One of the issues with attempting to pick stocks in the gambling industry is that gambling stocks as a whole are, for obvious reasons, highly correlated to the strength of the broad economy. This means that a position in a gambling stock – whether long or short – can be greatly affected by economic factors well beyond the sector. Given that nearly all casino stocks are “high-beta” – meaning that they rise faster, and fall harder, than the broad market – these economic impacts can outweigh correct assessments of the sector and its individual players. An investor can argue, as I did last week, that MGM Resorts (MGM) stock is overvalued, and fails the “common sense” test. That investor may be right; but if the global economy rebounds, MGM stock is going to rise, barring massive mismanagement at the company. It may not rise as much as its competitors, but a pure short sale of MGM stock against a strong global economy will lose money – even if our thesis that MGM is one of the weakest US casino stocks winds up being correct.
To avoid the impact of extraneous factors, investors in gambling stocks can hone in on their stock-picking abilities by initiating a “pairs trade.” A pairs trade simply entails a “long” position in one stock, with a corresponding – and equal – “short” position in another. These trades are commonly used in arbitrage, where investors attempt to capture short-term inefficiencies between similar securities (for instance, shares of the same company that are traded on different exchanges.) However, pairs trades can also be used to play two stocks in the same sector.
Since the trades essentially cancel each other out – we are long and short an equal amount – pairs trades are “market-neutral,” meaning the effects of the broad market are immaterial to the strategy’s success. A pairs trade is simply a bet that one stock – our long position – will outperform another, similar, stock – our short position.
As an simple example outside the gambling sector, let’s take Coca-Cola (KO) and PepsiCo (PEP). Both companies, being global distributors of beverages, sell similar products to similar markets, and face nearly identical challenges. The stocks are equally dependent on strength in the global economy, and equally sensitive to rises in input costs such as sugar and corn. If we buy $10,000 worth of KO, and short $10,000 worth of PEP, such broad market effects will be cancelled. If the price of sugar spikes, dampening enthusiasm for each stock and lowering their price by 5%, our trade remains unchanged. Our position in KO drops $500; our short position in PEP gains $500, and we are equal. If good economic data starts a worldwide bull market run, boosting each stock by 10%, we again are unaffected. KO rises $1000; our short sale of PEP loses $1000, and our net account stays flat.
The only events that can move this trade are company-specific changes. If KO outperforms PEP, we make money. If it falls behind PEP, we lose. If both companies report earnings, with KO beating expectations and PEP disappointing, KO stock might rise 5%, while PEP drops 4%. In our example, our KO position rises $500, our PEP short sale gains $400, and we, in total, make a $900 profit. Pairs trades allow investors to tease out broad market effects, and focus on a simple thesis: that stock A will outperform stock B.
With a pairs trade, however, the economic effects are removed. If we go long WYNN, for example, and short MGM, the stock market could rise 60% as Obama is re-elected, Iran gives up its nukes, and unemployment drops. Or the market could collapse by 80% as the euro implodes, China falters, and President Romney lays off three-quarters of federal employees. None of that matters, if we are right in our thesis that WYNN is a better stock than MGM.
As such, the pairs trade is especially useful for investors who have inside information on an industry. (Note to the SEC: I said “inside,” not “insider.”) If an investor can correctly identify a trend in the gambling sector, and its effect on the industry’s players, he can use a pairs trade to profit from that knowledge.
A second benefit of the pairs trade is that it provides a hedge against losses. As I noted previously, gambling stocks are notably more volatile than stocks in other sectors. But the neutral nature of the pairs strategy lessens its volatility. If we are short MGM, the stock could easily rise 50%, costing us a substantial amount of money. But if MGM rises, it is highly likely that WYNN – our long position – will rise as well, given the correlation between the two companies and their stocks, mitigating our losses on the short sale of MGM. Granted, the strategy also lowers the upside to the long position, but such upside requires not only a correct play on the gambling sector but on the broader economy as well.
So where do we start in looking for pairs trades in the gambling sector? Let’s start with Macau, since the gambling industry in 2012 will revolve around that island more than anywhere else. This is not news, of course – Macau’s revenue is now five times that of Las Vegas, and it continues to grow, with February showing a 22.3% increase year-over-year. But the market does not seem to understand that, at least not on a valuation basis. Stocks like Las Vegas Sands (LVS) and Wynn Gaming (WYNN), both of which have operations on the island, are trading at roughly similar earnings multiples to US-only operators such as Penn National (PENN) and Isle of Capri (ISLE). Yet Penn and Isle of Capri have no hope of approaching anywhere near the growth in the States that Sands and Wynn will enjoy in Asia.
The trade here is simple: long Macau, short US. Investors can choose their favorite stocks from Macau and the weakest in the US. One way I would recommend is to go long WYNN – on which I remain bullish – and short ISLE. ISLE is up 36% year-to-date, including a nice bounce last week after posting strong third quarter earnings. And yet, at Friday’s close of $6.37, ISLE still has nearly $30 per share in net debt (total debt less cash on hand). Over the past twelve months, taxes and debt interest alone equalled some 35% of its net revenues – money out the door before a single cent is spent on marketing, maintenance, and labor. Isle of Capri has earned just 15 cents per share over the last twelve months – giving it a P/E over 40, compared to WYNN’s still-pricey 26 – and total revenue grew just 1% year-over-year for the first nine months of fiscal 2012 (ending in June). True, Wynn has its own problems right now; but its exposure to the growing Macau market and the strength of its Vegas properties give it growth potential that far outstrips that of Isle of Capri. On every measure – valuation, growth, geography, and execution – WYNN looks far superior to ISLE. If it performs that way going forward, a pairs trade between the stocks would provide a nice return.
