Pairs Trading? 2 Stocks To Buy; 4 To Short

by: Hedgephone

When it comes to pairs trading, finding the exact correlation match or going long the better of two companies doing battle in an industry is a tough strategy in my opinion. Personally, I prefer buying great businesses at good prices and shorting poor businesses at overvalued prices in similar industries as a hedge. Many times, the overvalued business can jump substantially in the short run and if you are overexposed to that stock your losses can mount up in lightening quick fashion in a full blown short squeeze. OpenTable (NASDAQ:OPEN) jumped from $40 a share to $110 a share in less than eight months before collapsing. The stock was clearly overvalued, it was the shorts frantic buying to cover orders that drove the stock into the stratosphere. It is this example that shows why using options or a strict stop loss order policy is key along with strict position sizing limits in your trades.

Most professional hedge fund managers and prop traders limit trades to a certain percentage of their portfolio, and if I can remember correctly most of the "Turtles" shot for no more than 4% in any one trade. I think that's a pretty good rule for pairs trading -- you don't want to get concentrated in a long and short portfolio and you have to watch your correlations and industry news. High short interest/high PE stocks can become the best short investments of all time, but first the power of momentum and early shorts being forced to cover can really rip the faces off of even the smartest short. So figuring in our trading rules, we would come up with a 2% position long in Yahoo (NASDAQ:YHOO) and a 1% position short in LinkedIn (NYSE:LNKD) and a 1% short position in Amazon (NASDAQ:AMZN) as a pairs trade. Likewise, we are looking to put 2% into eBay (NASDAQ:EBAY) and to put a 1% short position on in Qlik Technologies (NASDAQ:QLIK) as well as a 1% short position into athenahealth (NASDAQ:ATHN). Overall, you are only tying up 4% of your equity, because most brokerage accounts will honor this type of trade without margining your account.

2% Long Yahoo - 1% Short LinkedIn -- Yahoo is not a dirt cheap stock but at 18X earnings, which are growing, we think the stock is under-rated when compared with its peers. While Yahoo's forward PE of 16X is not that desirable either, YHOO does have a huge market in the field of eyeballs and page views. Eyeballs and page view are really all that companies like LinkedIn and some others have so I think it's somewhat relevant to the value of Yahoo that the site receives an incredible amount of web traffic, which is 10X that of LNKD. Yahoo is also a good deal less expensive, considering that LNKD is trading for 800X earnings. LinkedIn is certainly not "the same" as Yahoo or anywhere near and apples to apples pairs trade; the valuation discrepancy could make this a great longer-term trade. While we want to play the valuation discrepancy of YHOO and LNKD, we also want to diversify our short exposure so we are adding another short:

1% Short athenahealth -- Athena is an internet based healthcare solutions company with extremely strong revenue growth. With that said, the current valuation of 134X earnings, looks unsustainable over the long run unless ATHN can reverse falling profits and compete with incoming cloud computing competition. ATHN sports an EV/EBITDA of 48X, a price-to-book-value ratio of 10.48X, a 6% profit margin and a 9% return on equity. Though revenue growth clocked in at 33% over the past year, earnings actually fell 27% year over year. Around 20% of the market cap is sold short, which makes this a stock to wait until a correction begins before shorting. You want some confirmation of a major move lower in this name. Otherwise, I would consider selling a bear call spread or buying a put spread to limit your risk. If the market does start to roll over, you can short the stock into a falling market.

2% Long eBAY - 1% Short Amazon -- EBAY is a cheap enough stock at 15X trailing and 14X forward earnings. While eBay is not as fashionable as Amazon among the investment community, among consumers it is still a top gun in the internet retail space. Value seekers across the globe have helped drive eBay to a 48 billion dollar market cap with 35% top line growth over the past year, which is higher than that of AMZN or ATHN, and phenomenal earnings growth of 254% YOY as of last quarter. EBAY is a steal in my view at current levels provided that management can continue to deliver. Pierre Omidyar is a likeable, humble leader who truly believes in philanthropy and the duty to helping others that being that wealthy requires of him on a spiritual level. His salary of $17,000 rivals just about anyone as far as the shareholder alignment aspect of his pay package is concerned, and we really like that type of management style. Omidyar is committed to giving away vast sums of money to good causes, and we think his drive to make the world a better place will propel EBAY shares higher over the very long term.

Meanwhile, we think is a great company, but that AMZN shares are a terrible investment at current prices. Amazon is trading at a 130 PE multiple and we think the company is actually growing at a much slower pace than EBAY. We also think that AMZN management is less centered and humble than Ebay's management team. Overall, we feel that the premium multiple that the market has placed on Amazon should instead be given to Ebay. That's the basic thesis regarding our short in AMZN and long in Ebay, and because both stocks are internet icons we think they will be somewhat correlated enough to lower market risk for this type of trade in order to achieve our market neutral alpha.

1% Short Qlik -- Though QLIK is expected to grow earnings substantially this year, the trailing twelve month PE ratio of 258X earnings should give investors caution enough to avoid the stock at current levels, no matter how robust the future seems for the company right now. The stock offers little in the way of book value or earnings, and the investment looks to me like "betting on the come" rather than a solid long-term investing decision at current levels. Sure, software and internet services to businesses is a high growth market, but we think the risks from competition from cloud computing along with the astronomical multiples on current earnings and book value make QLIK a good short candidate at current levels.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.