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By Jack Barnes

With all that's happening in Europe right now - not to mention economic expectations and consumer-spending trends both overseas and here in the United States - I find that we have an interesting "pairs trade" available to us.

And the trade that I'm talking about is to have investors sell Fiat SpA (Pink ADR: OTCPK:FIATY) and buy Ford Motor Co. (NYSE: F).

The inspiration for this trade stems from an experience I had as a teenager.

Indeed, it's been more than 25 years since the story I'm about to relate took place, but the memories are so vivid that they're never far from my thoughts. Neither are the lessons I learned - which is fortuitous, since those lessons are especially applicable in today's unforgiving financial markets.

You see, I was 18 and was in the market for my very first car. Against my father's wishes - and against what should have been my better judgment - I purchased a used-and-abused Fiat Spider. In the four years I owned the Fiat, I believe it was in actual running shape for a total of perhaps 11 months. True, the car had been driven hard before I owned it. And I loved that car, despite its failings - after all, I was 18 and the Fiat was a convertible. But I ultimately came to realize that my father had been right ... and that a big reason the Spider was in such bad shape was that it had been a poorly manufactured car to begin with.

Dad had tried to warn me away from that Fiat sports car: The warning signs were all there, he said at the time. I just didn't see or hear them. Today, when I look at Fiat - the company - I'm experiencing the same warning signals. But this time they're warning me away from Fiat's stock.

Here is how we can listen to what the market is saying about Italy - and its largest employer, Fiat - and use those insights in a pairs-trading strategy that will save some money on one trade, and make some money on the second.

Let's begin with a close look at Fiat SpA (Pink ADR: FIATY.PK).

A Thumbs Down on Fiat

When I look at Fiat, I see four key causes for caution. Fiat faces:

  • An unprofitable home market, where it is trapped by a hostile work force.

  • A major challenge in efforts to leverage its chief U.S. asset (Chrysler Group LLC.), which was acquired essentially for free, but which is dreadfully expensive to operate.

  • A crucial need to succeed in the international arena, which means it has to succeed as "Fiat" in the United States - a market it left in disgrace nearly three decades ago.

  • A need to survive and grow until it can take Chrysler public, which won't happen for at least a year.

Let's look at these in more detail.

What makes it particularly tough for Fiat is that there's no "home-field advantage" for the Italian carmaker. Indeed, Italy is the poster child for a Western nation that needs to refinance its sovereign debt.

Italy has the world's third-largest pile of government debt - but only the seventh-largest economy. It is this debt/gross domestic product (GDP) matchup that is going to drive Italy toward the financial cliff known as "default." In my mind, it's not a question of "if," but rather "when" this is going to happen.

Just to refinance the portion of its debt that's coming due this year, experts say that Italy will have to issue an estimated $300 billion in new debt. For some context, this is the same amount of money borrowed by the state of California - I mean, by all of the counties, cities, hospitals, airports, railways and anything else I've missed.

And Italy needs to do this rollover at lower rates, not higher rates (which isn't likely to happen, given that it's becoming a much larger risk. This sum is huge, but it's only a portion of the debt burden being carried by an economy that had a $2.04 trillion (GDP) economy in 2009. With a debt/GDP ratio of 116%, Italy's public debt exceeds its GDP. In all of Europe, only Greece has a higher percentage of debt to GDP.

Italy is sitting on a powder keg of sovereign debt in need of rolling over in 2011 - at the precise time that the country's central bank is facing a world market that's already saturated with sovereign debt. Italy has issued so much national public debt, that it is both "too big to fail" and "too big to bail out." Even more importantly, it may be too big to roll over the debt that it needs to refinance in the New Year.

In the U.S. market, Chrysler has spent decades playing the role of the Rodney Dangerfield of car manufacturers - getting little or no respect. And that's probably with good reason, given the carmaker's bargain-bazaar pedigree (the modern Chrysler was built by combining the largely second American Motor Corp. with Jeep assets plus the Chrysler and Dodge assets). The company has staggered from one crisis to another; in the last five years alone, three outside firms have tried to turn it around.

As one of what once had been the U.S. "Big Three" automakers, Chrysler was put into receivership as the U.S. government had to step in and bail out the U.S. auto industry during the 2008 financial crisis. Today, Chrysler is operated as part of the Fiat group of companies.

