- Global economic picture remains murky with negative skew
- Current equity valuations are high therefore risk is to the downside
- A market neutral strategy is recommended, we highlight three possibilities
In our piece entitled ‘Ray Dalio is right more quantitative easing is coming’ we discussed the state of the global economy and our belief that Mr. Dalio was correct in his assertion that the FED’s next big move would be quantitative easing. Low inflation, mixed jobs data, and global market chaos prevented the FED from raising rates September through November of this year. In December, expecting future inflation, but mainly to maintain credibility, the FED increased interest rates by 0.25%. Vital Data Science’s base case view is this will continue for two to four rounds before secular forces begin to impact the FED’s decisions again. We are collecting data, calibrating models, and will have an updated view early in the New Year.
3Q15 is behind us and the theme of the earnings season was the slowdown in global economic activity, especially in developing economies. S&P 500 earnings increased at their slowest rate since the recovery began (Chart 1) yet valuations remain stubbornly high. Inflation is low, and while the US labor market shows signs of picking up, significant slack remains. With slack in the labor market, a global slow down, and a stronger US dollar, we believe there is significant risk to achieving the FED’s stated goal of 2% inflation. Further, the PMI Composite Index (Chart 2), a reasonably reliable indicator of recession risk has been in decline all year and now sits below 50. A stronger US dollar will put further pressure on the PMI Composite Index.
In short, our current macro view is:
- the global economic picture remains murky with risk skewed negatively;
- US recovery remains uneven, however bright spots are developing;
- at current valuations, risks to equity markets are skewed negatively;
- in the short term US markets will be flat, volatile, and trends hard to forecast.
Therefore we recommend a market neutral strategy - pair trades. In this piece we highlight two pair trade ideas along with one speculative pair trade. We provide the results of an analysis Vital Data Science performed, in which we found most open, cointegrated pairs of stocks on the NYSE below. For a more complete list of open pairs on the NYSE please visit part one of Quantessential Views.
Chart 1: S&P 500 earnings real growth at lowest point since recovery (<-8%)
Chart 2: PMI Composite Index has been in decline all year and now sits below 50
The idea behind pair trades is to pair a long position in one stock with a short position in another stock. The two stocks are to be cointegrated, meaning that a linear combination of the stocks is integrated of order zero. Generally, the firms are in the same industry and have similar beta so a pair trade creates a hedge to the industry in which the firms operate as well as the market.
Top Pair Trade Ideas
1. Long 3 units of CNX, short 4 units of CNQ
Quantitative data for the trade is summarized in Table 1. CNX (Consol Energy) is a NE US coal and natural gas producer. CNQ (Canadian Natural Resources) is a Canadian oil sands and heavy oil producer. Relative price performance is show in Chart 3.
Table 1: Quantitative data for CNX/CNQ pair
CNX stock has been hammered to the point where value investors are starting to take notice. Consol Energy produces high BTU North Appalachia coal and has been able to take market share from Appalachian producers in the commodity downturn. Increasingly they are positioning themselves as a natural gas producer in the Marcellus - the best natural gas basin in the US. Natural gas is not imported into the US, in fact it is exported to Mexico, Canada, and will soon be waterborne, helping to clear the US over supply. Marcellus well economics are competitive globally. CNX is cash flow positive and has a manageable debt position. CNX trades at 5.30 EV/EBITDA, 0.33 P/B, and 0.54 P/S. CNX is well positioned to compete in a low commodity, over supplied market, and trades at a lower valuation than weaker competitors.
Chart 3: Relative price performance of CNX and CNQ
Because CNQ is a well-managed company it pains us to call it a short. Nonetheless we believe CNQ is overvalued relative to CNX. A business can be managed flawlessly but if cut off from markets, sells a replaceable product that is heavily discounted with high production costs, and faces ever increasing regulatory and taxation hurdles, the business will have a hard time competing. As a Canadian oil sands and heavy oil producer this is the tough position CNQ finds itself in; however on relative basis its valuation has held up. CNQ trades at 6.61 EV/EBITDA, 1.11 P/B, and 2.18 P/S.
