In our earlier blog, we detailed our bearish thesis for global logistics provider Panalpina. Likewise, in the past we have also written about the strategy of short selling and why we think it’s an important tool in the fund managers’ arsenal. Our ability to short-sell, borrowing shares and selling in the belief that we will be able to buy them back at a lower price, enables us to enter into “pair trades”, a strategy that is also inaccessible to long-only investors.
In its simplest form, we sell shares in a company which we believe is overvalued and invest the proceeds in one that we consider to be cheap. Importantly, such a strategy is agnostic to the direction of equity markets.
Markets rise more often than fall but provided the long “leg” rises more than the short leg, the strategy is profitable. Likewise, if markets fall, then the strategy is also profitable provided the long leg falls less than the short leg. A move of the respective share prices in the opposite direction represents the best (or worst) outcome.
Panalpina looked like a good candidate for short selling – overly optimistic expectations with the forthcoming results being a short-term catalyst for share price weakness. Longer term this strategy would be exposed to a positive surprise in global economic growth which would likely boost trade volumes and result in a higher share price and losses for a short-selling strategy.
PAIRS TRADES – COMPARING APPLES WITH PEARS
In researching any company, we typically spend considerable time analysing their close peers. Two freight forwarding companies, Danish listed DSV and Swiss listed, Kuehne & Nagel are sufficiently similar to Panalpina in their global footprint, business mix and comparable financial reporting such that they can be considered good benchmarks for each other. Whilst the future results of each will clearly differ at the detailed level, their common exposure to the economic cycle should be sufficient that pairing the short strategy with a long position in one of these peers should reasonably remove (or hedge) the macroeconomic risk.
Our analysis suggested that an investment in Danish-company DSV would be a suitable pair for the short position in Panalpina. Beyond the macro exposure, the risks remaining in such a pair trade are related to the smaller differences between the respective businesses, management execution of their strategies, and changes in investor perceptions as to their relative valuations. In this context, we note that DSV earns a material proportion of its profits from road-based logistics, a business that Panalpina has little exposure to.
At the inception of the trade, DSV was cheaper than Panalpina on a traditional valuation multiple basis – a 20x forward price-earnings ratio (PER) versus 25x. DSV has been busy integrating a recent acquisition which has been driving its revenue and profit growth. Our expectation was that DSV’s earnings would continue to rise whilst Panalpina’s would fall with share prices likely to follow in the same direction.
OPERATING PROFIT DOWN, SHARE PRICE UP, STRATEGY STILL PROFITABLE
To date, our prognosis of Panalpina’s operating performance has been correct. Management has delivered two profit warnings however the share price did not fall as much as earnings. In spite of earnings falling by 11%, the share price has actually increased by 2% (5% including a dividend paid in May) thus implying a 16% increase in the PER. The short sale considered in isolation has therefore been marginally loss-making.
On the other hand, DSV has had its continued growth rewarded with further PER expansion. Earnings have grown by 15% and the PER has expanded by 11%, resulting in a share price performance of 27%.
In combination, the profit on the long side of this trade has offset the small loss on the short side, resulting in a net gain of more than 30% thus far when the appreciation in the Euro is taken into account (Figure 1).
Figure 1 – DSV price performance relative to Panalpina (in CHF)
Source: Bloomberg, Team Analysis
Whilst the return to date has been good, we expect this strategy to continue to be profitable. We are continually testing our hypothesis that Panalpina’s valuation premium is unwarranted. Both companies face the same long-term organic industry growth opportunity which will likely not deviate much from global GDP growth, and we would argue that DSV is better positioned in the face of technological disruption due to a proactive IT strategy and simple scale advantages.
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Morphic Asset Management is a global equity investment manager based in Sydney. Morphic’s area of specialty is long/short mid cap stocks, which sets it apart from most other global funds offered in Australia.