Fiat ended up getting Chrysler for free, with the proviso that the Italian carmaker had to assume stewardship of the U.S. carmaker. Fiat viewed this as a chance to return to the U.S. market for the first time in 27 years. Today, new dealerships are being built for the standalone return of Fiat to the American car market.

Fiat needs its U.S. return to go well. You see, while the company is profitable internationally, it doesn't make money in its home market. And, as Fiat Chief Executive Officer Sergio Marchionne candidly stated recently: "We are losing money in Italy [and] we can't go on losing money like this."

In fact, according to IndustryWeek, Marchionne said Fiat would be best-served by closing all its factories in Italy, and outsourcing all its manufacturing to countries outside of Italy. As Italy's largest employer, Fiat is hobbled by a work force with many shortcomings - not the least of which is the fact that the Italian national work force is prone to regular, spontaneous strikes.

That home-market work force isn't efficient, either. Consider that:

  • In Italy, Fiat employs about 22,000 workers to build about 650,000 cars annually - for an ouput ratio of 30 cars per employee.

  • In Brazil, Fiat has a work force of about 9,400, and produces 750,000 cars per year - for an output ratio of 80 cars per worker.

  • And in Poland, Fiat has a work force of 6,100, and turns out about 600,000 cars per year, for a productivity ratio of 98 cars per employee per year.

Given that the Turin-based carmaker is also the largest employer in Italy, as Fiat goes, so goes Italy.

Clearly, Chrysler will have to be a key element of Fiat's growth strategies. Current plans call for Chrysler to conduct an initial public offering (IPO) of stock in 2011 or 2010, giving the U.S. government a chance to recoup some of the bailout dollars it provided to the U.S carmaker - in a similar fashion to the General Motors Co. (NYSE: GM) IPO that took place in November. Hopefully, the financial markets will be strong at that point, because with other nationalized assets - such as GMAC - also going public, there will be a competition for those IPO-investment dollars.

The key takeaway: Fiat needs a new business plan. The company is stuck with a loss-generating home market, and needs to leverage its Chrysler assets if it's to have any hope of remaking itself into an international powerhouse.

You know it's bad when you need to leave your home market, and pin your future on a market that you exited in complete disgrace 27 years before. It's not a good strategy, the odds of success aren't high, and the only conclusion that I can reach is that for anyone who holds Fiat shares - either as U.S. American Depository Receipts (ADRs) or as direct shares listed on a European exchange - now's a good time to "Sell."

Since we're looking at this as a 'pairs trade', let's now examine the other half of our proposed trade:

Ford Motor Co. (NYSE: F).

A Thumbs Up on Ford

When I look at Fiat, I see long lists of challenges and problems - many of them seemingly insurmountable. But when I look at Ford, I see possibilities and potential. Five points in particular underscore Ford's potential as an investment. For instance, Ford:

  • Has recorded $6.7 billion in profits so far this year, more than double last year's year-to-date results at this time.

  • Did not accept government bailout money in 2009 - making the Dearborn-based company that Henry built the only one of the so-called "Big Three" American carmakers to refuse federal handouts.

  • Is on track to gain U.S. market share - which would make 2010 the second straight year that Ford did so.

  • Reported a year-over-year sales gain of 20% in November.

  • Is already expected to do better in 2011 than it did in 2008 or 2009.

Ford Motor Co. - "FoMoCo" to longtime automobile aficionados (i.e. "gearheads") such as myself and Money Morning Executive Editor Bill Patalon - has appeared to do the impossible again and again during the past couple of years. After losing $30 billion between 2006 and 2008, Ford has shown real profits in 2009 and this year, with additional earnings growth expected for 2011.

Ford was the only major U.S. automaker that refused Uncle Sam's bailout entreaties when the U.S. Federal Reserve was handing out cash to major corporations during the liquidity crisis. Instead, the company used the crisis to address cost issues in its corporate structure. It sold off or spun off non-core international divisions. It reinvested in new product lines.

