A Leverage-Wary Partridge in a Pair Tree

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 |  Includes: AFAM, AMED, GTIV, LHCG
by: Daryl Davis

The mere thought of effective pair trading is alluring: Earn relatively safe (and often sizable) profits using other people’s assets. Imagine two companies from the same industry with similar business models but quite disparate stock valuations. If Stock A is valued at “X times some factor,” and Stock B is valued at 1.50 times X using the same or a similar valuation method, then one can arbitrage the 50% disparity by shorting Stock B and buying an equal long position in Stock A.

No matter what happens to the two stocks’ valuations in an absolute sense, if they eventually become more commensurate relative to each other, a trader can exit that singular position with a return on investment that is impressive, but a return on equity that might be expressed using at least one comma. The mechanics: a broker loans a trader (using his net account value as collateral) the shares for Stock B, which the trader immediately sells for cash (i.e., the monetization of someone else’s assets) which in turn is used to purchase a complementary long position in Stock A. The trader then waits, allowing the market to correct itself. Few market maneuvers are more satisfying for an investor than the effective execution of a pair trade.

But things could go badly. Excessive borrowing of cash was the effect, not the cause, of AIG’s downfall last year. The actual cause was excessive leveraging against its giant shareholders’ equity (a figure that was once greater than one hundred billion dollars). All investors considering any short sale should be extremely diligent to avoid a vicious cycle of unexpected events that could possibly allow such leveraging to wipe them out. An apropos Mungerism*: “Tell me where I’m going to die, so I don’t go there.” No matter how simple and lucrative a profit might appear, we must make certain one seemingly innocent position cannot kill our entire portfolio.

With that cautionary preface in mind, we can properly evaluate a holiday offering from the public home healthcare companies. But this invitation to pair trade at today’s valuations should only be accepted with entitlement by those owners of AFAM, GTIV and/or LHCG who can tolerate a bumpy ride.

Three of These Stocks are Doing the Same Thing…

Without doubt, AMED has created a franchise within home healthcare. The current industry paradigm (with its focus on such components as leveraging scale on impressive technology, referral growth outside of hospitals, and emphasis on the more chronically ill) was shaped by AMED more so than by any of that company’s competitors. AMED’s hegemony has scared away competitors (both actual and potential), and if imitation is the sincerest form of flattery, then the company might have been caught blushing in recent years. Going forward, this industry will not be dramatically influenced— as it was in the past—by entrepreneurs making absolutely bold moves, but rather by executives who will grade themselves and their companies with differentiators which can only be noteworthy in relative terms— relative to industry standards which were created in large part by AMED.

The company is not perfect— as the stock market so captiously and frequently points out. There are those who have searched for and reported on (if not actually discovered) potentially major problems. The company is quick to defend itself— possibly too quick, perhaps belying a deep-seated insecurity. Key executives have conspicuously departed. Also, management has not held significant ownership in years. Additionally, AMED’s growth and branding philosophy could lead to diseconomies of scale in the not-too-distant future. There are other (potential) negatives. Ultimately, there is a certain equivocal suspense with this company, as if all on-lookers are waiting for the other shoe to drop. To date, however, there are no negatives that affect this company’s franchise in meaningful ways. AMED resides in a solid industry and maintains a solid balance sheet which is managed by a solid technocracy.

The stock market has not been kind to AMED recently. Even though the company has registered stratospheric revenue and profit growth this decade, and there is an almost universal sense that the future for this industry bodes exceptionally well, the stock trades at less than eight times today’s earnings. Due to uncertainties regarding health insurance reform, discounts are easy to understand, but AMED is valued by the market these days in a way that is quite disparate from, and not nearly as favorable as, its peers (AFAM, GTIV and LHCG).

To be sure, pairing AMED with any/all of its peers is not without risk— especially considering how volatile each of these stocks has been in the past. It is not difficult to imagine AMED falling precipitously for any number of perceived or real reasons, while, say, LHCG skyrockets at the same time. In such a circumstance, were they paired the loss of equity could be monumental: AMED falling to less than $10 would be painful, but the greater risk would be a simultaneous portfolio-killing rise of LHCG. Show me a man willing to wager his financial destiny on LHCG not breaking $90 at some point in the next few years, and I’ll show you a man who should not have a margin account. Due to these risks, I cannot recommend such a trade in and of itself, regardless of how tempting it might be.

Earlier this year, however, I recommended purchasing shares of all four of these companies at much lower prices, which changes things significantly for some readers. If an investor already has an unfettered long position in any or all of AFAM, GTIV or LHCG, then he can now capitalize on pairing an at most equally valued holding with AMED with no risk of being brought to his knees because of it. If the investor is already long with, say, 1,000 shares of LHCG, then that is the absolute most the investor should even consider shorting with this pair trade. The subtle beauty of such a move is that any subsequent equity-killing rise in LHCG within this pair trade would be offset at least equally by the increased equity in the original and primary long position previously established.

A more likely scenario is that all of these stocks will be valued in more similar ways no matter what eventually comes of health insurance reform. Therefore, if the stocks double or half in price, a trader can pick up a nice gain on a side bet by safely and vigilantly leveraging this pair trade against an already established long position and simply waiting for valuations to converge.

Unlikely, but supremely enjoyable to contemplate, is a circumstance wherein all of these companies’ share prices escalate due to favorable legislation, which causes a short squeeze for AMED (a company whose short interest is a still-ridiculous 50% as of November 13, 2009). While a more resilient group of bears would be difficult to find than those currently entrenched around AMED, they will all exit someday—either intermittently or en masse. This certain but difficult-to-predict exodus could create such upward pressure on AMED’s stock price that its valuation relative to its peers would invert. In such a circumstance, however impressively our hypothetical trader’s original 1,000 shares of LHCG would perform, this pair trade would log astronomical returns.

While this trading strategy might be successful in the short, mid or long term, all traders even contemplating such a move should keep this abundantly clear reality in mind: These stocks define volatility. But even if things go poorly in such a trade, a loss— however painful—can be recovered from. The thrust of this strategy is as follows: If the short sales for this pair trade are transacted in the same brokerage account as that in which at least an equal number of long shares already reside, the trader cannot die from it.

*A Mungerism is a pithy formulation from Charlie Munger, Warren Buffett’s business partner.

Disclosure: Long AFAM, AMED, GTIV and LHCG; Short AFAM and GTIV