Primed To Profit By Pairs Trade: The Long And Short Of It

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Primed To Profit By Pairs Trade: The Long And Short Of It
Primed To Profit By Pairs Trade: The Long And Short Of It

Recession fears, surging inflation, rate hikes, geopolitical unrest, and uncertainty around the globe are prompting investors to sell off investments that have marked the worst first half of a year since 1970.

Year-to-date, the Dow Jones is down more than 14%; the S&P 500 is -19%; and the Nasdaq -26%, with some of their worst performances since the 2020 COVID lockdowns. Only one sector out of 12 is up this year, energy up 27.8%, and even this sector has gotten demolished over the last 4 weeks, falling 23%.

According to State Street Global Advisors, negative sentiment has prompted a decline over the last 36-month average inflows into equities of 30%, resulting in just $91B for Q2 2022, the lowest quarterly figure since Q1 of 2020. This figure is also 53% below Q4 of 2021 and 30% below the five-year quarterly average, as showcased in the below chart.

Selling Out: SPDR Quarterly Fund Flows ($ in billions)

 

SPDR Quarterly Fund Outflows ($ in billions)

SPDR Quarterly Fund Outflows ($ in billions) (Bloomberg Finance, L.P., State Street Global Advisors)

 

Although some sectors like energy experienced rallies this year above 40%, they have come back down, and investors are seeking ways to profit in any market environment, particularly the volatile one we’re experiencing. Coming from the hedge fund world, I am a fan of hedging my bets in bear markets, so I thought an article on pairs trade could be interesting, as a pairs trade helps hedge sector and market risks. In fact, bear markets are just about the best period to short stocks. As the saying goes, a lower tide brings down all ships.

What is a Pairs Trade?

A pairs trade focuses on profiting from two securities with similar characteristics and a high correlation that could benefit amid market imbalances, i.e., pairing two stocks against each other: one long position with great investment fundamentals and one short position with very poor investment fundamentals. Short selling is borrowing a security (lent to you from your brokerage firm) and selling it in the open market. The strategy is to sell the borrowed stock at a high price and repurchase it at a lower price in the future. Once the stock is bought back it is returned to the brokerage firm.

The pairs trade strategy aims to measure picked investments’ spread. For example, my stock picks for this article are The Hain Celestial Group, Inc. (NASDAQ:HAIN), currently trading at a share price of $22.56, and Sanderson Farms (NASDAQ:SAFM), trading at $215.61. Both stocks are in the Packaged Foods and Meats industry. Sanderson Farms has very solid fundamentals, and Hain Celestial has poorer fundamentals. Momentum has been on the side of this trade. In the last four weeks, the short recommendation HAIN is down 5.7%, and the long recommendation Sanderson is up 6%. Year-to-Date, HAIN is down 47%, and Sanderson is up 13%. The tricky part is determining the duration limit. As fear moves the markets, it is essential to closely monitor the stocks in a pairs trade and close the trade when the fundamentals or the directional recommendation has changed. In the case of these two stocks, I would monitor the Factor Grades and the Quant Rating. But when considering a pairs trade, investors should proceed with caution. You can easily find yourself on the wrong end of a trade.

Buyer Beware! Losses tend to accumulate exponentially on the downside rather than the upside, so when making a pairs trade, to mitigate as much risk as possible, you need to perform your investment research and be sure that the short trade is indeed a dog with poor investment fundamentals. Understanding the risks and rules involved in pairs trading and doing the appropriate research to make this a profitable option is critical. Let us dive into the stock picks.

2 Stocks for Pairs Trade

Because consumer staples are defensive and considered recession-resilient, I believe the sector should experience the least impact on margins and profitability during these uncertain times. Year-to-date, consumer staples (XLP) have experienced some of the smallest declines of the varying S&P 500 sectors, down -5.9% relative to consumer discretionary (-28.7%) and technology (-23.9%).

