When the stock market looks especially volatile, a pairs trade is a strategy worth considering. The idea is to match a long position with a short position in two stocks that have a relevant correlation. I usually buy an undervalued stock and short an overvalued stock in the same industry or with the same general economic attributes.
This strategy also adds a market hedge, theoretically. For example, if stocks plunge due to an unexpected event, the pairs trade should result in a gain on the short position offsetting the drop on the long position, easing any loss in spite of the negative occurrence. Here are a couple of interesting pair trades:
A hedge on the economy pairs trade
These companies are both highly leveraged to economic growth.
Sonoco is the long position. It’s a global provider of packaging and industrial products. The company reported sales for the December 2012 quarter of $1.18 billion, compared to $1.13 billion in 2011. Hurting results were a negative impact on consumer spending for packaged food from rising commodity costs and the European recession reducing demand.
On the plus side, quarterly gross profit grew to $204 million compared with $185 million a year earlier. The improvement was due to benefits from an acquisition and higher productivity. Management continues to improve the business. Examples are continued restructuring to improve efficiency and a willingness to pay tax on repatriated cash to help work down debt.
Sonoco looks to have a fair business value, or adjusted cash earnings times a capitalization multiplier, of around $34 to $40 per share based on an industrial standard 12 to 14 multiplier. Based on current results, sales are expected around $4.8 billion and average cash earnings at $291 million.
PACCAR is the short position. It is a global leader in the design and manufacture of light-, medium- and heavy-duty trucks.
PACCAR reported record revenue of $17.1 billion for 2012 and the $1.1 billion of net income was the fourth best in company history. Though 2012 was an exceptional year for PACCAR, 2013 might be less fruitful. The company has had declining year-over-year revenue for the last two quarters and indications are that demand may fall further.
In anticipation of demand, capital spending by trucking firm clients can be an imprecise but useful indicator. Trucking firm Werner Enterprises spent $176 million for property and equipment in 2010, with $302 million in 2011 and $285 million last year but expectations are falling to $150 million for 2013. Fellow operator Old Dominion Freight expended $106 million in 2010, $251 million in 2011 and $373 million last year but is only expecting outlays of $270 million for 2013.
Werner explains, "We currently expect our estimated net capital expenditures to be lower in 2013, in the range of $100 million to $150 million. This is because we intend to maintain the average age of our truck fleet in 2013 rather than reducing the average age of our truck fleet as we did in 2012 and 2011."
Based on 2012 results, with estimated sales of $17.0 billion and average earnings of $1.0 billion, PACCAR looks to have a generous fair value of around $40 per share based on a 14 multiplier versus a historical 12 multiple.
A shoe industry pairs trade
Both these companies are active in the athletic footwear industry,
Nike is the short position. The company recently reported a well-received quarter. But the report might not be a convincing indication of the company's future.
Growth has clearly slowed compared to the previous year. Over the last 3 quarters they have had an 8% revenue growth rise compared to 17% for the prior year nine-month average. The company also has a troubling reliance on their North America business. This region contributed about 8 percentage points to their Nike Brand revenue increase for the third quarter while China’s important market results negatively impacted Nike Brand revenue growth by approximately 1 percentage point.
Weakening unit growth is also a concern. In fiscal year 2013, though footwear revenue in North America increased 15% for the third quarter, unit sales increased only 9%. In 2012, comparable unit sales rose at a double-digit rate.
With revenue around $26.0 billion and cash earnings of $2.2 billion, Nike looks to have a reasonable business value of around $38 to $43 per share based on a fairly generous 16 to 18 multiplier.
The Finish Line
Finish Line is the long position. The company is one of the nation’s largest mall-based specialty retailers selling athletic shoes and apparel. Finish Line recently reported fourth quarter and fiscal year 2013 results with quarterly sales of $442.7 million and comparable store sales increasing 0.7%. For the full fiscal year, the company had sales increase 5.4% to $1.44 billion and comparable store sales increasing 5.9%.