This is the first in a series tracking a long-short portfolio for equity investors. The portfolio will be updated weekly though investments might not be changed every week. I use long-short investing in my own portfolio with the strategy consisting of approximately 10% of my total equity portfolio. The series will be just as much a learning experience as a practical guide so I encourage any suggestions or ideas within the comments section below.
The strategy can be fairly easy to understand though some technical signals and pairing statistics can complicate the actual procedure. When you buy a stock, you are said to be "long" or have a "long position" in the shares. You do this, presumably, because you believe the price of that stock will increase in value over a given period. If instead you believe the stock will decrease in value, you can borrow shares and sell them to another investor. This process, selling the shares without actually owning them first, is called "selling short," or holding a "short position," in the shares. The long investor must eventually sell his shares and the short investor must eventually buy back the borrowed stock. Just as the long position makes money when the price increases, the short position makes money when the price decreases.
In the long-short strategy, investors sell shares of one company short and use the funds to buy shares of another company. Normally, the strategy is done with two companies working in the same industry and reacting to the same return drivers. Because the investor has a net position of zero in the industry or the stock market, the procedure is called market-neutral. The investor is trying to reduce the effect from a rising or falling market, instead profiting solely from the relative value between two companies' shares.
Exchange traded funds now make it possible for the retail investor to employ the strategy in almost any asset class. I described a currency long-short in a previous article, buying shares of an Australian dollar fund and selling shares of an euro fund, that has returned 13.8% since last October.
On the Long Side…
Joy Global (JOY) is a manufacturer and servicer of mining equipment worldwide. The decrease in metals prices and stimulus plans over the last year has been accompanied by a 43% drop in the company's share price.
The shares could see support going forward as stimulus measures in China start making their way through to the economy and the eurozone agrees to cut back on austerity in favor of targeted growth. The People's Bank of China cut interest rates for the second time in a month last week and the government has increased the speed of approvals for many infrastructure projects across the country.
Shares of Joy Global trade for 8.1 times trailing earnings, well under the median price-earnings of 13.0 for large cap construction and mining manufacturers. The company is extremely well run with a net margin of 13.2% last year, more than twice the average net margin of 6.4% for the industry. Joy's value has caught the attention of other analysts with Bloomberg's Real M&A targeting the company for an acquisition. Using other takeovers in the industry as a valuation model implies a 64% premium on the current share price.
And On the Short Side
Shares of Deere & Company (DE) have jumped over 15% since the beginning of June along with other plays in the agricultural space. A 25% gain in the price of grain commodities due to a record heat wave and drought conditions in the United States has investors betting that farmers will continue to see record cash flows.
The problem is the increase in commodity prices is a supply issue and may not necessarily lead to increased sales for farm equipment. The Food & Agricultural Organization (FAO) revised down world corn production by 7% recently and reiterated estimates for a decrease in wheat production by 3.2% over last year. The group also lowered its estimate for world grain demand by a quarter of a percent for an increase in demand of just 1.8% over last year. Grain prices are increasing, but it is not because of a healthy market. Sluggish demand and decreased production might support prices but it will not put money into farmer's pockets.
The heat wave may result in increased revenues for some in the agricultural sector but most likely not for Deere. The heat, especially around the key pollination period, will reduce yields so farmers will need to increase their use of fertilizers which means business for companies like Potash (POT). The Department of Natural Resources in Indiana is reporting the largest jump in irrigation wells since the 1990s. Where there are new irrigation wells, irrigation equipment will soon be needed which is good news for manufacturers like the Lindsay Corporation (LNN).
Analysts covering Deere are expecting a 37% increase in third quarter earnings per share over the same quarter last year even though year-over-year earnings increases have decreased over the last four quarters and only averaged 25%. The shares are already relatively expensive at 11.2 times trailing earnings and margins are well under those at Joy. The average operating margin over the last three years was 10.2% and the company only made a net of 6.6 cents for every dollar of revenue.
The two companies are not perfect candidates for a long-short trade. Deere gets about 75% of its revenue from the Agricultural & Turf segment while Joy is much more focused on mining equipment. The correlation between the two companies' share prices is 0.90 over the last five years so they do have a tendency to move in the same direction.
There are several exit strategies used by long-short investors. For those trades made on a valuation basis, share prices moving closer to estimated targets will usually trigger a closing of the position. Some traders make their bets based on technical signals like momentum and sentiment, so these signals are also used for a sell point. The trade above is a combination of valuation and event-based, with the event trigger coming in quarterly reports so I will reassess the position after each have reported over the next couple of months. For the portfolio monitoring, I will be using the S&P500 as a benchmark with which to compare returns and will be deducting commission expenses but not accounting for tax effects.