Alibaba Group (NYSE:BABA) long has been one of the market’s most divisive names, and the split over Alibaba stock admittedly makes some sense. Both sides of the argument seem simple — and logical.
To bulls, the opportunity in BABA stock is almost self-evident. It’s the dominant eCommerce player in one of the world’s great growth markets. Market share greatly exceeds that of rivals JD.com (NASDAQ:JD) and Pinduoduo (NASDAQ:PDD). And even though comparisons to Amazon.com (NASDAQ:AMZN) are overly simplistic, both companies have achieved almost unprecedented growth at scale.
To bears, however, BABA stock is loaded with similarly self-evident risks. The Chinese economy may be growing at an impressive rate; but it’s still controlled by a single-party, Communist government. Predictions of a so-called “hard landing” for that economy have been made for this entire decade.
Alibaba Group itself adds to the skepticism. Accounting questions long have dogged the company. A byzantine ownership structure for U.S. shareholders adds another layer of risk. From the bearish perspective, BABA stock is something close to a ticking time bomb.
Of late, the bulls have been winning the debate. U.S.-listed BABA stock touched a 17-month high last week. And the company’s long-awaited initial public offering in Hong Kong finally went off, with Asian investors quick to snatch up shares.
What’s interesting about trading since that IPO is that it strongly suggests investors are happy to ignore one key risk often cited by bears. Put another way, investors are treating Alibaba stock like any other name. If that truly is the case, the bulls may continue to win, and BABA shares should continue to rise.
Alibaba Stock in the U.S. Vs. Alibaba Stock on Hong Kong
One of the big concerns long voiced by skeptics toward Alibaba is that it doesn’t actually guarantee ownership of Alibaba Group itself. That’s not the case for U.S. companies, in which a share of stock provides direct ownership. Even when overseas companies are owned via ADRs (American Depositary Receipts), those ADRs still represent ownership of shares directly in companies listed on non-U.S. exchanges.
But for BABA stock, the story is different. U.S. owners of BABA stock don’t have any ownership in the actual company. Instead, as Jonathan Berr detailed last year, they own a so-called variable interest entity (VIE) that has a contractual right to the profits of Alibaba Group.
The risks are obvious and myriad. Owners of U.S.-listed Alibaba stock have limited claim to the company’s actual assets. Yahoo! learned that the hard way when former CEO Jack Ma transferred Alipay (parent of subsidiary Ant Financial) out from Alibaba back in 2011, before his company’s IPO.
The Chinese government, in theory, could invalidate the structure at any time and has done so with similar VIEs in the past. From a broad standpoint, the basic protections to which U.S. shareholders are accustomed don’t necessarily exist when owning the U.S.-listed version of Alibaba stock.
The Hong Kong listing, however, is different. The roughly $13 billion in shares sold on the Hong Kong Stock Exchange provide direct ownership. There are still some VIE concerns (many of the company’s assets are held in those structures) but from a shareholder standpoint, a key risk relative to Alibaba stock is removed.
The Pricing Gap
And so, at least in theory, there should be a pricing gap between the Hong Kong and U.S. shares that reflects the VIE-related risk on the New York Stock Exchange. Similar effects play out in U.S. stocks with different types of shares, like Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL) or Under Armour (NYSE:UA,NYSE:UAA). Investors usually will pay more for shares with greater voting rights, with the price gap a reflection of the value of those attributes.
Obviously, other factors can affect relative valuation. Funds may not be able to buy non-voting shares, or may choose the class with more volume to achieve better price realization. But, as with most any other product, buyers will pay more for more features.
In the case of Alibaba stock, the Hong Kong shares would seem to have a rather large edge. After all, the difference between the U.S. and Hong Kong shares is rather stark.
There is a notable and material difference between owning a company and owning a Cayman Islands-listed variable interest entity that has rights to that company’s profits. That’s doubly true when the VIE’s contract runs afoul of the spirit of China’s investment laws.
Indeed, bears long have highlighted that VIE structure as an important reason not to own Alibaba stock at all. If that’s the case, one would think that the relative prices of BABA stock in New York and in Hong Kong would reflect that fact.
What BABA Stock Shows
They don’t. In fact, early trading in Hong Kong shows that investors basically don’t care. U.S.-listed BABA ADS (American Depositary Shares) are equivalent to eight direct shares. They closed trading Friday at exactly $200, or $25 per direct share. The Hong Kong-listed shares closed their Friday session at 198.40 HKD. At the exchange rate of 7.83 HKD per 1 US dollar, the shares are worth $25.34.
In other words, investors are willing to pay a premium for direct ownership but not much of a premium. Alibaba stock in Hong Kong trades a little over 1% higher than it does in the U.S. And it’s possible that early optimism in Asia from Chinese investors is responsible for some of even that meager spread.
For all intents and purposes, investors are fine owning either Alibaba directly on the Hong Kong Exchange or via the Cayman Islands VIE on the New York Stock Exchange. (Institutional investors obviously have their choice. And on some platforms, smaller retail investors, even in the U.S., can choose as well.)
That, in turn, suggests that investors don’t see the risk of the VIE structure as material at all. If they did, the gap between the U.S. and Hong Kong shares would be much higher. But on a percentage basis, it’s actually smaller than that between Under Armour’s Class A (ticker UAA) and Class C (ticker UA) shares.
To be sure, it’s possible the gap could widen. If the trade war between the U.S. and China got particularly nasty, or a VIE structure elsewhere was challenged by a Chinese court, investors might see the relative risk as higher, and price the two stocks accordingly. But, at least for now, investors don’t see much of a problem with the current structure.
What This Means for Alibaba Stock
And that’s probably good news for Alibaba because it remains largely an argument over risks. If investors are willing to take on one of the key risks, they’re probably happy to do so with others.
Given that BABA stock still is priced at a discount to its U.S. mega-cap counterparts, that suggests more upside ahead. Put another way, the bulls appear to have won one battle over Alibaba stock, which makes it seem more likely they will win the war.
As of this writing, Vince Martin has no positions in any securities mentioned.