There is another interesting – but riskier – way to play Macau against the US: through pairing US stocks with their publicly traded Macau subsidiaries. This can be done by shorting WYNN and buying its Wynn Macau subsidiary (1128.HK), or doing the same with LVS and Sands China (1928.HK), and MGM and MGM China (2282.HK). These trades do add currency risk to the equation, as the Hong Kong-listed shares are denominated in HKD; all else being equal, a strengthening US dollar will negatively impact our trade.
Still, the trade is hedged by the fact that much of the value in the US-listed companies comes from their ownership stakes in their Asian operations. MGM’s stake in MGM China, for instance, is equal to roughly half of its total market cap of about $6.7 billion USD. As such, a 10% rise in the Hong Kong subsidiary would, irrespective of any other factors, result in a 5% rise in the US-listed MGM stock. In our pairs trade, we would make a 2.5% gain simply on the upward movement in the Chinese subsidiary.
Why not simply buy MGM China stock? Again, the two benefits of the pairs trade come into play. First, we are hedged; if MGM China falls 10%, we lose just 2.5%, as the corresponding 5% drop in MGM creates a gain in our short position. Secondly, we are, again, betting that the Macau operations will outperform the US operations. It’s entirely possible that Macau will stay strong, while US economic worries drag down MGM’s Las Vegas properties, creating a larger gain for our overall trade. Should global economic worries cause a slowdown – or market anticipation of a slowdown – in Macau, those same worries will hurt MGM. Given that the US-listed company has nearly $14 billion in net debt, while the Chinese company actually has positive net cash, we are betting on a high-growth company with a strong balance sheet, and betting against a low-growth company with debt that is more than double its market value. These three trades – long Macau operations, short US business – are pure plays on the strength of the growing Asian market, versus the still-tentative recovery here in the States.
The “long Macau, short US” trade appears to be one of the most interesting, and most potentially profitable, strategies in the gambling sector. But it’s far from the only one. Investors with a feel for the gambling industry can use pairs trades to match stocks all over the sector. In Macau itself, pairing Wynn with a short position in Las Vegas Sands (or the same trade through the Hong Kong-listed subsidiaries) is an interesting contrarian play. Yes, Steve Wynn’s feud with Kazuo Okada is making the news, and Wynn stock has struggled over the last few months. Meanwhile, Las Vegas Sands is at a three-year high, closing Friday at $56.38, up 32% since the first of the year. But Wynn has traditionally outperformed Sands, and LVS got the dreaded “kiss of death” from CNBC’s Jim Cramer last week. Cramer called LVS “my favorite casino company,” an unsurprising choice given his usual stock selection process. While I enjoy Cramer’s opinions and antics, and in the interest of shameless self-promotion full disclosure have opened for him on his college tour, the TV personality has two weak spots in his choice of stocks. First, he is a classic momentum player – with LVS rising almost without interruption in 2012, it is a natural play for him. Secondly, Cramer’s remarkable breadth of knowledge of the stock market requires a sacrifice of depth. Yes, Sands is already strong in Macau, with its Cotai Central project coming online this spring – but the market already knows that. The market also knows that Wynn’s own follow-up project is not yet licensed – despite an erroneous SEC filing to the contrary. That is why LVS has been far stronger than WYNN over the last six months – and why contrarian investors might bet against that trend continuing.
These are just a few examples of possible pairs trades in the business; investors who truly understand the global gambling industry have a wealth of possibilities. If you believe, as I do, that the effect of online poker legalization in the US has been overblown, you can pair a long position in Betsson AB (BETSB.SS) with a short position in Bwin.party Digital Entertainment (BPTY.L). This is a bet on the more mature, more stable Betsson, with its emphasis on economically solid Scandinavia and a 5% dividend yield, over the over-hyped, possibly over-valued Bwin.party, whose stock has soared based on potential US profits that seem unlikely to materialize any time soon. Regional US players such as Penn National and Ameristar Casinos (ASCA) can be paired off based on investors’ beliefs in valuation, competition, and cannibalization in the increasingly crowded US market outside of the legacy meccas in Las Vegas and Atlantic City. US slot machine leader International Game Technology (IGT) has competitors such as Bally Technologies (BYI) and small-cap upstart Multimedia Games (MGAM) nipping at its heels. Will IGT rebound and re-take market share, or do Bally’s new games and Multimedia Games’ tribal presence make them better choices going forward? Investors can use pairs trades to play their thesis.
The beauty of the pairs trade is in its simplicity. It is simply one stock against another, with no “noise” from the broader market, world economy, or other factors. It is simply a question of picking the better stock. For investors with a good read on the gambling industry, pairs trades offer a lower-risk way to turn that knowledge into profits.