- Borrowed from the world of currency trading, carry trading can be surprisingly profitable in the equity markets.
- With proper risk management, position sizing, and risk management, carry trading on components of the S&P 500 offers superior risk-adjusted return.
- Hospira, Inc. and Frontier Communications Corp. are two prime candidates to engage in an effective equity carry trade.
- HSP yields 0% and is one of the most overvalued names in the S&P 500 index.
- FTR is one of the highest dividend yielders in the S&P 500 index (at 6.1%) and is undervalued.
This spring, University of Chicago researchers took an academic approach to highlight an original idea that sparked my insight into a potential equity market yield-related trading strategy. To make a long story short, the researchers' analysis demonstrated that a "zero-cost carry trade portfolio - one that buys high carry securities and sells low-carry ones - captures a significantly better risk-adjusted return" within an asset class as compared to other models of asset pricing. Traditionally, carry trading is conducted in the arena of foreign exchange, where traders will borrow at lower rates in order to hold higher-yielding currency assets. As long as the spread relationship between interest rates across markets remains steady, there is continual profit to be made. Essentially, this position dramatically reduces the traditional idiosyncratic risks of such investments by only being subject to interest rate risk.
Borrowed from the world of currency trading, carry trading can be surprisingly profitable in the equity markets. With proper risk management, position sizing, and monitoring, carry trading on components of the S&P 500 offers superior risk-adjusted return. Hospira, Inc. (NYSE:HSP) and Frontier Communications Corp. (NASDAQ:FTR) are two prime candidates to engage in an effective equity carry trade. HSP yields 0% and is one of the most overvalued names in the S&P 500 index. FTR is one of the highest dividend yielders in the S&P 500 index (at 6.1%) and is undervalued.
I contend that going short HSP - which trades at 53 times trailing earnings and over 200 times free cash flow - and using the proceeds to go long FTR - which is trading at less than 2 times book value and has great potential for event catalysts in the next few months - will be a profitable deep value long/short equity carry trade that is both attractive on a risk-adjusted return basis and requires relatively little to no capital outlay at underwriting depending on position sizing. If the spread between the two securities remains the same or widens (which would be consistent with the current valuation thesis), underwriters of this trade would have the potential for a free, guaranteed 6.1% yield over time.
For the uninitiated, FTR is a communications company based in Stamford, Connecticut, that provides regulated and unregulated voice, data, and video services to residential, business, and wholesale customers across America. FTR has the potential for significant capital gains in the near future, substantiating the merits of the long side of this particular trade. Recent news of Windstream Communications' (NASDAQ:WIN) decision to unlock value for shareholders and spinoff several assets into a REIT structure has sent FTR and peer shares upward in expectation of a similar strategy announcement by FTR management in coming months. Even further gains could be possible here if and when this speculation and expectation turns to reality. Moreover, there has been speculation of dividend coverage being stable into the near future, contrary to what some critics believe; certainly the company's cash flows would be able to support such a move on the part of management.
HSP is a provider of injectable pharmaceutical drugs and infusion technologies to develop, manufacture, distribute, and market these globally. Recently, the company has actually beat Wall Street guidance, but I would argue that the shares have traded up far higher than their fundamental value as a result. As in the past, this might be a similar situation where expectations far outpace reality and both Wall Street and individual and institutional investors are far too optimistic about the company's prospects. 53 times earnings is too high a price to pay for shares of a company that exhibit such price uncertainty. Critics might contend that one has to pay 60 times earnings for FTR, but this is more justifiable, as book value for this company (for which assets are a primary concern) is only about half of market capitalization. HSP, on the other hand, is trading at nearly 20 times book value.
As with any equity market trade, this strategy would carry investment risks. Potential risks to this investment thesis are several, and the probability of each should be considered to determine the overall expected value of this investment.
HSP may present earnings results that are higher than Wall Street consensus estimates or even the "whisper estimates" that typically are the baseline for earnings expectations. If this is the case, the shares would like increase significantly in price, causing a loss on the short side of this pairs trade. HSP may also declare a dividend to equity shareholders if management believes this is the best way to either support a falling share price or return value to shareholders. If this occurred, not only would the stock see some support and potential upward movement, but the holder of a short position in HSP would also be liable for the dividend payments.
On the Frontier side, if FTR indeed did cut its dividend, there would likely be some movement to the downside in share prices. In addition, this move would make the trade itself less profitable from a carry standpoint. Fundamentals here could also deteriorate in the event of a weak quarter or earnings report.
Finally, shorting HSP would carry considerable additional short risks, aside from the risks of the investment thesis going the wrong way. For instance, in the long run, the equity markets generally appreciate. In the event this short position were open for a long enough time period, inflation's effects would work against it, ceteris paribus. Potential losses are also infinite, unlike a long position. Short squeezes could occur in the event of a positive event, pushing share prices higher and higher as short sellers rush to buy back their shares. Though I believe many of these risks are mitigated by HSP's deteriorating fundamentals, they are still very real and more conservative investors may be better off passing on this one.
On balance, however, I believe the upside potential on FTR far outweighs the downside risk and this carry trade would be a smart one for alpha-seeking equity market investors, especially those with a desire for low-cost, risk-mitigated yield. With the increasing uncertainty that stems from all-time equity market highs, this market-neutral trade could serve as a compelling and comfortable opportunity for both income and capital appreciation. Leveraging this play using options strategies could also prove suitable for certain investors. Best of luck!