Hogs Over Snowmobiles, This Is A Fair Weather Spread

Jun.13.13 | About: Harley-Davidson, Inc. (HOG)

The recreational vehicle sector is one that mirrors the ebb and flow of the economic cycle. During downturns, luxury consumer items are leading indicators, and a number of these companies struggle.

Here's a price chart of four companies in this sector over the last 10 years, you'll notice three of the four are either at, or below their 2007 price levels.

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This second chart shows performance over the last few years, relative to the S&P. I showed this graph after the first graph because although Thor Ind. (NYSE:THO) and Winnebago (NYSE:WGO) performed okay since the market bottom, any investor that had invested before 2009 would not have reaped those returns.

HOG Chart
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As you can see, Polaris (NYSE:PII) has greatly outperformed its peers. The company's book value has always been rich, but with a current ROE (return of equity) of 51.16%, investors which focused on performance ratios over the last 5+ years were rewarded.

When Winnebago and Thor were struggling with quarterly losses, Polaris beat earnings expectations for 26 straight quarters!

The recession of 2007 hit this sector hard, companies that were selling RVs, and other high-ticket consumer items, suddenly were facing questions of solvency. Despite the struggles of Harley Davidson (NYSE:HOG), Winnebago, and Thor, Polaris continued to be a model of efficiency; quicker to adjust to weaker conditions, and quicker to respond to positive changes.

In addition to a continual, steady increase in earnings, Polaris pays a healthy dividend. The 5 yr. Dividend yield sits at an average of 2.9%, but now currently at 1.7%, it's no longer attractive.

The premium is simply bought out of the stock!

Trailing P/E

Polaris - 20.4

Industry - 19.3

S&P 500 - 16.9

Price-to-Book

Polaris - 8.8

Industry - 4.7

S&P 500 - 2.4

It's really hard to defend a justification of Polaris price at these levels (given that it's rallied so hard over the last five years), especially when we compare Polaris to the big brother of the sector - Harley Davidson.

Harley Davidson beats Polaris on both P/E (with a 17.9), and much more so on P/B (4.5).

What I'm suggesting is to take advantage of this inefficiency via a pair trade.

In the past I would play this spread from the Short side, shorting Hog, buying PII (mostly as intraday scalps and swing trades). But there's no way I could recommend buying Polaris at these price levels (regardless of its valuation to HOG, the S&P, or any other competitor).

And when I was shorting HOG (during the recession of 07-09), and going long PII, the discrepancy in the P/B wasn't as pronounced, and Polaris had a clear edge in all operating ratios.

Looking at this weekly period chart below, we see the all-time low in this ratio spread (1.5 dollars of Harley Davidson stock to every 1 dollar of Polaris) is just below -22.

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Fundamentally, and technically, we've got the wind at our back to be buying the spread here.

Here's a Quick Nick catch-up for anyone confused with equity pairs. The close on Monday June 10th was around -15 using a 1.5 ratio spread; the composition is 150 shares Long HOG, minus 100 shares (using 100 as a base for simplicity) Short PII.

150 * $54.01 (Harley Davidson Monday Close Price) = $8101.50 (Long Dollars)

(Subtract) 100 * 96.03 (Polaris Monday Close Price) = $9603.00 (Short Dollars)

Total = -$1501.50 out of $17,704.5 total capital employed (-8.48% short portfolio) leaves you a little unhedged, assuming of course there is no leverage involved, then otherwise the net exposure is going to be higher.

Generally when the dollars start to get out of whack I like to stay balanced, and there's many ways to do that. In this case the additional edge is in the premium of Polaris (not in the value of HOG being cheap, in which case we would want a positive differential), so being a little extra short provides a nice bonus.

It's important to know how the spread is calculated (which is the basis of your position); a differential with -15 if Harley Davidson's stock price is $20 and Polaris's stock price is $45, is not the same as the current spread price. If this were the case, I would use some market timing to add additional long shares to hold in the core position (which would make my spread dollar neutral). Holding extra long shares before a stock rally, or being extra short during a decline, can be the difference in a profitable trade that would otherwise be flat (or slightly negative).

And because I really like this as an initial entry point (as the spread is so beat-up here), I would just change my ratio to 2 if the spread dropped lower. At -22 on the 1.5 ratio (using $50 and $97), the spread becomes +3 on a 2.0 ratio. We're now hedged, and adding a second layer at -22 (assuming we added there) reduced a bit of the extra short exposure from the first layer.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.