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Sirius Mispricing

Sirius XM and Liberty Media, which owns 40% of the satellite radio company, have seen their stocks trade in a similar manner, presenting some interesting opportunities.



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Sirius XM Radio

(SIRI) - Get Sirius XM Holdings, Inc. Report

has finally topped the $1 mark, quelling delisting fears (assuming it can hold this position for 10 consecutive days) and allowing institutional investors to load up on the satellite radio provider, helping to support the price in the process.

While topping $1 does not justify purchase by itself -- mainly because serious questions remain about the long-term viability of the format and the debt load of the company -- the increase of the past few weeks has led to a rather interesting investing scheme that logically should prove to be quite profitable.

Liberty Media


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was Sirius' savior last February, when it came in at the 11th hour and saved the company from a potential bankruptcy by investing millions in exchange for preferred shares convertible to 40% of the post-conversion effect equity in the company. Liberty's stock has since been moving in a manner quite similar to Sirius' -- as well it should, as they are tied together quite tightly.

Currently, for every penny that Sirius gains, Liberty Media should gain about 15 cents, based on the fact that its warrants lay claim to 40% of the market cap for Sirius. Disregarding all other portions of Liberty's business, a simple trade that can be performed would be to arbitrage the prices of the two stocks. If Sirius were to gain 3 cents and Liberty were to gain only 30 cents, a mispricing of about 15 cents would be present and a profit could be made by taking a long position in the underpriced security -- in this case, that would be Liberty Media.

This type of trade can be fairly tricky to execute if you lack access to a speedy trading system or the ability to short a stock, since the trade really should include a short position in the overpriced security to hedge the movement while the two prices converge.

A simpler trade could be to simply buy Liberty Media if you are bullish on Sirius. This should reduce risk by not taking a full-on position in Sirius, the more volatile of the two stocks, while still allowing exposure to the business. Also, when Liberty Media does exercise its option and take control of 40% of the equity, an investor in Sirius directly would get crushed by the massively dilutive issue of stock to Liberty. Investors in Liberty would not feel the same waves since the company is not diluting its own position.

More exotic investors could even buy Liberty and short Sirius now to lock in a profit from the dilution effect. This would take a bit of tinkering to get the right balance between Sirius and Liberty and would still leave the investor open to risk from Liberty's other businesses, but in theory it would work. Liberty would rise as Sirius did, offsetting the losses on the short position in Sirius, and when the shares were converted and the price of Sirius would drop but the price of Liberty would remain high, allowing the investor to sell the long position in Liberty and cover the short position in Sirius with the profits.

Sirius may not be a sound investment based on the fundamentals, but there are some interesting trading opportunities related to it. Of course, taking on the risk of trading based on mispricing should only be done by those able to sustain potential losses if prices diverge further, and it should only be done by those that understand the interaction of these securities very well.

-- Reported by David MacDougall in Boston.

Prior to joining Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.