Pairing star stocks with short calls

Jean-Philippe Choquette is glad when he finds an overvalued company.

An equities and alternative strategies manager, Choquette is in charge of the North American Market Neutral Fund. The portfolio uses pairs trading — holding long positions in strong securities and shorting underperforming stocks in the same sector — to deliver returns. The fund makes money on the margin between the short and long positions.

The fund’s mandate is a 7% to 8% return, regardless of market conditions. Since its start in 2007, its net annualized return as of 2015 was 7.7%.

The fund isn’t benchmarked, giving the team freedom to choose only the investments they’re confident in. For instance, they don’t have any healthcare or utilities stocks.

“As a traditional equity manager, if utilities or healthcare are 5% of my benchmark, I’ll need to put in at least one or two names,” he explains. Instead, “if we’re not able to identify two healthcare stocks we think can make money, then we’ll just pass the sector over.”

Q: How does market-neutral pairs trading work?

A: In pairs trading, we’ll take a long position in the securities of one company, and short securities of another company. For instance, we’ll pair two oil companies. We think one has potential for upside, and one has potential for downside. This strategy is much less volatile than Canadian or U.S. equity products, because most of those names are correlated, and they all go up or down together. If oil prices go down by 50%, then both stocks will go down, but in pairs trading the goal is to have one company go down less. So if the company I’m long in goes down by 30%, and the company I’ve shorted goes down by 40%, then I’ll have made 10% with that pair. The same can be said in an up market.

If you do pairs trading within the same sector, the goal is for both names to go up — and to own the one that goes up most.

Q: Is it more difficult to be neutral when the market is more volatile?

A: No. We’re cheering for more volatility because there are more opportunities to pair trade within a sector. The last four or five years of low volatility means that when you looked at banks, for instance, the performance spread between the top bank and the worst bank was quite narrow.

Q: How do you manage risk?

A: When volatility goes up, we’ll take smaller positions in stocks. Instead of a pair making up 4% of the portfolio, we’ll go in at 3%. In 2008 and 2009, we significantly lowered our exposure to maintain the portfolio’s volatility target. Since we trade large-cap securities, our positions are easy to adjust. We have a volatility target of about 8%. Compare that to equities, which have had an average volatility of more than 12%, or bonds, which have been at 5% or 6%.

Q: How do you benchmark your performance?

A: We’re targeting a 7% or 8% absolute net return per year, which we’ve been delivering for the last seven years. Whether the market is up 40% or down 40%, we couldn’t care less. We don’t look at peers. We don’t look at other asset classes. We focus on alpha generation.

In general, most of our ideas originate as long positions and then we identify a passive short, which is a company we think won’t go up, and that will isolate us from market movements. For instance, it could be a firm we think is fully valued, and doesn’t have a catalyst that could create value in the short term.

Q: Have you ever changed a pairing?

A: We change pairs weekly or monthly — any time we have new information, such as a competitor entering the market, or a new idea. In reporting seasons, there can be more changes to the portfolio, depending on results, earnings guidance and discussions with management.

For example, we’re extremely focused on free cash flow, so if we can see in our analysis that a company will accelerate free cash flow generation, we won’t hesitate to buy it.

A company that’s stable has 5% free cash flow yield, but we like a company that’s growing slightly and able to produce a 7% free cash flow. But, a company could generate a lot of free cash from a declining revenue base. If a company is producing 7% or 8% free cash flow from a revenue base that’s going down by 10% a year, you know it’s going to stop eventually. Or there could be a company that offers small free cash flow yield from a revenue base that’s going up dramatically, like Gildan Activewear is right now. We know they’re reinvesting heavily in order to grow, so we don’t mind having a position in Gildan.

Q: After materials and energy, consumer goods have the next biggest weight in the portfolio. Why is that?

A: It’s unusual to have a large position in that sector, but right now we have a positive view toward Canadian grocers. In a shaky environment, investors have already put a lot of money toward low-volatility stocks like Dollarama, Couche-Tard and Jean Coutu. We think the next ones to benefit will be Loblaw and Empire, and that the market for grocery stock is getting better. Walmart’s massive expansion is slowing down, and Target is leaving, so there’s good supply-demand balance in the market.

Q: The fund’s stated investment horizon is 12 months. What does that mean?

A: If we don’t think that we’re going to make money with a pair over the next 12 months, then we shouldn’t be invested in it.

Updated August 2016.