As a predominantly "hedged" pairs trader, I am rarely inclined to trade outright long or short stock positions, being more comfortable (and profitable) placing funds into "non directional" market neutral pairs trading ideas that have a proven track record of success.
Such a strategy involves simultaneously trading an "undervalued stock long" against another competing "overvalued stock short" when the two stocks move out of "sync." Such statistical arbitrage (or pairs) trades are popular, tried and tested methods practiced by most true-to-the-spirit hedge funds, quant trading desks and an increasing number of independent self-directed traders.
The process involves application of statistical probability math on two closely related stocks that tend to move together "most of the time" but "temporarily" diverge. At some mathematically fixed "extreme" point of divergence (using standard deviation), the pairs trader buys undervalued stock "A," and shorts overvalued stock "B," in equal dollar value, in anticipation of the pair reverting back to the "mean." This is a basic market-neutral trade based on statistical mean-reversion probability. The goal is to eliminate the broader market directional risk and focus only on whether stock A will outperform stock B.
Such an opportunity is presently unfolding in a pair I continually track within my pairs watchlist - Apple stock (AAPL) versus Netflix (NFLX). On a purely fundamental basis, AAPL is heavily undervalued "relative" to NFLX (I have listed some of the core fundamental metrics below).
There is however, an additional, rare factor, which can be attributed to this particular pair trade, which does not always appear in every pair I uncover - but when it does, provides for a compelling reason - a virtual no-brainer - to enter this pair trade without over analysis. While AAPL operates within a more diverse market of products and services than does NFLX, the almost inevitable, sustainable success of a certain service (the delivery of movies, television and streaming video, which Netflix depends upon almost exclusively) presently pursued in full flow by Apple, has a direct impact on Netflix and provides added weight to the argument in favor of the long AAPL/short NFLX strategy.
Focusing on the fundamentals, many investors who follow my articles/tweets will know I look primarily for strong Free-Cash-Flow-Yield metrics, as a basic starting point for further analysis. This simple to calculate metric measures the Free-Cash-Flow (or FCF) divided by the Enterprise-Value (or EV) of a business.
The FCF is a superior, more accurate reflection of a companys ability to generate profits than the very basic, almost out-dated (at least by professional standards) earnings or EBITDA figure, which is often prone to tactical/questionable carry-back/forward accounting. Similarly, the EV is a superior, more authentic reflection of the worth of a company, than the commonly used market-cap figure. The EV, in simple terms, takes into account the company's debts and cash holdings, effectively revaluing the business based on what a potential acquirer would theoretically pay (the true value).
By dividing FCF by EV, hence calculating the Free-Cash-Flow Yield, investors can quickly measure and identify potential undervalued plays as an excellent starting point for further analysis/diligence (looking at additional fundamentals, long and short term debt, management competence, entrepreneurialism, innovation in product/service, whether the business operates within a growth or shrinking market and so forth).
Moreover, the Free-Cash-Flow-Yield allows quick comparison between several competing stocks (or stocks which directly affect mutual cause-and-effect markets, as in the case of AAPL/NFLX), which, with a little intricate research, starts to unfold some interesting, highly compelling potential market-neutral hedged pair trading opportunities.
At the time of writing, the current Leveraged Free-Cash-Flow figure for AAPL stands at $17.41 billion, with Enterprise-Value being $272.56 billion. The Free-Cash-Flow-Yield for AAPL is hence 6.38%. At the same time, the current Leveraged Free-Cash-Flow figure for NFLX stands at $421.82 million, with Enterprise-Value being $13.39 Billion. The Free-Cash-Flow-Yield for NFLX is therefore 3.15%, almost half of AAPL, providing AAPL plenty of upside relative to NFLX.
Note, with pairs trading, I am not concerned in the least about the overall market direction, whether we are in a bull or a bear market - this is irrelevant - my only point of focus is whether AAPL will outperform NFLX. Even if both stocks tank, but NFLX drops more than AAPL, a net profit is produced.
Additional metrics in favor of the long AAPL/short NFLX trade include the Price-To-Earnings-Growth (or PEG) ratio with AAPL exhibiting an ultra-low PEG of just 0.74 (compared to NFLX PEG substantially higher at 2.58), the Forward P/E ratio (11.34 vs 39.29, in favor of AAPL), the Price/Book ratio (4.91 vs 49.04, in favor of AAPL), and the Debt/Equity ratio (0.00 vs 0.85, in favor of AAPL).
Pairs trading is an ideal strategy if you dont want to play AAPL long as an outright directional trade. Many investors sit on the fence despite knowing the undervalue opportunity AAPL currently offers - anxious about the overall market sentiment, which can (and does) effectively drive many otherwise solid stocks, including Apple, into extended bear market negativity. With a pair trade, much of the directional market uncertainty is neutralized.
By trading stock pairs, whether based on bread-and-butter mean reversion statistical probability (when pairs move outside the mean by 2 standard deviations), or fundamental comparison metrics (such as the AAPL/NFLX pair trade idea), the goal is to insulate against the wider market risk/volatility. Pairs traders are not concerned about overall market sentiment or direction. It does not matter if the stock market (or a sector) rallies, declines or crashes. The only objective is that stock A outperforms stock B.
If you are long A and short B, and the specific industry sector (or the entire stock market) pops, then the loss on the long position in stock A, would be generally counter-balanced by the profitable short position in stock B. The objective is, over time, that the fundamentally superior stock will tend to outperform the weaker, allowing the astute pairs trader to keep his/her head when it seems all others are losing theirs. I am long AAPL, short NFLX, equal dollar value either side.
Enterprise Value/Free-Cash-Flow Data Sourced From Yahoo Finance. Stock Data & Performance Analytics Sourced From TradePilot.com.
Disclosure: Market Neutral, Long AAPL, Short NFLX position held.