A little over a year ago, I wrote an article here on CalvinAyre.com describing potential pairs trades in the gambling sector. A pairs trade is a strategy that enables the investor to tease out broad market or even industry-specific effects, essentially ‘pairing’ one stock or another. The strategy can be used across all classes of investments, and often is. Institutional investors might use pairs trading to arbitrage differences between commodities on different markets, or bonds issued by the same government but holding different durations. At that level, pairs trading can become remarkably complex; in fact, it was a pairs-based “convergence strategy” that led to the blow-up of Long Term Capital Management in 1998, which led to a minor economic panic in the West.
For our purposes, however, pairs trades can actually simplify investing, since they remove broad market effects. Since gambling stocks in particular are significantly correlated with economic sentiment, any investment in the gambling sector is, in large part, a bet on (or, in the case of a short sale, against) the strength of the world economy. By ‘pairing’ two stocks in the gambling industry – buying shares in one, and selling short sales in the other – the trade becomes much simpler. The play essentially becomes: will Stock A outperform Stock B?
To illustrate the trade, I’ll use a trade I recommended back in March of 2012: long Wynn Resorts (WYNN), short Las Vegas Sands (LVS). At the time, Wynn was struggling, beset by the beginning of the long-running Okada affair, while Las Vegas Sands was roaring along, opening 2012 with an almost interrupted upward movement in its stock price, buoyed by hopes for the new Sands Cotai Central, which would open a month later. These two stocks make a natural pairs trade. Both have extensive exposure to Macau; indeed, the value of their stakes in their Asian subsidiaries represents a strong majority of their overall market value. The US operations of both companies consist mainly of higher-priced and higher-class hotels on the Las Vegas Strip. And both companies are led by respected, long-time casino executives in Steve Wynn and Sheldon Adelson.
Because the two companies are so similar, a pairs trade will neutralize most of the effects of outside forces on the companies. If, for instance, the avian flu outbreak in China harms visitation to – and gambling in – Macau, the share prices of both companies will likely drop. But, in the aforementioned trade I recommend last year, that epidemic would have little effect on the trade. Both stocks would drop; our long position in WYNN might lose four percent, but our short position in LVS would gain a similar amount, as the effect of that news would likely move both stocks in tandem. On the other hand, if April gaming revenue in Macau were to come in higher than analyst expectations, again, our trade would likely be little changed; our long position in WYNN would gain, our short position in LVS would lose, and the net effect would be minimal.
This provides one of the key benefits of the pairs trade – it is a hedged play. In the gambling industry, that is a nice benefit, because gambling stocks can be exceedingly risky investments. Bear in mind that LVS stock went from $120 per share in late 2007 to $1.42 per share in early 2009, at the height of the financial crisis, a decline of almost 99 percent in roughly eighteen months. (For its part, Wynn would lose roughly 85 percent of its value over the same time frame.) But a long WYNN/short LVS pairs trade, over that period, would have returned a modest gain, as the effects of the 2008-09 broad market collapse were teased out.
And, indeed, the WYNN/LVS pairs trade I recommended a year ago has provided a positive return as well. Including dividends, LVS has returned about six percent over the time period; WYNN has returned over thirteen percent. That trade would have returned nearly four percent over the fourteen-month period; hardly anything to get too excited about, but not a bad return considering US government bonds are paying two percent annually and accounting for the downside protection in the trade.
Of course, that examples also shows the downside of a pairs trade; you can tease out positive effects as well. The pairs trade returned less than LVS, the poorer performer of the two stocks in the trade. And given that both the broad market and gambling stocks as a whole returned roughly fourteen percent over the same period, our 3.7 percent return looks rather paltry.
But there have been several long-running, and highly profitable pairs trades available to gambling investors over the last few years. As always with these moves, the question becomes whether to jump on board and ride the trade out; or whether to bet that the trade will eventually have to reverse. It’s hardly an easy decision, Long Term Capital Management, famous for having two winners of the Nobel Prize in economics on its board of directors, would go belly-up because it bet, essentially, that then-popular pairs trades were bound to reverse. They didn’t; and LTCM would lose nearly $5 billion in a matter of months.
Most of the recently successful trades fall under one basic grouping: “long Macau, short US.” This makes sense at first glance, because the Macau gambling industry is so much healthier and more profitable than the US industry. Macau stocks fell hard during the summer of 2012 because growth dropped to the low double-digits in percentage terms; US operators would give up their first-born children to see that kind of growth. Last year, I recommended a trade of long WYNN, and short Isle of Capri (ISLE); that trade has been volatile but, as of this writing, would stand at about break-even. Right now, a similar trade would be to go long LVS, and short Boyd Gaming (BYD). Boyd has nearly doubled over the last six months, fueled in large part by optimism over its exposure to the newly installed iGaming regime in New Jersey. But Boyd only has 10 percent of a joint venture with MGM and bwin.Party Digital Entertainment, and it remains to be seen how exactly online gambling will affect the Borgata, one of Boyd’s key properties. Pairing LVS and Boyd is a bet that the real profits in Macau will continue to outpace the so-far potential revenues coming from New Jersey.
