Byrne's Eye View

I thought the deal was off, but apparently Bear Stearns and Citic are almost ready to trade together. This plan involves swapping ownership stakes -- BSC will own part of Citic, and Citic will own part of BSC. Which brings up a question: how do you analyze a situation like that?

To consider a simple version, let's imagine A Corp. and B Corp. Each has 100 shares, and each has $1 of cash. First, let's imagine A owns half of B, and B owns half of A. In this case, you can end up with a foolish recursive increase in value: A's market value is $1, and B's is $1, but since A owns half of B, A is worth $1.50 total. And since B owns half of that, it's worth $1.75 -- and since A owns half of that, A must be worth $1.75/2 + $1.00, or $1.825. A naive investor would keep ratcheting up values until both companies were worth around $2 total: $1 of cash and $1 worth of the other's stock. Of course, that gives a total valuation of $4 on two businesses whose only assets are $2 in cash and a complex ownership structure.

This was apparently one of the problems with Japanese equity markets in the 80's. If A, B, C, and D were connected in a chain of cross-ownership, A's good quarter (in operations) could show up on B's P&L thanks to trading, which would boost C's results, which, in turn, would give D's balance sheet enough heft for it to issue more debt, which it would lend to A, which would...

At some point, it's necessary to just analyze each company operationally first, and then factor in cross-ownership. That's the only way to avoid giving $2 of cash a $4 market value, or making one good quarter for one company siphon cash into four mediocre operations. If BSC and Citic are doing something legitimate, one would expect a simpler structure. As it is, they're knotting up their finances with extra complexity, which, as far as I can tell, only makes it easier for investors to accidentally overprice them. What's their motivation?