RealMoney Silver - Keep on Truckin' With a Pair Trade

Keep on Truckin' With a Pair Trade
By Bill Trent
RealMoney.com Contributor
2/27/2008 10:18 AM EST

My bullish Landstar (LSTR) column from November 2007 represents my most successful pick for RealMoney to date. The stock is up 20%, compared to a 6% decline in the S&P 500. Landstar has also outperformed CH Robinson (CHRW) by 9% since I predicted as much in December, and YRC Worldwide (YRCW) has underperformed the S&P by 10% since I advised looking elsewhere.

Given that my transportation picks seem to be working out better than my others, I decided to push my luck with another long-short idea. This time, I think United Parcel Service (UPS) can continue its recent outperformance relative to FedEx (FDX) .

Two years ago, I wrote briefly about the relationship on my blog, saying:

FDX has greater operating leverage and will continue to outperform as long as the economy continues to expand and trucking capacity remains tight. ... Timing this switch is the difficult part.

Over those two years, the timing has clearly happened. UPS has outperformed FedEx by about 10% since then, and by 25% in the last 12 months.

Other than the operating leverage, I think the stocks are similar enough that a long-short trade would truly offset much of the risks. Clearly the macroeconomic and industry exposures are similar.

FedEx is expected to grow slightly faster (15% compared to 13% for UPS) over the next five years and has a lower P/E multiple. But UPS generates far more free cash flow. The free-cash-flow yield at UPS is 5.3%, compared to just 2% at FedEx. The cash flows can be used to buy back shares, pay dividends, or make acquisitions. All of these could boost the EPS growth rate for UPS. Because of the higher yield, I think there is much less downside for UPS.

Accrual Ratio

Click here for larger image.

Source: Zacks Research Wizard, compiled by William Trent

UPS also tends to have slightly higher earnings quality, on average, than FedEx. I use the accrual ratio, which measures the difference between cash earnings and accounting earnings, as a proxy for earnings quality.

This ratio is less volatile for UPS and tends to be closer to zero in most periods, both of which give me more confidence in the earnings reported by UPS (though earnings quality at FedEx is by no means poor.)

The differences in performance, however, are only relative. Long-only investors have been disappointed by UPS over time, with the shares trading within 10% of the current price for the last two years, and within 20% for the last five. In fact, UPS is almost exactly in the middle of its long-term trading range.

I think the future performance will remain uninspiring. The 5.3% free-cash-flow yield is reasonable and offers some downside protection, but it is not enough to juice returns. At roughly 5 times book value and 16 times earnings, I don't see a huge opportunity for expanding valuation.

The tight trading range has also means there is little advantage to a put-write strategy. Low stock volatility means the March $70 puts offer just over a 1% premium. That isn't enough for taking the risk that the stock falls to the low end of its trading range, though I'd be much more favorably disposed toward UPS if the stock pulled back to $65 or so.

For the reasons outlined above, I think a paired trade going long UPS and short FedEx could continue to work over the next few months.