We see this gap closing within the next year driven by bad news out of Canada.
2. Long 1 unit of PII, short 4 units of UPS
Quantitative data for the trade is summarized in Table 2. PII (Polaris) is an industry leader in the powersports industry. UPS (United Parcel Service) is an industry leader in parcel delivery and freight. Both companies are leveraged to consumer financial health. Relative price performance is shown in Chart 4.
Table 2: Quantitative data for PII/UPS pair
Polaris recently lowered their 2015 guidance and the stock was hammered as a result. Guidance was lowered due to lower than expected Off-Road Vehicle sales and unusually warm weather impacting snowmobile sales. Top line growth was adjusted to 4%-5% compared to the previous expected value of 10%-11%. PII now trades at 1.14 EV/EBITDA, 5.95 P/B, and 1.12 P/S.
PII share price appreciated significantly in 2013 when the company was growing at a record pace, but earnings growth and share price have since matured. Polaris offers a broad product suite that hits every segment of the powersport industry. With a healthy balance sheet, industry leading products, and a management team that is dedicated to growth, Polaris has many options to get out of the current rout. We believe the recent dip presents an opportunity to buy an industry leading, innovative company for an attractive valuation.
Chart 4: Relative price performance of PII and UPS
UPS is a giant in parcel delivery and freight, a growing but highly competitive industry. As online shopping sales sky rocketed UPS was well positioned to reap the rewards. Coming out of the 2008 downturn UPS share price has closely tracked the broad market, and like the market UPS shares have become richly valued. UPS currently trades at 11.47 EV/EBITDA, 46.23 P/B, and 1.53 P/S.
Most recently headwinds are beginning to show:
- Amazon announced it is investigating its own parcel delivery system
- Peer to peer economy options are rising
- UPS has been having trouble keeping up with increased online orders as on time delivery times fell following Cyber Monday to 91% from a 97% last year
The parcel delivery business is competitive and ripe for disruption. As traditional companies fail to meet market demand adequately, online retailers will move to non-traditional options that will take market share away from incumbents.
We see this trade closing within the next one and a half years as it will take several quarters for PII team to reposition, in the mean time non-traditional parcel delivery options will continue to multiply.
3. The speculative trade: long 1 unit of MW, short 4 units of UPS
Warning: this one is not for the faint of heart. A massive spread has developed between UPS and (MW) Men’s Wearhouse, two companies whose share are cointegrated and leveraged to consumer spending. Table 3 shows quantitative data for the trade and Chart 5 shows relative performance.
Table 3: Quantitative data for MW/UPS pair
For those who follow equity markets Men’s Wearhouse needs no introduction. The affordable men’s fashion retailer’s shares have been slaughtered, down over 60%, since management cut earnings forecasts down by 40% in November, and then reported very weak sales at Jos. A. Bank early this month. Men’s Wearhouse acquired Jos. A. Bank in 2014 for $1.8 billion, and largely paid for the deal with debt. Any value from the acquisition has been erased from MW’s share valuation, yet the debt remains. MW is now trying to change brand perception and consumer buying patterns to give the business a sustainable long term strategy. This will take time, there will be further missteps, additional write downs, and there is risk that the strategy will not work.
While the future of MW is not clear there is potential for significant upside from the current valuation, hence why it is part of our speculative trade. The company trades at 7.05 EV/EBITDA with much of the $2.3 billion EV being comprised of $1.65 billion in debt, 0.71 P/B, and 0.19 P/S - a significant discount to its direct competitors. MW legacy brands are in good shape and the firm generates $2.3 billion in revenue without Jos. A. Bank. MW is cash flow positive and focused on reducing debt. We believe that while significant risk remains, there is potential for a phoenix to rise from the ashes.
Given the overhang on MW stock, we do not see this spread closing for at least one and a half years, likely two.
Chart 5: Relative price performance of MW and UPS
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