 

S&P 500 Sectors Performance

S&P 500 Sectors Performance (Yardeni/Standard & Poor’s)

 

As inflation continues to rear its head and recession fears mount, essentials like food and beverage will continue to be purchased. Consumers have to absorb price increases, which bodes well for companies in the sector. I have one consumer staple stock on a downward trend with very weak demand and decaying gross margins, Hain Celestial Group. Conversely, Sanderson Farms is the consumer staple stock that is all about meat and packaged foods and has been on a bullish trend since the second quarter of 2022. Two similar consumer staple securities with a high correlation could benefit from a pairs trade in this highly volatile environment.

1. The Hain Celestial Group, Inc. (HAIN)

  • Market Capitalization: $2.09B
  • Quant Rating: Sell
  • Quant Sector Ranking (as of 7/12): 162 out of 187
  • Quant Industry Ranking (as of 7/12): 47 out of 56

A packaged food and meats company, The Hain Celestial Group, Inc. manufactures and sells organic and natural products, including infant formula, plant-based beverages, and desserts, in the U.S. and United Kingdom. Known for its popular brand Celestial Seasonings, this company is on a downward trend despite a solid free cash flow, struggling to gain momentum, with short interest currently at 3.79%.

 

HAIN 1yr Price Performance Chart

HAIN 1yr Price Performance Chart (Seeking Alpha Premium)

 

Following a disappointing 2022 Q3 earnings, Hain stock plunged nearly 20% and cautioned about its future revenue outlook. While the selloff may have been an overreaction, perhaps it foreshadows the headwinds, including plant-based ingredients that are becoming more costly, food shortages, and increased pricing amid inflation that have prompted analysts to reduce their $42.50 fair value estimates. Additionally, European sales fell 8% for the period.

Hain has been flagged as a Sell since May by Seeking Alpha’s quant ratings. As I wrote last year in an article on short screens, the amount of short interest on a stock tells investors the number of shares that are tied up in bearish trades called “shorts.” Investors borrow these shares, then sell them to someone else, hoping the stock will fall and they can repurchase them at a lower price. The current 0.3% borrow rate makes this stock an attractive short-sell candidate, and although HAIN is trading below $23 per share and comes at a C+ valuation, some prudence is required when considering this stock.

HAIN Valuation & Momentum

On specific key valuation metrics, HAIN is attractive. Possessing an overall Valuation Grade of C+, HAIN’s trailing P/E ratio is 18.5x, a -10% difference to its sector peers. Its trailing PEG is 0.06x, -88% below the sector, and the forward Price/Sales ratio is 1.04x. But discount does not always equate to a great stock pick. When looking at the collective metrics for HAIN, including growth, revisions, and momentum, as you can see by the scorecard below, the illustration paints a different picture.

 

HAIN Momentum Grade

HAIN Momentum Grade (Seeking Alpha Premium)

 

HAIN has been on a bearish trend and has lost more than 40% share price over the last year. Seeking Alpha’s quant ratings indicates HAIN is a sell, given its characteristics that have historically been associated with poor future performance. Quarterly, HAIN’s price performance showcases decelerating momentum, four and five times worse than the sector. Not only do HAIN’s shares remain below the 200-day moving average, as investors are selling shares, but the stock’s share price is also falling lower. With already slowing growth and competition in the plant-based foods and health and wellness space, coupled with rising prices and geopolitical concerns in Europe, more headwinds in terms of growth and profitability could be on the horizon.

HAIN Growth & Profitability

In addition to revenue decline, reduced gross margins, and consumers evaluating spending in certain categories as prices rise, cost pressures are creating concerns for companies like HAIN that offer unique food items that can come at a premium cost to shoppers. Not only did it miss its latest earnings, but challenges that include supply disruptions, ingredient and package shortages, and falling confidence in the long-term trajectory of its health business could also pose problems. The most recent EPS of -$0.33 missed by $0.12, and revenue of $502.94M missed by $21.63M, resulting in 13 downward analyst revisions over the last 90 days.

