The Long Stock/Short S&P Pair Trade

How To Minimize ‘Directional’ Risk, By Entering ‘Long’ The Undervalued Stock, And Simultaneously  ‘Shorting’ The S&P 500 Index - By Shiraz Lakhi.

There are two ways of trading stocks – either ‘single-directional’ (long-only, or short-only) speculative positions, which anticipates a selected stock moving in a particular direction along with the rest of the market, or a ‘comparative’ position, which anticipates a selected stock ‘outperforming’ the general market as whole (such as the S&P 500 index).  The latter, provides an advanced, market-neutral method of trading, which wagers on the stock doing ‘better’ than the S&P index, irrespective of whether the particular stock moves up, down, or sideways…

For the investor who wants to advance beyond the conventional, single-directional speculative (‘long-only’ or ‘short only’ positions) trade, and more critically, protect his/her position against the broader market directional risk (corrections, crashes, prolonged negativity), the long stock/short S&P pair trade provides resolve. The strategy involves taking a ‘long’ position in a stock the trader believes will increase in value, while taking a simultaneous ‘short’ position in the the S&P 500 index ETF (symbol: SPY)…

More popularly coined pairs trading, this particular strategy (entering long the stock and shorting the S&P) wagers on the stock ‘outperforming’ the S&P index. Put simply, the investor is not concerned about whether the selected stock will move up or down, but how it will do ‘relative’ to the overall market (S&P). By entering a long position in stock X (preferably one which exhibits robust fundamentals, such as a high free-cash-flow-yield, amongst additional undervalue metrics) and simultaneously entering a short position in the S&P index, in exactly the same dollar value (in other words, if you enter long $30,000 XYZ stock, you would short $30,000 SPY), investors can establish a ‘dollar-neutral’ market-hedged position.

Effectively, no matter which way the overall market moves, whether it corrects, crashes or rallies, direction is of no relevance. In a pairs trade, the single point of focus is purely whether stock X will outperform the S&P. If both the stock and the S&P fall, as long as the stock declines less (in percentage terms) than the S&P, the trade results in a profit. If both the stock and the S&P rise, as long as the stock rallies more than the S&P, the trade results in a profit. Only if the stock ‘underperforms’ relative to the S&P does the trade result in a loss. The objective is, over time, the fundamentally superior stock will tend to outperform the market (S&P index).

Wishing you every success in your trading… and good spirit…

Shiraz Lakhi – Independent Investor/Entrepreneur

Intelligent Investing With The Free-Cash-Flow-Yield

How To Use The “Free-Cash-Flow-Yield” Metric To Capture The Strongest, Most Fundamentally Undervalued Stocks – By Shiraz Lakhi.

Most investors who focus purely on ‘technical analysis’ as a basis to make trading decisions ignore and overlook the ‘fundamental’ values within the stocks they are trading. That’s a mistake, and one which, with a little forward planning, and a few minutes of additional time commitment, can be easily avoided. By maintaining a ‘watchlist’ of the most ‘undervalued’, fundamentally superior stocks, using a few simple, finely tuned metrics, investors are in a much better position to profit from these specific pre-qualified stocks using, as an ‘added’ measure, technical ‘timing’ signals. Better yet, investors will significantly improve the odds of finding the undervalued home-run stocks that provide the best returns.

Whenever I look for a company to invest in, I make it a rule to ‘initially’ focus only on ‘fundamentals’. The key metrics I need to see, which instantly tell me whether a company is worthy of trading (or not) include positive revenue growth year-on-year (which compares the current quarter results to the same quarter the previous year), positive operating income growth (or EBIT) year-on-year, operating ‘margin’ growth year-on-year, and long-term-debt versus working capital (short-term-assets minus short-term-liabilities). This particular metric looks for long-term-debt to be below working capital, and instantly red-flags any company with excessive leverage, which I prefer to avoid. The information for all of the above are readily available via a number of free financial portals, including both Google Finance and Yahoo Finance.

In addition, one of the core metrics I utilize, to fine-tune the fundamental side of my analysis, is to measure the ‘free-cash-flow’ relative to the ‘enterprise-value’ of a company. The process begins by screening an initial universe of around 1,500 US stocks, listed on the NYSE, Nasdaq, and Amex, in order to isolate only those companies with a minimum market-cap of $30m, positive operating income (loss making businesses are removed), and a minimum free-cash-flow-yield of 10% (you will learn more on this in a moment). In addition, I screen for companies which have produced year-on-year revenue, operating income, and operating margin growth, as well as maintained long-term-debt below working capital. This screening process quickly narrows down the original universe of 1,500 stocks, to around 30-40 companies I can practically focus on…

At this point, financial stocks are removed, as are gold/silver stocks, biotechnology companies, and coal stocks. At the core of this particular strategy, as mentioned, is the minimum 10% qualifying ‘free-cash-flow-yield’. This is calculated by dividing a companies free-cash-flow by the enterprise-value. Both the ‘free-cash-flow’ and ‘enterprise value” data points are readily available for most all US stocks, via Yahoo Finance, under ‘key statistics’ (click here for an example snapshot)…

The enterprise-value (EV) is a more accurate version of the commonly used ‘market-cap’. EV measures the true value of a company, from the perspective of a potential buyer of the business. By taking the market capitalization value of a business, then adding the debt, and subtracting the total cash, you get a more exact reflection of what the business is genuinely ‘worth’, and more crucially, what a potential buyer would consider paying to acquire the business. Think about this. A potential buyer of the company would not pay the market cap, but would have to also pay for any debt the company has outstanding, minus keeping any cash.

