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Yahoo, Microsoft Best Bets

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Smart plays for the tech tsunami.

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For Microsoft (MSFT) to be trading at current levels is bear market insanity. The beneficiary of its best product cycle in a decade, a glorious market position for its Xbox on the heels of Sony's (SNE) PS3 missteps, a heavenly balance sheet and wilting competition, the company is in classic big-cap position to grow share, recruit talent and become increasingly profitable over the next couple of years.

And that's to say nothing of the inherent potential of Yahoo (YHOO), which Microsoft has made clear it wishes to acquire.

This potential is being debated ad nauseam, but in contrast to those critical of the deal, I maintain it's huge. Yahoo's maneuvering as it should, seeking to extract the highest possible price. Anything less and the board wouldn't be doing its job. Microsoft knows this, too: I doubt they approached Yahoo with their highest offer. Who said the companies have to play nice?

So will Microsoft meet Yahoo's asking price? In my view, it could sweeten the offer some, wait for Yahoo's response, take it to the shareholders. Anything north of the current price of $31 would be hard for the majority of Yahoo shareholders to turn down.

I believe Yahoo's fair value is closer to $40 than $30, but it wouldn't surprise me to see Microsoft gain control at anywhere from $31-35 – not the $40 plus that Yahoo's board is asking for.

How best to position yourself for this tech sector tsunami?

First, you could tune out the noise from the talking heads and focus on fundamentals. The best fundamentals currently reside with Microsoft and Google (GOOG) so you can be long the two leaders and let the rest of this play out; that's how I've positioned since exiting my Yahoo long on the deals announcement.

I think this deal is positive for Microsoft longer term. Google is still very much on its own trajectory, with many potential positive catalysts and continued near-term search dominance (dominance that could benefit on short term deal noise).

Second, you could play a potential volatility move in Yahoo with a straddle position or simply own calls to capture upside while knowing your ultimate downside. You could also blend a host of combinations by applying common short against calls, but this strategy is more for market professionals.

Finally, the traditional merger arbitrage play of shorting Microsoft and being long Yahoo is an option, but I don't love this play from the current levels at which the two stocks are trading. Microsoft is very inexpensive on a fundamental basis, even more so when you consider the strength of its last quarter and the fact that it's sold off five quick points since the deal's announcement.

The short side looks pretty thin. Plus, there's a risk of Microsoft playing hardball initially and announcing they're going to a shareholder vote. If this were to occur, Microsoft could jump and Yahoo's upside could be seen as quite limited.
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Positions in MSFT, GOOG

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