Potential pair trades in small- and mid-caps

In a way, long a small cap and short a blue chip is a classic play against the former’s likely superior growth rate.

Just to mix it up a bit, here are some thoughts about potential pair trades in the small- and mid-cap space (i.e. long a stock and short another to make one market neutral, but profiting from one stock’s out performance of the other).

A classic play is guessing that one stock is undervalued and growing faster than another higher rated, but slower growing stock in the same sector, therefore you are betting that one will essentially gain market share and re-rate upwards versus the other.

In a way, long a small cap (like Capitec) and short a blue chip (like ABSA) is a classic play against the former’s likely superior growth rate.

Anyway, theory aside, some disclaimers:

Firstly, I do not short stocks as a general rule, so my use of the word “short” below needs to not be taken literally.

Secondly, some of these long positions I hold in my Small Cap Fund, so I am bias/putting my money where my mouth is.

Finally, here are the thoughts…

Long AdaptIT/Short EOH

Not just do I see AdaptIT as a superior business model to EOH (see here), but the former is trading at a price earnings (PE) of 24.0x versus EOH’s fairly ludicrous PE of 26.7x.

Then there is the significant acquisition that AdaptIT just concluded that will likely add more momentum to its growth trajectory, and suddenly as a relative play ADI is looking a lot hotter than EOH.

Long Rolfes/Short Omnia

Both Omnia and Rolfes supply chemicals, but the former supplies a material portion of these chemicals into the mining sector, while the latter has a much broader base of clients.

While Omnia is on a PE of 10.6x, Rolfes is on one of only 8.4x. Just to add to this, per my models, Omnia is likely to see its Heps recover by c.20% in FY 16E, yet Rolfes (largely due to its game changing Bragan acquisition) looks set to deliver equivalent Heps growth of 60%.

So, not only does Rolfes have better industry exposure and its share is on a lower valuation, but it has better near-term prospects regarding growth.

Long Balwin Properties/Short Calgro M3

Interestingly I actually hold both Calgro M3 and Balwin Properties. That said, the valuation differentials are just too large to be ignored in a collection of thoughts like this.

See my pre-listing note on Balwin here and my last article on Calgro M3 here.

Similar structured business models in different parts of the same market: building homes.

Except, Calgro M3 is on a 17.3x PE and Balwin Properties is on an equivalent PE of c.8.5x.

Long CSG Holdings/Short Adcorp

What if I told you that you could buy a business with double the margins, less debt, more cash and at a lower multiple than an equivalent business?

Well, in a way, CSG Holdings is that to Adcorp.

Both are labour broking businesses in South Africa, but while Adcorp has bulked up its scale and pushed internationally, CSG has built out its services into related industries like cleaning, catering and industrial services.

While Adcorp’s international trajectory looks more glamorous, it has a problem: none of its returns to scale have ever found its way to its bottom line. They are all gobbled up long before they reach there…. See the CAGR of revenues, profits and Heps for 11 years ended FY 15 here:

ADCorp 1

Now compare Adcorp against CSG’s returns in the below graph:

ADCorp-vs-CSG 2

Personally, CSG just looks like a better business.

Also, Adcorp has just put out soft results and its share price looks unlikely to re-rate any time soon for any reason. Yet, CSG is currently trading under a cautionary announcement (probably a material acquisition) and could well re-rate on any positive conclusion of this announcement.

Finally, there is the fact that Adcorp’s script is trading on a PE of 9.1x, while CSG (as the “better business”) is trading on a 8.5x PE.

So, CSG is “better”, more profitable and cheaper than Adcorp.

The above are just some interesting ideas, but like I said, I don’t think you should short any of these shares. You should probably not buy any either. In fact, rather just don’t do anything until you have done your own research.

This article was first published on SmallCaps.co.za here, and republished with permission.


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If one is not to take your use of the word “short” “literally”, then how on earth should one take it?

Why is it that you are long AdaptIT on a 24x PE, but dismiss EOH as trading on a “fairly ludicrous” 27x? 11% difference in multiple, but one is a bargain and one is ludicrous? Or maybe your weren’t being “literal”?

Hi Popper,

The article was written around the long/short theme of pair trading for market neutral portfolios. Hence, I used the term “short”.

In reality, many of these stocks are too liquid to literally short, so rather view this term as implying that they are relatively overvalued.

If you had followed my link on why I see AdaptIT as a much better quality business than EOH, then you would understand my view hereon.

For ease of reference, that link is here: http://smallcaps.co.za/blog/adaptits-edge-over-eoh/

Paying a higher multiple for a worse business model does not make sense to me, hence I prefer AdaptIT, particularly given its IP-rich moat and its higher cash generation than EOH.

Hope that answers your questions..

Kind regards

Thank you Keith. I worked in IT industry from 1997-2004 and saw the formation of EOH. The distinction between the two companies is critical because it comes back to IP and there must be growing international potential in this business. If you are implementing other people’s software e.g. Oracle or SAP, you have to pay them a portion of your licensing fees. When Adapt IT develops their own software, they can keep 100% of the profits.

Thanks Keith. Interesting as always.

Hi Keith,
Interesting article, I like the small & mid cap space.
Mustek, perhaps instead of Adapt, to me looks very undervalued and also looks like it generates superior operating FCF’s. Have you looked at or have any thoughts on Mustek?
Kind regards

Hi Paul,
Thanks. Mustek is really an ICT distribution business, its most relevant comparative is Pinnacle which has seen (what appears to be) market share losses. If you like Mustek, then Pinnacle would be your more logical contra-position on the basis that you see Mustek taking market share away from Pinnacle and/or any Mustek is a better value than Pinnacle.
That said, I’d be careful trading that pair, as Pinnacle seems to be currently event driven as it tries to drive its turnaround and this may push this trade out of equilibrium.
Kind regards

Thanks for your reply
I agree, I wouldn’t short PNC, but rather just be long MST, which I am.
Kind regards

End of comments.



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