Set Up a Pairs Trade With Lowe's and Home Depot

Judging by the response to the Home Depot (HD Quote) third-quarter earnings report Tuesday, with investors pushing the stock down 12.5% to $25, you would think the company's management has no idea how to operate a retail business.

At least not like Lowe's (LOW Quote), which has only lost 11.9% year to date compared with a 50.8% drop for Home Depot. The three-year returns, in which Home Depot shares have fallen 53% while Lowe's has gained 52%, hammer home the diverging paths along which investors have sent these two rival home-improvement retailers.

Granted, Lowe's is benefiting from being the smaller of two, with about 800 stores in 42 states, versus Home Depot's 1,400-store national coverage. Lowe's can still satisfy Wall Street's desire for growth by expanding into fresh territories, but once the expansion inevitably tapers off, will the growth rate be that different? Is Home Depot really about to become K-Mart to Lowe's Wal-Mart? I don't think so. And how can you play this divergence? Pair them up.

What It Means

A "pairs trade" is the simultaneous purchase of one equity and the short sale of another that are in similar businesses. In this case, we're working on the supposition that valuation multiples will converge and the performance and price spread will narrow.

Currently, Home Depot trades at 15.9 times the fiscal 2003 estimate of $1.57, while Lowe's sports a price-to-earnings ratio of 22 times the fiscal 2003 estimate of $1.78. For fiscal 2004, Wall Street expects Home Depot's earnings to rise around 17% to $1.81, while Lowe's is seen growing more than 18% to $2.10.

We can't ignore the possibility of an unlimited loss (the short position can theoretically go to infinity while the long goes to zero) associated with a traditional equity pairs trade, but using options will tilt the risk/reward in our favor.

Here's one possible options strategy. In early trading Wednesday, with Home Depot at $25 and Lowe's trading at $39, you could have bought the Home Depot May 25 call at $3.40 and sold the Lowe's April 40 call at $3.90. Thanks to Lowe's higher stock price, we'll get a net credit of 50 cents, or $50 per pair, even though the shorted Lowe's call is a dollar out of the money and its expiration is one month earlier.