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2 Boring Pair Trades to Spice Up Your Returns - 5146 views
MINNEAPOLIS (Stockpickr) -- What’s wrong with boring? In the stock market, "boring" gets the short end of the stick. The much-maligned buy-and-hold strategy, for example, is too boring. Investors want to make money and make it fast.
On the other side of the coin are such terms as "day trading," "program trading" or "quote stuffing," an alleged cause of the 2010 flash crash. It's enough to make your head spin. Jack Bogle is right when he says the game is rigged. But Bogle's "boring" index-based buy-and-hold approach isn't as appealing to investors who look at today's market and don't see much change from 10 years ago.
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An alternative to buy-and-hold investing is another boring strategy: an absolute return strategy using pair trades. Offsetting a long position with a corresponding short position is far from sexy -- in fact, it pretty much guarantees that you will lose money on one side of the equation. But if you're more right on the other side than you were wrong on that side, it can result in overall slow and steady positive returns while protecting your portfolio from the whiplash losses of rapid-fire trading.
With pair trades, I often look to exploit short-term pricing inefficiencies. Today, though, I'm going to go longer-term and seek out pair trades that should work for as long as three to five years.
The key to a longer-term pair trade is to find the stock on the long side that will stand the test of time. On the flip side, we can short companies with fundamental flaws that are likely to be exposed over the long haul.
Here are boring pair trades to consider for your absolute return portfolio.
Long Travelers/Short AIG
If you are looking for clues as to how Warren Buffett made his fortune, consider the insurance industry. After all, major player Geico has been a wholly owned subsidiary of Berkshire Hathaway (BRK.B) for 15 years.
I like the insurance model of being able to charge premiums that total less than claim payouts -- and I especially like being able reinvest those premiums in undervalued stocks or other securities in order to enhance returns.
Insurance isn't necessarily the most exciting industry, but there's nothing boring about AIG (AIG), one of the 10 worst-performing S&P 500 stocks of the year. AIG's involvement in derivative products nearly destroyed the company when the housing market collapsed in 2008. A broad restructuring has allowed AIG to survive, but you cannot change the nature of this beast.
I’ll just ask this question: What sort of exposure do you think AIG has to the debacle unfolding in Europe? Based on its previous activity with credit default swaps, I suspect there is some level of further exposure that could jeopardize future earnings. AIG is the sort of stock you want to short in a pair trade.
On the long side, I would stick to a company like Travelers (TRV). Sure, it’s boring, but over the long haul, Travelers is likely to outperform a company like AIG just as it has done over the last five years.
No matter what happens in the economy or the market, I just don’t think you will get hurt owning Travelers and being short AIG. The five-year chart really speaks volumes of that dependability. For a boring pair trade, I would be long Travelers and short AIG.
Long BlackRock/Short Bank of America
I’ve always been a huge fan of the money management business. Fees can be quite lucrative and the operating expenses low. That formula creates huge profit margins for investors. More important, once an asset is raised, it tends to stick with a manager through thick and thin. That makes the business reliable over the long haul.
Sure, there will be times when asset values stagnate, as we've been experiencing over the last decade, but over the long haul, stock prices tend to go up and go up nicely. Not many other businesses can deliver the same sort of organic growth.
On the long side of this pair trade is asset manager BlackRock (BLK). Shares of the company are sharply lower since the beginning of July. With the stock down about 20% during that time, now is the time to buy this large asset manager. Sure, the stock market is down today, but shares are likely to move higher in the long term. At the same time, BlackRock will continue to add new assets to its business, ensuring profit growth for the future.
Wall Street, on average, expects BlackRock to make $12.36 per share this year, with that number growing 11.5% to $13.79 in the following year. At current prices, BlackRock trades for only 12 times current-year estimated earnings -- very reasonable price for a business that is likely to deliver double-digit profits even during a market correction. BlackRock also shows up on a recent list of 6 Financial Stocks That Offer Excellent Value.
On the short side of this pair trade I would select a large U.S. bank with the most warts: Bank of America (BAC), another of 2011's worst-performing S&P 500 stocks. This behemoth bank continues to struggle with a balance sheet plagued by problem loans stemming from the end of the housing bubble.
Bad decisions at the end of the cycle -- in particular, buying Countrywide Financial in January 2008 -- doomed the company to its current fate. Shares of Bank of America have collapsed this year. Not even an infusion of capital from Buffett has stemmed the tide. At best, Bank of America common stock is dead money for the foreseeable future.
Although past performance has nothing to do with future results, a five-year comparison of Bank of America and BlackRock is telling.
I would buy BlackRock and short Bank of America in a boring pair trade today.
-- Written by Jamie Dlugosch in Minneapolis.
At the time of publication, author had no positions in stocks mentioned.
Jamie Dlugosch is a founder and contributor to MainStreet Investor and MainStreet Accredited Investor. Formerly, he was president and CEO of Al Frank Asset Management. He has contributed editorially to The Rational Investor, The Prudent Speculator, Penny Stock Winners and InvestorPlace Media.