Fabrice Taylor, CFA, publishes the President's Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.
Not many investors sell stocks short. That's a shame because shorting can be highly profitable and it can also magnify your returns and reduce the risk of an investment.
Here's an example. I think shares of The Brick are cheap, and I own some. The furniture retailer escaped death four years ago when it was blindsided by the recession. It survived, thanks to some Hail Mary financing from founder Bill Comrie and Fairfax Financial. Today, not only is the balance sheet the picture of health but the company is setting records for earnings. Investors haven't quite fully noticed, though.
A straight investment in The Brick would have been a nice trade over the past couple of years, and it still has lots of legs in my view. But had you bought stock in the company and shorted something else, you might have done even better.
This is the specialty of Jerome Hass, who runs the nimble Lightwater Partners, a small hedge fund. One of Mr. Hass's specialties is the pair trade, which entails going "long " – buying – one stock and "shorting" – selling – another complementary stock it doesn't own.
In this case, he bought The Brick and sold short arch-rival Leon's. It isn't that he thinks there's anything wrong with Leon's: "It's a very well run company," he says. It's that shorting Leon's provided Lightwater with some protection in the event that retailers or stocks in general fell while it owned The Brick.
Mr. Hass wanted to own The Brick because he thought it was cheap. The Brick was generating cash and rapidly undoing the damage caused by the emergency financing.
So Lightwater decided to go long The Brick while shorting Leon's. The effect of this pair trade, in the event that retailer stocks all fell 10 per cent, would be that Lightwater would profit from its short position on Leon's and lose on its long position on The Brick, making the trade a wash. Ditto if retailers all rose 10 per cent.
But if Lightwater's analysts were right about the fundamental value of The Brick, they could profit regardless of the market. They saw in The Brick a stock in the penalty box. Despite gaining market share, it was underpriced versus Leon's on a price-to-earnings basis. No matter what the market did, they would win if the valuation gap closed.
It turned out to be a brilliant call. The Brick is up 165 per cent while Leon's is down 14 per cent. In this case, the fund's cautious approach produced a home run.
And although Lightwater doesn't calculate its returns this way, a pair trade can also magnify profits. When you short a stock, you borrow it, sell it and put the cash in your account. You can use most of that cash (you have to leave some as collateral) to buy something else. In this case, if you'd sold Leon's and bought The Brick with the proceeds, your return on equity would be much higher than if you'd used your own money. Alternatively, you could have use both your money and the proceeds from the short and made more.
The tighter a pair trade – meaning the more complementary the stocks – the better Mr. Hass says. Long Apple, short RIM is an obvious example. There are lots of others, and if you're confident in your picks, these trades can pay off (and they can also burn you if you blow it.)
As for The Brick, it faces headwinds with consumer spending tapering off. But with $150-million in cash securities, annualized cash flow in excess of $80-million, market share gains and a valuation that's still substantially below Leon's, it looks very attractive given a market value of only $480-million. The company is, in my view, likely to reinstate its dividend, probably this year. When it does, the valuation gap vis-à-vis Leon's will close even more.