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HAIN Revisions Grade

HAIN Revisions Grade (Seeking Alpha Premium)

 

Competitive dynamics and higher fuel costs amid the conflict in Ukraine have trickled into direct and indirect supply chain disruptions, leading to decreased sales and profits.

“Despite industry-wide supply challenges, we’re maintaining service levels in the 90% range, which is exceeding most of our competitors and allowing us to take share. This was and is a conscious decision, and one that we are confident strengthens Hain for sustainable long-term profitable growth…we continue to face unexpected challenges with ingredient shortages, rising fuel costs, and increased labor expense adding additional disruption costs. To offset these costs, we took more pricing in the quarter. The pricing, however, lagged inflation thereby contributing to the margin erosion in the quarter. The expected impact of these price increases will be fully reflected in Q4 and is part of our go-forward guidance” –Mark Schiller, HAIN CEO.

With financials that are eroding and limited growth in the healthy and plant-based foods industry caused by significant headwinds, based upon the quant ratings and factor grades, this stock is a sell. Hopefully, it proves as such relative to my long pick, Sanderson Farms.

2. Sanderson Farms, Inc. (SAFM)

  • Market Capitalization: $4.82B
  • Quant Rating: Strong Buy
  • Quant Sector Ranking (as of 7/12): 2 out of 187
  • Quant Industry Ranking (as of 7/12): 2 out of 56

Sanderson Farms Inc. has had quite the success and uptrend over the last year, taking advantage of pricing power in this inflationary environment resulting from shortages domestically and amid unrest abroad. Attractive on all factor grade investment characteristics, including value, growth, and revisions, this poultry company is priced low with bullish momentum that stands to benefit from many tailwinds in this environment.

 

SAFM Rating and Factor Grades

SAFM Rating and Factor Grades (Seeking Alpha Premium)

 

Sanderson Farm’s market share is attractive. A Fortune 1000 company and the third-largest poultry processor behind Tyson Foods (TSN) and Pilgrim’s Pride (PPC), food stocks have been gaining as many investors are playing defense with their portfolios. Currently ranked #2 in its sector and industry, SAFM is flying high.

 

Top 10 Poultry Companies

Top 10 Poultry Companies (SAFM Investor Presentation/WATT Poultry USA Survey (March 2021))

 

I included SAFM in a December article about 3 Top Stocks for Any Course when it was trading at $186.98 per share. Since that period, the stock has climbed 15% vs. the S&P 500, down 15%. The company had announced a joint acquisition with Continental Grain in August that baked in a share price of $203 upon completion of the acquisition – no-brainer upside! Since then, the stock has exploded amid sharp increases in chicken and egg prices, resulting in the Department of Justice’s (DOJ) accusation of price-fixing that has created a delay in the acquisition. Regardless of a deal-breaker, barring any outrageous decisions in the case, and weighing the risk-reward potential for this stock, I am optimistic, along with most analysts, that this stock is a strong buy, given the stock’s stellar fundamentals. According to a Seeking Alpha News report:

“Barclays analyst Benjamin Theurer wrote in a note earlier this month that he sees potential upside in a deal break. If Barclays were to value the stock on simple DCF or target multiple, the price target would be $250/share based. The analyst sees modest downside case to $176 and a more optimistic upside case to $324.”

As we review Sanderson Farms’ consistent growth over the years and ability to outperform the market, it’s clear why I believe SAFM is the perfect long for the pairs trade.

SAFM Growth & Profitability

Continued inflation benefits SAFM. SAFM’s fiscal 2022 Q2 earnings crushed expectations with an EPS of $4.34 beating by $1.84 and revenue of $1.13B beating by $86.92M. Whether or not a deal is reached following the DOJ hearing, shareholders could stand to gain even more.

“Sanderson Farms operated very well during the second quarter of fiscal 2021 in all areas of our business. Improved poultry markets more than offset feed grain costs that were significantly higher compared to last year’s record fiscal quarter, resulting in increased operating margins…In addition to improved domestic demand for chicken, export demand also improved during the quarter as a result of higher crude oil prices, improved liquidity as a result of currency valuations and some relief from COVID-19-related restrictions” –Joe Sanderson, SAFM CEO.

