My favorite type of paired trade is to buy (go long) the best company in an industry and short the worst company. This strategy allows for hedging of a position, so if the entire industry suffers a downturn, the overall damage should be minimized because, theoretically, the gain from shorting the worst company should outweigh the loss from owning the best company. I think paired trades are especially good with cyclical or commodity-dependent stocks where there always seem to be unpredictable external macro factors.
One industry that comes to mind with those conditions is semiconductors, where I see an interesting setup for a paired trade.The long part of this trade will be Lam Research (NASDAQ:LRCX), the maker of semiconductor manufacturing equipment. Lam’s specialties are in etching equipment and wafer cleaning systems. Lam has a market cap of just under $7 billion, but $900 million in net cash for an enterprise value of about $6 billion. LRCX trades for 11.6x free cash flow, and from FY2004 to the trailing twelve month period steadily increased gross margins from 46% to 51.3% and net profit margins from 9.7% to 25.4%, as well as FCF return on capital from 17.1% to 31.9%. Lam has also been aggressively using its cash to repurchase stock, and over $200 million remains allocated for further buybacks. I value LRCX at $57/share, or 17% upside from the most recent closing price.
Applied Materials (NASDAQ:AMAT) is another chip fabrication equipment provider, and one of the larger competitors in the space with an enterprise value of $24.4 billion. AMAT trades for 14.3x FCF, although that 23% premium to LRCX is in spite of 5 year forecasted growth of 15% for AMAT and 20% for LRCX. Gross margins stand at 47%, fewer than 100 basis points above where they were in FY2004. Net margin is 18.5% for Applied Materials, 130 basis points above FY2004’s reading. FCF return on capital is a solid 26.5%, but has slipped from the 30.7% return generated in FY2004. Although Applied Materials is a good company, I believe it is overvalued on a peer-comparable basis and cash flow basis. I value AMAT at $17, or 9% below the most recent closing price.
Nearly any metric used to compare Lam and Applied Materials show that Lam is the better company, yet also the more underpriced stock. I have tried to reconcile this paradox and failed, which suggests that there may be a market mispricing present. Yes, concerns about cyclicality in semiconductors abounds, which is why I believe the smart trade is to buy LCRX and hedge the position with a short on AMAT. At the same time, I can’t help but believe that Lam will go higher, while Applied will need to considerably outperform current implied expectations in order to move the stock price higher. In pairs trade terminology, I am suggesting a short of AMAT as the worst company - but “worst” is relative here, and I don’t mean to say that Applied is a terrible company; I simply think Lam is the superior player and the expectations surrounding the stock are too pessimistic, which presents a good opportunity to get long LRCX.
LRCX/AMAT 1-yr comparison chart