Underperforming The Market - So Why Am I Sticking With This Trade?

Includes: BTU, DE, JOY, KOL
by: Efficient Alpha

This article updates the long-short strategy portion of my portfolio, begun on July 9th and detailed in a prior article. The strategy is used to remove general market risk from investing, profiting from fundamental differences between two companies. Two companies are selected, both from the same industry or influenced by the same return drivers, with the investor buying shares in one while selling shares in the other.

I started with a long position in Joy Global (NYSE:JOY) a manufacturer and servicer of mining equipment against a short position in Deere & Company (NYSE:DE), the Illinois-based manufacturer of agricultural equipment. While the two companies are not perfectly related, manufacturing different types of heavy equipment, they are highly correlated.

Last week opened nicely with a total gain in the trade as the 8.6% decline in the stock price of Deere, a profit for short sellers, offset the 7.7% loss in shares of Joy Global. The 1% gain on the trade was all the sweeter against the 1.2% loss in the S&P 500 over the period. The late rally in the markets erased gains as Deere jumped 4% on Friday and the market finished up more than 3% on the week. Joy also finished up for the week but not enough to cover losses on the short position. The trade has a net loss of 0.7% on Friday's close and is underperforming the 2.4% gain in the broader benchmark.

China pulls Joy upward while the United States drags Deere down

I still like the trade and will keep it on at least until before Deere reports earnings on August 14th. Shares of Joy took a hit on July 10th when competitor Komatsu said it would not be interested in acquiring the smaller manufacturer. Investors were hoping that an extremely low valuation in Joy would attract suitors and inspire a takeover premium. Despite the loss in the shares on the news, the stock gained 4.8% since then and is still attractively valued at eight times trailing earnings and well-managed with margins above industry averages. The HSBC Markit flash PMI for China increased last month and further data is likely to show that government stimulus is starting to flow through to the economy. This will boost metals prices and the demand for mining equipment.

Deere & Company reports earnings in a couple of weeks with expectations for a 37% increase in 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%. Estimates are for revenue to increase to $9.6 billion, an increase of 24.6% from the same period last year, even though competitor AGCO Corporation (NYSE:AGCO) missed expectations with a sales increase of just 12.5% on their report. I continue to believe that the record heat and drought conditions through much of the United States will weigh on crop yields and reduce the margins on farming operations this year. With less profit on their crops, farmers will be forced to wait on upgrading their equipment and sales for Deere will come down. I will be looking for some acknowledgement of this during the company's earnings conference call but am ready to wait the trade out longer if necessary.

Best of breed versus a troubled industry

I have been following the problems in the coal industry over the last year and believe Peabody Energy (NYSE:BTU) is a good candidate against its peers. Despite revenue and earnings per share roughly in line with expectations, investors did not like weaker guidance for the third quarter and sent shares down almost 18% in two days before regaining some of its losses. The shares are still down 15% over the last month versus a decline of 5% in the Market Vectors Coal ETF (NYSEARCA:KOL). Bears are looking to a boom in natural gas production and environmental regulations as the death of the industry. While a secular change may occur, much of the world is still very much a coal user. Nat gas production and the current operational bottleneck transporting gas from the United States is keeping coal cheap but Europe and Asia are experiencing a different dynamic. Despite a carbon credits program, Europe is burning coal at the fastest pace since 2006.

Peabody has a big advantage over rivals in the industry in its profitability and this should help it not only survive the storm but make competitive progress. The company has a current ratio of 1.48, well above the industry average and allowing it to worry less about near-term debt. Peabody was fortunate, or just plain lucky, to spin off its eastern U.S. assets with the now bankrupt Patriot Coal back in 2007. It kept the more profitable western assets and Australian assets that give it better exposure to growth in China.

The company is fully contracted for its 2012 U.S. production and has 75% of next year's production contracted so cash flows should be relatively stable. The company's operating margin, a key measure of efficiency, is higher than peers at 18% though it is down slightly from prior quarters.

Peabody has an extremely high (0.89) correlation with the coal fund and the performance of this best of breed company should not trail others in the industry. While further pain from low natural gas prices and environmental regulations may cause a secular shift in the industry, Peabody should outperform competitors and the industry fund.


It should be noted that both long trades will be largely driven by a rebound in economic data out of China. Peabody will also benefit from higher natural gas prices in the United States and increasing use of coal for energy in Europe, while Joy Global will move closely with the prices of metals and activity in the mining sector but a major driver will remain China and its recovery. Optimally, a long-short portfolio would be more diversified across drivers and themes but I have not found any others compelling enough to trade on yet.

I will reassess the first trade before and after Deere's earnings report in August and decide whether to exit according to any new developments. The position in Peabody may stay on longer as I believe the outlook for the company and the industry will need to develop over the next few months. Another unseasonably warm winter would represent significant risk for the trade, so I will probably exit before October or November. Otherwise, I will continue to track the portfolio and make regular additions or deletions.

Disclosure: I am long JOY, BTU.

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