One way to take advantage of inefficiency is to employ a trading strategy called pair trades. Pair trading is a strategy in which you buy the stock in one company and sell the stock of a similar company. For companies in the same industry but different geographies, or that perform similar services but one company is trading at a premium to the other, investors can employ the strategy of pair trades to hedge the specific risk associated with holding a particular stock.
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There are three big drug distributors in the public market: Cardinal Health (NYSE:CAH), McKesson (NYSE:MCK) and Amerisource Bergen (NYSE:ABC). The main line of business for these companies is to act as the go-between for the drug manufactures and the end markets (for example the retail drug stores). The distributors get paid on a fee-for-service basis.
With similar distribution strategies, the ability to garner significantly different fees is rather difficult. Although a couple of these companies have other lines of business, the distributor business is the largest. Thus, these companies should trade at similar P/E multiples.
However, they do not. CAH historically has traded at a premium to the both MCK and ABC, but that premium is currently significantly wide. CAH is trading at a 14.9x forward P/E, above the industry average of 13.7x. Competitors MCK, trading at 13x, and ABC, trading at 14.4x, can be used as a pair trade with CAH, to take advantage of the multiple imbalance.
Commodities are without borders but often companies that explore, mine and produce the commodities trade at premiums or discounts to each other or to the commodity itself. There are various reasons for the trade differentials, but when two companies, both with very high quality producing assets trade vastly different, then a pair trade can be made.
BHP Billiton (NYSE:BHP) is one of the world's largest copper producers. Located in Australia, with assets in Australia, Americas and Africa, BHP, at 19x forward P/E, tends to trade at a premium to its peers (trading at 16x forward P/E). Freeport McMoRan (NYSE:FCX) is the next largest copper producer. Located in the U.S. with assets in Americas, Indonesia and Africa, FCX, at a 9.9x forward P/E, trades a steep discount to BHP and the industry. Thus, a pair trade where you buy FCX and sell BHP can be made to take advantage of the market inefficiency while maintaining an exposure to the copper industry.
The Bottom Line
A pair trading strategy is a useful tool to employ when investors are looking for exploiting discrepancies in valuation. However, when making pair trades, investors must determine why the multiple discrepancies exist between two companies. If inefficiency is analyzed and determined to be unwarranted, then a pair trade can exploit that inefficiency and the investor should benefit. (To learn more, check out Finding Profit In Pairs.)
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