were rising, and the stock was stabilizing. The market, similar to TravelZoo, had begun to revalue the company based on another set of data, or, the company’s ability to produce revenue had changed in the eyes of traders and analysts. They key to this equation was Yahoo’s 40% ownership in China based Alibaba, Alibaba’s holdings, and Yahoo’s other Asian assets.

The market began to realize that although Yahoo’s domestic business was toast, its large holding in other businesses that were growing rapidly, and which had opaque business models, was very valuable. This is why you need to pay attention to movements in valuation multiples. Some see these charts and say Yahoo was getting more expensive, you should see these charts and say that the market was revaluing Yahoo based on a different set of circumstances.

Discounting Information

You will often hear from those who follow Yahoo’s business closely that they knew about the growth of the Asian assets a long time ago. I had heard this going back to early 2010. They proclaimed that Yahoo should be trading much higher, that Yahoo was a great value and that they didn’t understand why the stock price wasn’t moving north.

The answer provides a great lesson. It turns out that the market is not a great discounting mechanism, and thank god. If the market discounted information perfectly every day, it would be very difficult to trade. The truth is that the market often discounts information all at once, rapidly. Yahoo is a great example. Many market participants knew that the value of their Asian assets was not being factored into the valuation multiples or the price. But the rest of the market had not come around to this conclusion yet. We use technical analysis to give us clues as to when this shift takes place.

I like to say, the market doesn’t care, until it cares.

You need to read the tea leaves for when this shift takes place in the underlying psychology of the market for that asset.

How do we know the market has revalued Yahoo based on its Asian assets? Simple. When it was announced that ownership in Alipay had been transfered from Alibaba to another Chinese company, Yahoo’s stock got slaughtered. Why would the transfer of ownership of a company owned by another Chinese company have an effect on Yahoo, an American search engine company? Exactly. Because Yahoo is no longer an American search engine company, it is for all intents and purposes a holding company for a 40% stake in Alibaba, an Asian company growing extremely quickly with great assets. When one of those assets slipped through the hands of Alibaba, for whatever reason, this was big for Yahoo.

And why has Yahoo’s stock stayed down over the past couple of days while news that Alibaba will be compensated for Alipay at some point has surfaced? Simple. Owners of Yahoo’s stock now are not in it for the cash value, they could care less how much Alipay is worth to Alibaba and thus worth to Yahoo today, they are concerned with what Alipay is worth to Alibaba and thus Yahoo in a year, in 2 years, and 5 years. They are interested in the growth, not the cash.

Even if this situation gets ironed out, the fact that Yahoo no longer owns a piece of Alipay via Alibaba is a disaster, there’s no other way around it.

Business Risk

It isn’t hard to see why through this example you are taking on huge business risk by investing in Chinese companies, or US companies that are being valued on the basis of Chinese assets. Rules are not the same all over the world, China is still the wild wild west, and the Chinese government is looking to protect the growth of its industries for itself. Is this fair trade? Hell no. Are these fair practices? Hell no, but this is the game that must be played in China; they are setting the rules.

There is an old saying, thee who has the gold, makes the rules. China has the gold, it’s in the growth of its economy, and its currency reserves, and China will make the rules. Those rules can change overnight, based on nothing, so you better account for business risk when you trade or invest in these assets.

Conclusion

I don’t know where Yahoo’s stock goes from here, primarily because I don’t know how much of that revaluation was in Alipay. If the stock breaks back through the recent highs while ownership of Alipay is not returned to Alibaba or a stake in the company is not given directly to Yahoo, you will know that Yahoo’s other Asian assets are golden. If the Alipay story continues to weigh on Yahoo’s price, you will know that it was a big part of that valuation story. This is no longer an easy trade, and not one that I would want to be involved in.

Source: The Yahoo/Alipay Debacle Is a Great Learning Experience for Traders