General building material stocks appear promising for constructing* net-short positions because stocks in this industry produced below-trend average return on equity for their price-to-book multiples. (This is based on a prior article, which used a top-down approach to identify industries for long and short positions.) Using this top-down approach as a starting point for constructing a net-short position, attractively-priced stocks and overpriced stocks were identified in the general building materials industry.
Alpha hunters might consider net long positions in industries trading at attractive prices, market neutral positions for fairly valued industries, and net short positions in industries with substantially unattractive valuations. If they are willing to hedge their positions, they can find more investment opportunities than they would by just hoping to find the best stocks to buy today. Instead, they can use fully or partially hedged positions to bet on the mean reversion of different stocks in an industry, while minimizing or reducing exposure to industry and market volatility.
Plots of companies within the general building materials industry reveal that there are some stocks which are more attractively priced than others:
In each of these graphs a measure of quality or growth is plotted on the y-axis as a function of a measure of cheapness on the x-axis. Historical price-to-earnings multiples, price-to-book multiples, and price-to-sales multiples were used as measures of cheapness. Analyst estimates for earnings growth, historical return on equity, and historical sales growth were plotted as measures of growth or quality. More attractive stocks are found up and to the left while less attractive stocks are found down and to the right.
Two above-trend stocks are presented in bold and three below trend stocks is listed in red:
Armstrong World Industries
LSB Industries Inc.
MDU Resources Group
Martin Marietta Materials
Quanex Building Products
Trex Co. Inc.
Universal Forest Products
Vulcan Materials Company
LXU and NX were found to lie among stocks in the upper left of these plots (higher quality, undervalued stocks) while APOG, MLM, and TREX were found to lie at the lower right of these plots (lower quality, overvalued stocks). Based on this work, a net short position in the agricultural chemicals industry can be constructed by buying LXU and NX shares while hedging with a larger total short position in APOG, MLM, and TREX.
Please read the article disclaimer.