 

SAFM Growth Grade

SAFM Growth Grade (Seeking Alpha Premium)

 

Based on SAFM’s Earnings and Growth, it’s no surprise there have been seven FY1 Up analyst revisions over the last 90 days, resulting in an A+ Revisions Grade. In addition to attractive earnings, the company is undervalued.

SAFM Valuation

Boasting an extremely low forward P/E ratio of 4.61x, SAFM is trading 77% below its sector peers and has a trailing PEG ratio of 0.01x, a -97.43%, representing a steep discount relative to the sector.

 

SAFM Valuation Grade

SAFM Valuation Grade (Seeking Alpha Premium)

 

With significant growth and earnings strength on top of a great valuation, this stock’s financial performance has allowed it to pay its shareholders a dividend for 32 years, declaring a $0.44 dividend in May. Its 0.81% forward dividend yield doesn’t seem to be much. Still, the company possesses tremendous dividend safety and dividend growth. With continued rising commodity prices that include grains that impact the company’s ability to hike prices, SAFM is a defensive stock in a lucrative market, with hopes to benefit as the long pick in the pairs trade.

HAIN & SAFM Common Denominators & Opportunities

According to a New York Fed survey, near-term inflation soared to a 6.8% high in June, a peak since 2013. As the Fed intends to raise interest rates over the next few meetings to help curb inflation, the markets have shown signs of a pullback.

What does that mean for consumer spending?

 

Spending Slump Chart

Spending Slump (Bloomberg/Bureau of Economic Analysis)

 

May experienced the first signs of cooling in consumer spending, with a 0.4% drop in goods, despite services increasing. Although demand for goods is not declining, the personal consumption expenditures (PCE) index experienced its smallest gain since November. The slowdown and sensitivity to interest rates are adding to the growing concerns about the economic outlook. Because consumer staple stocks are essential and still very attractive to investors, Hain Celestial Group and Sanderson Farms offer the perfect pairs trade opportunity. As evidenced by the below price performance, the divergence in price is precisely what investors look for when selecting a short and long.

Hain Celestial Group vs. Sanderson Farms 1yr Price Performance

 

HAIN vs SAFM Chart

HAIN vs SAFM Chart (Seeking Alpha Premium)

 

As indicated by the Seeking Alpha Quant Ratings and Grades, HAIN is likely in trouble, while Sanderson Farms is on an uptrend, considered a strong buy. Consider this pairing an option for the worst market since 1970, or pick your own pairing.

Pick a Pair

Investors want the best stocks when markets rise or fall, betting on whether selections will be winners or losers based on collective characteristics. Sanderson Farms and Hain Celestial Group are fundamentally different, which I find beneficial for this pairs trade. Utilizing one stock projected to underperform and absorb losses is a great way to make a profit, regardless of market conditions. An advantage of pairs trading is that investors can completely hedge their bet by selling an overvalued security while purchasing the undervalued stock and limiting the chance of loss. Notably, it can be significantly easier to profit from shorting a stock in a bear market compared to a bull market.

While a lot of emotions are moving today’s markets, as fellow Seeking Alpha Lance Roberts once wrote, “Investing is not a competition. There are no prizes for winning, but there are severe penalties for losing…You are generally better off doing the opposite of what you “feel” you should be doing.”

 

Typically, investors are conditioned and trained to invest on the basis that stocks always climb. In this current environment, many investors are fearful, and negative sentiment is driving the outflows from equities and prices down. Emotional investing can be challenging, but you can thrive in an up and down market, taking advantage of pairs trade, like HAIN and SAFM. Our investment research tools help to ensure you’re furnished with the best resources to make informed investment decisions. Consider identifying stocks with Strong Sell recommendations using our Seeking Alpha’s ‘Rating Screener’ to help you make tactical investment decisions or just to help you diversify into defensive sectors such as Top Consumer Staples.