While the EV provides a valuable indicator of the true ‘worth’ of a business, the free-cash-flow (FCF) provides an indication of the true ‘earnings’ power of the business. The FCF is a more superior, accurate reflection of a company’s ability to generate cash (real, booked profits from actual core operations), than the commonly presented ‘earnings’ data regularly reported within the financial press/media. Net earnings (and the EPS) are flawed metrics, subject to manipulation and bias by management who are more motivated to ‘impress’ rather than exhibit the true operational integrity of a business. There are numerous metrics professionals utilize instead of the ‘net earnings’. These include ‘operating-income’, or similarly, ‘earnings-before-interest-and-tax’ (also known as EBIT), and of course, the ‘free-cash-flow’. All three metrics provide for a more accurate measure of the companies’ earnings than the commonly quoted net earnings and earnings-per-share (EPS).

Relying only on the much touted ‘earnings’ data carries considerable added risk for investors. Earnings can often be subject to questionable accounting tactics, which can obscure the true reflection of ‘operational’ performance, for instance, tactical accountancy can carry forward (and backwards) figures which results in vague information at best. Any serious investor would be doing him/herself an injustice by not delving deeper into the accounts, and relying purely on ‘net’ earnings (or EPS) data.

With regards to the free-cash-flow metric, note, that this figure is also readily available (just like the enterprise-value) for any US listed stock, via Yahoo Finance, under ‘key statistics’. Armed with the FCF value and the EV value, an investor can quickly, and accurately measure the ‘percentage free-cash-flow yield’ a company generates, by dividing the free-cash-flow (FCF), by the enterprise-value (EV), multiplied by 100…

Looking at this in simple terms, assume you are in the market to buy a running business. You look at business “A” for which the owner wants to be paid $70,000 (the ‘price’). On it’s books, the company owes money, to the tune of $40,000 (‘debt). On the plus side, the company also holds some cash reserve of $15,000 (‘cash’)…

So, you do a quick calculation, and see that, in order to acquire the business, you would need to pay the owner his $70,000, add to this the debt which you are taking on, amounting to $40,000, and keep the cash already on the books, totaling $15,000. Therefore, the total ‘true’ cost to acquire the business, better known as the “enterprise-value” is $95,000 (that is $70,000 price ‘plus’ $40,000 debt ‘minus’ $15,000 cash).

Next, you study the companies accounts and see the pure, free-cash-flow generated in the business, which amounts to $18,000. From this data, you see that, for company “A”, the FCF/EV is 0.1894 ($18,000/$95,000). In other words the true percentage ‘yield’ (or the free-cash-flow-yield) is precisely 18.94%. All things equal, for your investment of $95,000, you can expect an 18.94% return.

Another example. You look at another competing business in the same industry, company “B”, for which the owner wants to be paid $110,000 (the ‘price’), plus the debt which the business owes, to the tune of $75,000 (the ‘debt’). In it’s books, the company also holds some cash reserve of $12,000 (the ‘cash’). So again, you do the same simple math, to discover if company “B” offers better value proposition…

You see that, in order to acquire the business, you would pay the current owner her $110,000, add the debt, amounting to $75,000, and keep the cash, totaling $12,000. The net cost to acquire the business (the “enterprise-value”) is $173,000 (that is $110,000 price ‘plus’ $75,000 debt ‘minus’ $12,000 cash).

Once again, you look at the company accounts and see the pure, free-cash-flow generated in the business, which amounts to $37,000. From this data, you punch in the numbers and see that, for company “B”, the FCF/EV ratio is 0.2138 ($37,000/$173,000). In other words the true percentage ‘yield’ (or the free-cash-flow-yield) is 21.38%. All things equal, for your investment of $173,000, you can expect a 21.38% return.

Based purely on these metrics (always subject to further analysis and due diligence), company “B” looks to offer a better value investment opportunity (more ‘undervalued’, by offering a higher ‘yield’) than company “A”.

The free-cash-flow-yield removes much of the defect and questionability inherent in the commonly viewed P/E ratio, and provides a more transparent, mature measurement, from within which individuals can more accurately evaluate equity investments. Moreover, the ‘comparisons’ of free-cash-flow-yield between various competing businesses operating within the same industry, provide an excellent starting point for potential investing ideas when you are looking to ‘pick’ specific stocks within a specific industry or sector.

The free-cash-flow-yield, is one of the three metrics I prefer to utilize in the fundamental side of my research, in order to find qualifying businesses, before applying any technical analysis. The other two metrics are, as mentioned above, the ‘operating-income-to-market-cap’ (which I call ‘operating yield’) and the ‘EBIT/market-cap’ (‘earnings-yield’ based on EBIT). Any one of these three key metrics, applied to a list of companies operating within the same industry, delivers valuable insights into the specific companies I want to invest in.

Added to this, investors can implement a fully hedged long stock/short S&P pairs trading strategy which wagers on the undervalued stock outperforming the S&P index (overall market) without anxiety about market direction.

To summarize, no matter which method you utilize towards seeking out potential stock investment opportunities, be it technical analysis, fundamentals, or a ‘mix’ of the two, it is a good idea to get back to the basics, the nuts and bolts of the ‘operational performance’ (FCF), relative to the ‘true worth’ (EV), of a business, as expressed by the simple-to-calculate, and demonstrated free-cash-flow-yield metric.

Investing in a company, whether short, medium or long term, is no different to buying into a business, which is effectively, precisely what you are doing. As an investor, you need to know what profits are being generated from the ‘operation’ of the core business. If the business generates $50m free-cash-flow, and the enterprise-value is quoted at $800m, then the yield is 6.25%. By comparing this to other businesses within the same industry, you will begin to identify potentially undervalued and overvalued businesses. These simple metrics, more often than not, are the very starting point for evaluating potential mergers & acquisitions.

Wishing you every success in your trading… and good spirit…

Shiraz Lakhi – Self Directed Investor/Entrepreneur


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