Five potential pair trades for worried investors
Many investors are worried about the stock market’s valuation. It has been a long rally, certainly. At our research shop, 5i Research, we are not overly concerned. Just because a market is at records doesn’t mean more records are out of reach.
However, if you are one of the concerned investors out there, maybe you might want to take a page out of the hedge fund playbook, and set up some ‘pair trades’ for your account. A pair trade is where you go long one company, and short sell another similar company. The key is to simply determine that one is better than the other. In a pair trade, the market’s overall direction is far less important, it is the differences between the two sides of the pair trade that dictate whether you make money. If the market falls, one stock (the shorted stock) should fall more than the other, and you can still make money. If the market rises instead, one stock (the one you are long) should rise more than the other, and you can make money. For this reason, pair trading is often seen as a market neutral strategy. If you do it right, it really does not matter that much what the market does. Let’s take a look at five possible pair trade ideas:
LONG SPIN MASTER (TOY ON TSX) AND SHORT MATTEL INC. (MAT ON NYSE)
The fundamental performance differences of these two toy companies has been stunning. Spin Master has knocked earnings out of the park, whereas Mattel has missed earnings in six of the past eight quarters. Mattel is down 30 per cent this year and is expected to report lower earnings this year. Spin Master is up 40 per cent this year and growth is expected to be in the 50 per cent range this year. Its secondquarter results were way higher than estimates; Mattel’s were 50 per cent lower than expected. As a bonus for investors setting up a pair trade, Spin Master also has a much, much stronger balance sheet. In the toy business, Spin Master just seems to know what it is doing.
LONG VERMILION (VET ON TSX) AND SHORT BAYTEX (BTE ON TSX)
The energy sector hasn’t made many friends this year, and almost everything is down. Baytex shares are down 45 per cent; Vermilion shares are down 28 per cent. In this pair trade, you get a six per cent dividend from Vermilion and a company with debt about two times cash flow. In Baytex, you get no dividend and a company with debt at nearly six times’ cash flow. Vermilion has not had to cut its dividend in the downturn; Baytex eliminated its dividend in 2015. The risk here is if the oil sector stages a massive rebound. If so, Baytex shares will have greater leverage to the price of oil. Still, it looks like a good pair trade to us.
LONG CINEPLEX (CGX ON TSX) AND SHORT AMC ENTERTAINMENT (AMC ON NYSE)
Both companies reported fairly bleak results this week, causing their stocks to take big hits. Cineplex is now down 12 per cent for the year; AMC is down 55 per cent. The thesis here is market share and debt. While Cineplex has debt, it looks much stronger than AMC, which has gone on a debt-fuelled M&A rampage. Cineplex also, effectively, has a monopoly in the Canadian theatre business, with market share near 75 per cent. The U.S. business of AMC is much more competitive. We doubt shares of either will recover until there is a better movie slate on the offering, but Cineplex seems both the safer and the better company here.
LONG FACEBOOK (FB ON NASDAQ) AND SHORT SNAP INC. (SNAP ON NYSE)
Snap is down 50 per cent this year, and Facebook is up 46 per cent. Facebook, of course, has two billion customers, and we don’t know any other company with that many. Snap is a very popular app, but Facebook has already shown it can compete with almost anything Snap comes out with. Snap is losing money, and Facebook earnings are continuing to grow much faster than many expected. This one seems obvious, but the risk of such a pair trade is a takeover of Snap. This would of course change the profit outlook for this trade to (likely) a loss.
LONG WSP GLOBAL (WSP ON TSX) AND SHORT AECON (ARE ON TSX)
This is a pair trade in the engineering and construction space. We don’t have real issues with Aecon, only that we think WSP is “better.” It is much larger and more diversified internationally. WSP is also cheaper on a valuation basis and very high earnings growth is expected next year. WSP shares are up 12 per cent this year; Aecon’s are down three per cent.
What are the drawbacks to pair trading? For one, you need to cover any dividend on the stock(s) you have shorted. Two, you need to pay a “borrow fee” to short stocks. And three, sometimes shorted stocks are subject to a “buy in” where you are forced to cover your short sell before you want to. Pair trades are not for everyone. But, if you want to forget about the market for a while they are another useful tool in your tool shed.