Let me start by saying a long/short strategy is not one I ever adopt. In fact I don't ever short stocks. I view a short trade as one designed to lose because there is no limit to how high price can rise, while the price can fall only from where it is to zero, and so while the loss potential is uncapped, the gain potential is limited. If I had to short a stock, I would have to [a] have a high conviction that the company shorted would fail, [b] be influential enough to make others believe as I do, [c] be influential enough to beat the stock to death if the company involved was not co-operating and dying, [d] be financially able to absorb a loss inflicted, if the company refused to fail despite my best efforts. In short I'd have to be Ackman, and I'm not, so I don't short. I am writing this post because I am intrigued at how different market participants behave, and thought that writing this post might give me some insight into why pair traders behave as they do.
The advantage of the long/short trade is that a smaller level of initial risk capital is at stake, but the risks are higher compared with a long only position. In many ways a pair trader is seeking pure alpha: the trader stands to make money regardless of market direction as long as the company specific assessment is correct.
The best case scenario would be one where the long position rose, while the short position fell. But there is a profitable outcome if the long position rose more than the short position rose, or if the short position falls more than the long position falls. The worst scenario would be one where the long position fell, while the short position rose. And of course there is a loss-making outcome if the long position falls more than the short position falls, or if the short position rises more than the long position rises. So really the primary objective is to be as comfortable as is possible that the long position will outperform the short position.
I am looking at Coca-Cola (NYSE:KO) and Pepsi (NYSE:PEP) because they are both are mega-cap stocks with a market capitalization of over $100 billion. Both stocks belong in the Consumer Goods Sector and the Beverage - Soft Drinks industry. Both are low-beta stocks with Pepsi having a slight edge: Value Line reports that Coca-Cola has a beta of 0.70, while Pepsi has a beta of 0.60. But Coca-Cola has a lower-risk capital structure.
The similarity between the stocks means that it is likely that the stocks will be treated by markets in a very similar manner: any difference in treatment will be a result of company specific factors rather than market driven factors. To determine which of the two stocks fills the long position, and which the short, would depend on departure from historic consistency in relative price levels, and on company specific factors.
Pepsi looks better valued than Coca-Cola. The only parameter on which Coca-Cola beats Pepsi is on Price/Cash, but Pepsi wins on all others including Price/Free Cash Flow. Both companies are near equals on Price/Book. And the dividend yield following Pepsi's recent hike to $0.655 per quarter (payable 6/30/14) takes the dividend yield up to a level very similar to the dividend yield for Coca-Cola.
As far as growth is concerned, Pepsi outperforms Coca-Cola in recent, present, and future expectations.
Coca-Cola has outperformed Pepsi on earnings growth over the past five years. Part, but not all, of this is a result of differences in the capital return policy. Both companies have returned near 70% of earnings via dividends plus buybacks net of employee issuances. Compared with Coca-Cola, Pepsi has returned more via dividends and less via buybacks net of employee issuances. Coca-Cola has returned value through buybacks and reduced fully diluted average shares outstanding by 3.2% over the past five years, compared with Pepsi which has reduced fully diluted average shares outstanding by 1.08% over the past five years. The growth adjusted for the difference in capital return plans still puts Coca-Cola ahead of Pepsi as far as the past five-year earnings growth is concerned, but the differential is 43 basis points less than that indicated by looking at the per share five-year earnings growth differential.
For the forward five years, given the recent debate over the recently approved executive compensation plan, I suspect Coca-Cola may not be returning so much capital net of dilution on account of employee issuances in the years going ahead. In addition, forward five-year growth expectations for Pepsi are at 7.2% compared with 6.7% for Coca-Cola.
From the value and growth criteria we know that Pepsi is better placed than Coca-Cola for future gains. But as you will see from the below data momentum at Pepsi has been stronger than Coca-Cola off late. However, the reward through momentum has not yet eliminated the value and growth advantaged seen at Pepsi.
The Pair Trade
The price of Pepsi divided by the price of Coca-Cola is approximately 212.50% today. The price of Pepsi divided by the price of Coca-Cola based on the 200-day moving average is approximately 209.20%. Thus it is clear that the markets are rewarding Pepsi for its better value and growth potential in recent times. But the differential between current relative price and relative price based on the 200-day average is small. Momentum has not rewarded Pepsi sufficiently to eliminate the growth and value premium apparent in Pepsi.
The departure from historic consistency in relative price levels is low, and the company specific factors in terms of value and growth prospects are superior at Pepsi. In addition Coca-Cola carries an Albatross in terms of its unpopular recently approved executive compensation plan. Thus, over-all I conclude that if I were to engage in a pair trade, I would have to be long Pepsi and short Coca-Cola.
As I said in a prior post, Coca-Cola is a good long position. In my view, both stocks have upside, but the upside in Pepsi is higher. And if I am right, I can expect a positive return with a lower level of initial risk capital deployed.