Ford has a nice head start on GM or Chrysler in the realm of new-vehicle research and development, since the two "government motors" companies were forced to slash R&D initiatives during their "reset" periods. Reports, of late, say that Ford has also been very active in addressing its unfunded retirement liabilities.

Ford has become profitable again and - even more importantly - is proactively taking the steps needed to boost its corporate bond rating. These actions will bear fruit, as the cost of borrowing will start to drop.

As noted, Ford has already reported $6.7 billion in profit in the first three quarters of the year. It is using this to pay down its corporate debt load, which ballooned during the economic upheaval of 2008. In fact, Ford has already pared $10.8 billion in debt so far this year - bringing its total debt down to $22.8 billion.

At Friday's closing price of $16.80, Ford shares are trading near the top of their 12-month trading range. But the shares are only trading at 10 times earnings, which is well below the growth rates the company is experiencing in its profits.

And the U.S. car market is looking bullish. Light vehicle sales rose 17% in December to a seasonally adjusted rate of 12.3 million units - signaling a strong recovery. For all of 2010, industry sales are projected to be range from 11.5 million to 12 million units - a major rebound from the historic nadir of 10.4 million units sold last year, says Zack's Investment Research.

All the major automakers - except problem-plagued Toyota Motor Corp. (NYSE ADR: TM)- experienced double-digit sales gains. But Ford paced the field, recording a 24.3% gain. That was more than double GM's results and was nearly 50% better than Chrysler's.

There was a big upswing in demand for pickup trucks and sport utility vehicles (SUVs) - both historical Ford strengths - during the month. In fact, Ford's soaring growth was driven by sales of a new Ford Edge SUV (55.2%), F-Series trucks (26.4%) and Lincoln MKZ crossover (48.1%), Zacks analysts said.

And Down Came the Spider...

By the way, I'll finish the sad story about my first car. In the time I owned it, I replaced the engine, transmission, and even the ignition system - chiefly because they were poorly made and wore out. I also spent a small fortune on bondo and paint in an attempt to stay ahead of the bumper-to-bumper rust that afflicted that little car like an automotive cancer - again, the result of its poor construction.

And that goes back to my comment about the lessons I learned three decades ago still being relevant today. In the end, I could not afford my poor Spider anymore, so I gave it away. That's akin to the challenge Fiat has with Chrysler, which was presented to Fiat at virtually no cost, but is still to expensive to fix.

Daimler AG (OTCPK:DDAIF) owned Chrysler for nine long years. Cerberus Capital Management LP, is the private-equity firm that bought the carmaker in 2007, and that is now trying to sell the Chrysler financing arm that it still owns. Daimler and Cerberus walked away from its multi-billion-dollar investment in Chrysler, much as I did with my hefty investment in the Spider.

Some investments are just too expensive to keep. Fiat's shares are in that category.

Actions to Take: The essence of the "pairs trade" that I'm talking about here is to have investors sell Fiat and buy Ford.

If you have exposure to Fiat - either through its Milan-traded shares, or through the U.S. ADRs that trade on the U.S. pink sheets - end it. If you can arrange for shares to borrow, you might even consider going "short" on Fiat.

If I were still a hedge-fund manager, I would look to pair the Fiat short trade with an offsetting equivalent long trade using a stock like Ford. It is a nice way to get a short on an overpriced Euro-based manufacturer, while at the same time getting the potential added return that a turnaround play such as Ford can provide.

In simple terms, this is all about shorting Europe, and going long on a U.S.-based multinational - making sure that both are in a similar sector. With the continuing contagion that EU countries are experiencing, European countries aren't going to be able to keep rolling over their debt. When the haircut comes, you don't want to be anywhere nearby.

That's why you do want to short Europe, and this trade achieves that goal.

Disclosure: Jack Barnes holds no interest in Fiat or Ford.

Disclaimer: Money Morning and Stansberry & Associates Investment Research are separate companies, and entirely distinct. Their only common thread is a shared parent company, Agora Inc. Agora Inc. was named in the suit by the SEC and was exonerated by the court, and thus dropped from the case. Stansberry & Associates was found civilly liable for a matter that dealt with one writer’s report on a company. The action was not a criminal matter. The case is still on appeal, and no final decision has been made.

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Source: A Profitable Pairs Trade: Short Fiat, Long Ford