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2 Pair Trades to Weather the Debt Debate Storm - 8959 views
MINNEAPOLIS (Stockpickr) -- The market is set to end the week with big losses. Investors initially shrugged off the stalemate in Washington with respect to the debt-ceiling debate, but stocks have been losing value as the week progresses. The S&P 500 was off 3.3% through the end of trading on Thursday.
Despite the market uncertainty, the past week has been a big one in terms of initial public offerings. About a dozen IPOs were scheduled, and eight of them occurred. The most-watched of the lot was Dunkin' Brands Group (DNKN), which came to market on Wednesday and soared 47% in its first day of trading.
Setting the national debt issue aside, increased IPO activity indicates short-term strength in the market. Underwriters bring deals to market when there are sufficient buyers to absorb the new supply of stock that is now available. Some argue that IPOs are a signal of a market top. That argument says that an increase in IPOs represents overzealous bullishness that could end at any time.
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Unfortunately, the debt debate and a pause in economic activity during the second quarter make the current environment uncertain. Stocks may go up from here, and they may go down. There are strong arguments on either side of the coin. Given the unknown direction of stocks, an absolute return strategy may be appropriate. The goal of such an approach is to protect capital while still generating positive returns.
Pair trades, in which investors match a long position against a corresponding short position, are a great tool for achieving absolute returns. My own pair trades strategy is to find stocks within an industry or category to set against each other. The IPO market is fertile ground, then, for pairing a stock on the long side with a stock on the short side.
Here are two IPO pair trades to consider.
Long Cornerstone OnDemand/Short LinkedIn
Social networking is all the rage -- including in the IPO market. Shares of LinkedIn (LNKD) exploded after the stock's initial offering in May at $45, stumbled for a brief period and have since rallied to the current price of just over $100 per share. Yesterday it traded as high as $115.05, nearing its first-day high of $122.70.
The promise of LinkedIn is its vast network of job holders and job seekers. The ability to monetize that network as a vital cog in the job search and placement process is indeed attractive. LinkedIn is quickly becoming the go-to site for search firms, and it is a must for anyone in the job market. "See and be seen," as the old saying goes, could pay rich dividends for investors.
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But as anyone with a network knows, networks can be broken. Given the low barrier of entry in the space, LinkedIn holds no particular advantage other than being first in the game. The same can be said of Twitter, but how nervous do you think executives there are of the new Google +? My point is that these networks can be a house of cards. MySpace is another good example of how things once so promising can reverse course.
LinkedIn shares are expensive by any measure. Shares trade for more than 10 times expected revenue and 350 times 2012 expected profits of 29 cents per share. To be fair, valuation metrics can change for a company growing so quickly, but there can be no doubt that this stock is not cheap. It is hard to say if the current price is a function of true promise or simply hype and relatively few shares available (only 7.82 million shares float out of a total 94.5 million shares outstanding).
Given the risk and high valuation, I would be short this stock in a pair trade. On the flip side is Cornerstone OnDemand (CSOD). Cornerstone, like LinkedIn, is in the job market business. The difference is that Cornerstone is not a social networking company but rather a software technology company. Cornerstone provides integrated platforms for learning management, enterprise social networking, performance management, succession management and extended enterprise.
Shares of Cornerstone went public in March at a price of $13 per share. After the obligatory pop that had shares peaking at $23, the stock is now trading at around $17 per share. At that price, Cornerstone trades for 10 times 2011 expected sales. There is no comparable for earnings multiple as the company is expected to lose money this year and the next.
Unlike LinkedIn, there are more shares available, with 21.69 million shares trading out of a total of 47.54 million shares outstanding. As such, the market pricing of Cornerstone is less a function of supply and demand and more of a function of expected future value.
I’ll always favor the company that makes something vs. the network hype. I would be long Cornerstone and short LinkedIn.
Long Zipcar/Short Pandora
Sometimes it is better to wait than to jump right into an IPO. After the initial hype evaporates, what is left is a truer sense of value and opportunity. In the case of Zipcar (ZIP), shares jumped after the first day of trading, hitting a peak of $31.50 per share. Today you can buy Zipcar for around $23 per share. That is a solid discount and only slightly higher than the offering price of $18 per share.
Zipcar may not be a red-hot IPO based on that price action, but its business model is quite interesting. Catering to urban centers, the company’s short-term-rental concept is a unique solution to the energy crisis. For those not interested in driving all the time but who would still like to have a car for that one errand or special trip, Zipcar is a great alternative.
Zipcar is not profitable yet, but the average Wall Street estimate has the company making 5 cents per share in 2012. The company is using IPO proceeds to pay down debt and expand its business. Although the company does face competition from rental car companies, Zipcar’s edginess give it a distinct advantage. It is certainly worthy of a reasonable IPO speculation.
On the short side, I’ll do a pair trade short of Pandora (P). The online music streamer came public in June and has had a rough start. On the initial day of trading, the stock jumped from its offering price of $16 per share. After it hit a top of $22 per share, short-sellers attacked. The stock closed the day at approximately $13 per share.
That is not the kind of action underwriters like to see on a stock. The concern for investors relates to competition in the space. Not only does the company compete with Sirius XM (SIRI), but monsters in technology such as Apple (AAPL), Google (GOOG) and Amazon (AMZN) all pose a threat. With few barriers to entry and rapidly changing technology, the risks for owners of Pandora are quite real.
After the rough start, shares of Pandora have stabilized at the original offering price of $16 per share. I would use that stabilization as an opportunity to sell. This one has all the markings of a company that rushed to go public to take advantage of a strong market. I’m not sure it is worth the current $2.5 billion market cap. One stumble and more sellers could emerge.
Upside surprises seem unlikely making Pandora a good candidate to short in a pair trade with Zipcar.
To see these stocks in action, check out the 2 IPO Pair Trades to Weather the Debt Debate Storm.
-- 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.