Pair Trades and the Search for Absolute Returns

MINNEAPOLIS (Stockpickr) -- Over the past several months, I have offered readers 14 different pair trade combinations for investors interested in generating absolute returns. The general idea with absolute returns is to utilize long and short investments to produce positive results in a portfolio. Investors can theoretically rest easier knowing that capital is preserved while at the same time producing some amount of positive earnings.

So how have my pair trades performed? As one might expect with such a strategy, the results have been mixed. Of the 14 combinations, eight pair trades have done exactly as expected while the other six failed to produce the expected results. Assuming an investor committed $10,000 to each trade beginning on Nov. 8, 2010, the net return of the 14 pair trades was a positive 1.4%.

That might not seem like such a great number, but with respect to the objective of the strategy, the number is quite solid. Remember, the primary goal with an absolute return approach is to reduce risk in your portfolio. During the same period of time, the S&P 500 produced a return of 3.4%.

With such bullishness, it makes sense then that my pair trade recommendations would lag the market. Had the market suffered losses during the period, the long side of the pair trades would have theoretically protected investors. It is interesting to note that one of the absolute return mutual funds that I follow, Quaker Akros Absolute Strategies ( AARFX) has lost 4% of its value since Nov. 8, 2010.

Related: 5 Stocks Setting Up to Break Out

Relatively speaking then, my picks have done quite well. My suspicion is that the Akros fund was overly bearish during the period that backfired as stocks continued to power higher. Instead a balanced approach of buying undervalued stocks and shorting over valued stocks was the wisest absolute return approach.

Let's review of some of those pair trades, including what investors should do moving forward with the stocks involved.

Long Zions Bancorp/Short Piper Jaffray

This was my first pair trade recommendation in early November last year, and it's performing as expected. Zions ( ZION) is up 12.3%, and Piper Jaffray ( PJC) is down 1%. That is exactly the type of performance you should expect from a long and short. Considering the bullish environment in stocks, the most impressive feat of the trade is the loss in Piper.

The conditions in regional bank are improving. At the same time, Wall Street is struggling to generate profits. This particular trade should be maintained by investors going forward.

Long Verizon/Short AT&T

Both Verizon ( VZ) and AT&T ( T) have moved higher benefitting from the boom in smart phones. The long position, Verizon, is up more than AT&T, making this a winning trade.

I expect that outperformance to continue with Apple's iPhone now available on the Verizon network. Rightly or wrongly, the perception is that Verizon is the stronger network and that will benefit longs here for the foreseeable future. Maintain this pair trade.

Long Target/Short Whole Foods

This grocery pair trade, offered up in mid-November, has been a complete disaster. Shares of long position Target ( TGT) have lost more than 15% since the time of recommendation in mid-November, while short position Whole Foods ( WFMI) has gained 17%. Losing on both sides of the trade is not the outcome you want with a pair trade.

That said, I would keep this trade intact. With commodity prices much higher the premium grocery sector is not long for this environment. Target should perform relatively better from here given the consumers desire for savings.

Long Ford/Short General Motors

Both Ford ( F) and General Motors ( GM ) took a step back since mid-November. Both positions were down more than 15%, with Ford being the big loser down 18%. That outcome should not be a surprise given the heady gains in 2010 for the auto sector.

Going forward, I am still comfortable with my preference of Ford over General Motors.

Long Microsoft/Short Yahoo!

In a battle of two tech giants that have been slumbering for much of the new millennium, both Microsoft ( MSFT) and Yahoo! ( YHOO) lost value since I offered this trade in December. Unfortunately, Microsoft lost more.

Yahoo! is down just under 10%, and Microsoft is down more than 12% since Dec. 3. Such performance indicates a continued preference for other tech names such as Google ( GOOG) and Amazon ( AMZN). Microsoft should be doing better given its resources, but that is not the case. Yahoo remains in a difficult competitive position to Google. Its best hope is to be bought by a larger player or financial buyer.

I would close this pair trade. Microsoft has been stuck in a rut for a decade, and the risk of a buy-out premium on Yahoo! is not worth the risk on the short side.

Long Amazon/Short Barnes & Noble

Speaking of acquisition risk, the Amazon ( AMZN)/ Barnes & Noble ( BKS) pair trade has been sabotaged by the bidding up of Barnes & Noble by a potential acquirer. Barnes & Noble is up nearly 50% since Dec. 3. Amazon has gone up as well in the same period (up 6%) but not nearly enough to keep returns in this pair trade on the positive side.

This pair trade should be closed.

Long Caribou/Short Starbucks

The coffee house battle continues with Starbucks ( SBUX) making a solid recovery over the last six months. Since I recommending selling it short on Dec. 22, Starbucks has gained 6%. Tiny rival Caribou Coffee ( CBOU) also gained value in that time, adding 7% to its market capitalization.

Investors in this pair trade have made a small gain. I'm still skeptical of Starbucks and its potential for future growth. Long term there is simply more for Caribou to accomplish. I like this pair trade and would keep it intact.

Long Sirius XM/Short Cumulus Media

Who said pair trades are boring? Investors can make big money when placing a pair trade that delivers on both the long and short side of the equation. That has been the case in spades with my long Sirius XM ( SIRI) and short Cumulus Media ( CMLS) recommendation.

Sirius XM is up 22% and Cumulus Media is down 24% since Dec. 22. Combined, the net result for investors is a huge gain. Clearly the demise of terrestrial radio has had a negative impact on Cumulus, while satellite radio continues to gain traction.

The trend will likely play out for the foreseeable future, but I am recommending that investors close this pair trade. Locking in big gains is never a bad idea.

To see these stocks in action, check out the Pair Trades Update portfolio.  

-- Written by Jamie Dlugosch in Minneapolis.


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At the time of publication, author had no positions in stocks mentioned.

Dlugosch is the editor of Penny Stock Winners. He has over 20 years of experience in financial markets including investment banking, equity analysis and research and money management. In addition to being the Editor of Penny Stock Winners, he is also a Contributing Editor of and founder and editor of The Rational Investor.

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