investing on the backdrop of coronavirus

'Tis the Season for Long Shorts?

7 MIN READ

What is Relative Value?

We're a little more than a month into the Coronavirus Crisis and there are already some excellent publicly traded companies available at compelling valuations. Take, for example, Disney, a brand made to last. As of March 24th, the stock was trading at levels not seen since 2014. Yet many investors are loath to plow money into equities for fear the stock market could fall further and take down good companies and bad in its wake. Biding their time on the sidelines, they try to time the market and jump back in at just the right inflection point. The vast majority fail to do so. Others just ignore their portfolios during these difficult times, preferring to ride out the volatility and wait for better times. However, there is another approach that can take advantage of opportunities in a bear market without more risk.

In this article we'll be discussing a strategy that investors can use to generate returns in both normal and unstable markets. When the market is declining rapidly or exhibiting high levels of volatility, it can be psychologically difficult as an investor to step in and take on additional risk. Moreover, most investors are long-biased and don't feel comfortable betting on declines. Using an equity strategy known as relative value can allow one to participate in the market during volatile times at a lower risk level than buying equities on an outright long basis.
The wise man is he who knows
the relative value of things.
William Inge

The Pairs Trade

One of the better known forms of the relative value approach is the Pairs Trade. As the name implies, this trade involves a pair of securities. They should be highly correlated assets that have become temporarily out of sync, creating an opportunity for the investor to step in and place a trade that generates a return as the two securities revert to their historical relative values.
There are two parts in the trade: one security is bought (a "long"), while another is simultaneously sold (a "short"), normally in equal dollar amounts. The traditional pairs trade makes a return when the spread narrows. An additional benefit for the investor is that relative value strategies don't typically depend on the market's direction. This doesn't mean that the investor is guaranteed to make money but that the effects of the overall market on the strategy's returns are reduced. By turning down the knob on market risk, the investor can focus on relative value between the two securities and not worry as much about market declines.

Variations on the Pairs Trade

Here are some variations on the pairs trade theme to give you an idea of the possibilities in the relative value universe and the drivers behind trades:
Same Sector: Widening Spread Between Two Companies
Buy an undervalued company in a sector and offset it with a short against an overvalued company in the same sector. Fundamental analysis of a company's historical and expected cash flows, value of tangible and intangible assets are all used in determining valuations. With this strategy, the investor hopes to neutralize or at least muffle market and sector fluctuations while picking a company to outperform and another to underperform relative to the long.

Examples:

  • Buy Netflix (NFLX) and sell short Cinemark Holdings, Inc. (CNK). Thesis: online streaming will outperform movie theaters on the backdrop of social distancing.
ii. Buy Amazon (AMZN) and sell short L Brands (LB). Thesis: online shopping will outperform brick and mortar retail.

Different Sectors: Widening Spread Between Two Companies

Buy an undervalued company in a sector and offset it with a short against an overvalued company in a different sector -- both driven by a common theme. With this strategy the investor hopes to neutralize market fluctuations while selecting a company in a sector to outperform and another company in another sector to underperform on a relative basis.

Example:

i. On the backdrop of coronavirus and more people staying home, you buy Netflix and short Delta Airlines because you think that online entertainment will outperform airlines and that Netflix is a better bet than Delta Airlines given the expected drop in demand for air travel and more demand for online viewing.

Different Sectors: Widening Spread Between Them

Buy an undervalued sector and offset it with a short on a different sector that is overvalued. With this strategy the investor hopes to neutralize market fluctuations and remove individual company risks. The investor is more interested in broad macroeconomic and societal themes and aims to identify a sector that is expected to outperform relative to another sector that is expected to underperform.

Example:

You buy a technology company ETF and sell a retail ETF focused on brick and mortar retail. You think that technology companies are better positioned than retail stores to outperform since you believe online shopping will increase, hurting traditional retailers. Moreover, you think technology companies have a high proportion of services offered online, which plays into the social distancing phenomenon.
There are many other possible relative value strategies including those that make use of factors such as geography, competitive positioning, currency or a company's capital structure.

Special Considerations When Shorting

But there are some special considerations to take into account when implementing a pairs strategy. The first relates to the ability to short certain securities. At times, exchanges will restrict or prohibit investors from shorting to help stabilize markets. This is currently the case in several European markets. In addition, shorting involves borrowing a security one doesn't own, which has a cost associated with it called the borrow. During times of high demand for short positions, this cost can become onerous and make a short position too expensive for use in a pairs trade.

Managing Risk

The biggest risk involved with a short position? Losses are theoretically unlimited. However, this risk can be effectively controlled through the use of risk mitigation techniques such as stop losses and portfolio diversification.

Despite the goal of market neutrality, some relative value trades become more risky as market volatility rises. This is because volatile markets tend to exacerbate mispricing of assets. Therefore, it's imperative that one carefully choose entry and exit points and have a predefined strategy for managing risk.

Beta, a measure of an asset's historical volatility relative to the market, can be used to manage risk so that one side of the trade does not move too radically in relation to the other. That said, since beta is a historical measure, there's no guarantee it provides an accurate forecast of the future. Finally, if a trade is successful, the dollar amounts of either side of a trade will diverge, making it necessary to periodically rebalance the trade.

Last but not least, a portfolio containing relative value trades will have less overall risk if the theses behind those ideas are unrelated, and therefore, less correlated. In writing this article we thought our readers would be interested in ideas related to the unfolding of the coronavirus crisis. That said, in creating portfolios for clients, we strive to identify relative value ideas with different underlying drivers.

Learn More

To learn more about designing a personalized investment plan that incorporates relative value strategies, set up a free consultation with Westbridge Wealth Management here:
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About the Authors

Eduardo Simpson
Investor, Entrepreneur
Eduardo is an investments professional with over twenty years of experience in the asset management industry, focusing on credit securities, including emerging market bonds, US high grade and high yield debt, distressed debt and project finance loans. Additionally, he has experience with private and public equity as well as equity derivative instruments. Most recently, Eduardo has been helping startup firms in the Nordic region connect with capital and services in the US. His university studies include an MBA from the Yale School of Management with a specialization in Finance/International Strategy and a B.S. from the University of Florida with a Finance specialization.
Matthew Lewis
Founder, Westbridge Wealth Management
Matt is a private wealth advisor at Westbridge Wealth Management and moderator of the Wealth Bootcamp podcast. He has 20 years of experience as an investment professional and has held positions in equity research, wealth management, real estate private equity, and commercial real estate development. He earned his MBA from the Yale School of Management with a distinction in investment management (taught by David Swensen), studied abroad in Cambridge and Moscow, and earned several professional credentials including the CFA, CAIA and CCIM designations. Having lived in Russia for a number of years, he is fluent in Russian.
Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. This content was created as of the specific date indicated and reflects the author's views as of that date.Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
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