November 22nd, 2011 by

2 ‘Pair Trades’ for an ‘Absolute Return’ Strategy, By Jamie Dlugosch

by Jamie Dlugosch | November 21, 2011 9:59 am

The lack of confidence in the stock market should be no surprise. Investors have been put through the ringer, and even though a dearth of enthusiasm is ultimately bullish for stocks, it’s tough to be a believer these days.

The U.S. economy is teetering, and the lack of a debt deal from the supercommittee[1] is an immediate threat to investors. Then there’s Europe. The potential for a complete collapse of the euro, thanks to massive sovereign debt loads, is a very real risk to investors across the globe. Every whiff of negative news from Europe makes stock values go poof.

And when you consider stocks have barely budged over the last decade, it’s hard to argue for the long-term bull case. Frankly, it’s hard to argue for any case. Even the most seasoned pros are having difficulty navigating this market.

Where can an investor find sanity?

One sensible strategy is to follow an “absolute return” approach to the market. The general idea with absolute returns is to preserve capital and not lose money. If done shrewdly, this strategy can also deliver strong positive returns.

By “shrewdly” I’m mostly referring to being accurate with both your long and short positions. Absolute return investors use both sides of the market. At a minimum, the approach should preserve capital. But profits can be made on longs and shorts, creating surprisingly strong returns.

In searching for absolute returns, I like to use the concept of “pair trades,” in which we match a long and a short. For example, investors can use the Target (NYSE: TGT[2]) and Wal-Mart (NYSE: WMT[3]) stock showdown[4] as a tool for picking a long and short trade.

In this case, I would look at the performance of these two very similar companies. To the extent there’s a divergence of returns, I would short the strong performer and go long the underperformer. The expectation is that market forces are such that any advantage of one company over another is likely to be short term in nature.

In other words, the returns generated by each would revert to a mean.

Here are two pair trades that you can use in building your own absolute return portfolio:

Long PepsiCo /Short Coca-Cola

The battle between PepsiCo (NYSE:PEP[5]) and Coca-Cola () goes way beyond a simple taste test of the two beverage and snack-food giants. At various times over the last decade, one company or the other seemed to grab the edge. They have both won and lost various battles in their long-term war.

Over the last year, Coke has been outperforming PepsiCo. Shares of Coke have managed to gain more than 5% in the last 12 months compared to PepsiCo’s flat performance. As recently as this past September, the divergence in returns was even greater.

Don’t expect the gap to last much longer. PepsiCo is certainly quite capable of turning the tide. It has had lackluster earnings over the last four quarters, simply matching or slightly beating analyst profit estimates.

For the full year, PepsiCo is expected to make $4.40 per share. That’s expected to grow by a paltry 6% in 2012 to $4.65 per share. At current prices, PEP trades for 14 times current-year estimated earnings.

Coca-Cola has had similar performance against Wall Street estimates over the last four quarters, including a miss of estimates by a penny per share in the quarter ending March 2011. For the current year, Wall Street expects Coke to make $3.83 per share growing by 9% to $4.16 in 2012. At current prices, Coke trades for 18 times current year estimated earnings.

To the extent PepsiCo surprises to the upside, its stock should do relatively better than Coke over the next 12 months. I would buy PepsiCo long and sell Coke short in an absolute pair trade looking for a reversion of performance to the mean.

Long McDonald’s/Short Starbucks

When McDonald’s (NYSE:MCD[6]) launched its popular coffee drinks, it was taking direct aim at Starbuck’s (NASDAQ:SBUX[7]). How has Mickey D done since making the move in March of 2007? Well, pretty good on a stock basis. McDonald’s more than doubled in value over that time, while Starbucks is just fractionally higher.

That divergence has shifted over the last two years with Starbucks nearly doubling in value and McDonald’s up just over 40%. The huge reversal in Starbucks during the last two years creates an opportunity for absolute return investors today.

Reversion to the mean is likely to see McDonald’s continue to power forward at a steady clip. At the same time, Starbucks’  steam is likely to dissipate. Rarely does such strong short-term performance continue in perpetuity. This is especially true when you consider that Starbucks has likely maxed out growth opportunities by oversaturating the market.

In addition, Starbucks shares are a bit pricey today. Wall Street is looking for $1.82 per share in the current fiscal year ending September 2012. In the last fiscal year, the company made $1.52. That 20% growth in profits sounds impressive, but is it worth paying 23 times forward earnings?

McDonald’s has a different value profile. Wall Street expects it to make $5.22 in the current fiscal year, growing 9% to $5.71 in 2012. At current prices, McDonald’s trades for 16 times next year’s estimated earnings. That value is expensive relative to growth, but cheaper than Starbucks. When you consider that estimates may be overly optimistic for Starbucks, the pair trade is more obvious.

I would buy long McDonald’s and sell short Starbucks.




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