A purer version of “long Macau, short US” is to go long the Macau subsidiaries of US operators – Wynn Macau, Sands China, and MGM China, all of which are listed on the Hong Kong exchanges or through over-the-counter trading in the US – and short the US parents. While Wynn Resorts has actually out-paced Wynn Macau over the last fourteen months – though not by much – this trade would have returned about 18 percent at MGM and 20 percent at Las Vegas Sands. In the case of Las Vegas Sands, for instance, the market value of the Sands China subsidiary – 70 percent owned by Las Vegas Sands – has risen 36 percent since March 2012; Las Vegas Sands itself is actually down slightly over the same time.
This seems likely to reverse, and makes LVS a strong investment on its own, and one that can be hedged by a pairs trade with Sands China if investors are worried about a Chinese economic slowdown, the possible flu outbreak, or other issues. As I noted in a piece for Seeking Alpha in December, between the end of 2010 and the end of 2012, the market value of Las Vegas Sands, less the value of its stake in Sands China (currently worth roughly $25 billion) fell by half. Granted, the Vegas operations have not shown much growth; but Sands Bethlehem has been just fine, and it’s hard to believe that investors in 2010 were forecasting that the Vegas Strip properties would rebound much quicker than they have.
The possible explanation for the weakness of LVS versus its subsidiary is that investors are scared to death of Adelson’s massive “EuroVegas” project, and have elected instead to invest in the Macau-only subsidiary. But the fall in LVS has simply been too steep relative to Sands China, and a pairs trade of long LVS, short Sands China would be a smart play on a reversal.
In MGM’s case, it seems likely that much of the reticence toward the US parent has been due to its multi-billion debt load, while MGM China remained debt-free. That changed, however; MGM China took on its own debt to help finance its new property on the Cotai strip. With MGM a continuing laggard in Macau, the optimism behind MGM China may be tempered, and, like with LVS, a bet on a reversal of the “long Macau, short US” trade would seem wise.
Indeed, overall, the “long Macau, short US” trade may be in some danger, simply because the expectations have changed. There is no doubt that anyone remotely familiar with the gambling industry would rather own a casino that catered to Asian whales as opposed to Midwestern housewives. But at what price? While I’ve been largely against investing in most US-facing operators, there is an interesting contrarian argument to be made that those US stocks could outperform their Macau counterparts. It seems most likely to happen if the US stock market continues to rise; if there is any fear in the market at all, the low-growth, high-debt US operators will likely feel more pain then their Asian counterparts.
In other sectors, interesting pairs trades abound. In Europe, a long position in 888 Holdings (888.L) or Paddy Power (PAP.L) can be matched with a short position in bwin.Party Digital Entertainment (BPTY.L) or Ladbrokes (LAD.L), betting that the continued outperformance and innovation of the former two companies will create better returns than their older, struggling competitors. In the US, larger casino operators such as Penn National (PENN) and Pinnacle Entertainment (PNK) can be paired against their smaller rivals – such as Dover Downs Entertainment (DDE) and MTR Gaming (MNTG) – on the thesis that cannibalization and competition in the US regional market will be a game best played by the largest players.
And last but not least, there is an interesting, somewhat out-of-the-box pairs trade on the pace of US iGaming: long Zynga (ZNGA), short Caesars Entertainment (CZR). Now I’ve hammered both Zynga and Caesars in the past, and truth be told, I’m still not entirely sold on either stock. That said, both stocks move when US legalization progresses. Caesars’ $20 billion in debt and manipulated float generally make it move a bit more. Zynga’s balance sheet, in contrast, is pristine – the company has over $1 billion in cash and no debt. So a “long Zynga, short Caesars” trade provides a hedge to an outright short sale of Caesars. If US iGaming legalization efforts see success beyond the three states currently installing regulated online gambling, or if progress on a federal bill is seen, both stocks will jump, limiting the pain to a Caesars short. If US iGaming should falter, Caesars will likely be forced to spin off its interactive division at a less-than-expected price, causing a big dive; meanwhile, Zynga will drop, but its cash cushion will strongly lessen the blow. While neither stock is a good investment, as a pair, they make an interesting trade. That’s because of the basic nature of pairs trades; Zynga doesn’t have to succeed at online poker, or US iGaming. It only needs to have the effect of US iGaming help it more – or hurt it less – than iGaming affects Caesars. Given the vastly different nature of the two companies’ balance sheets, that seems a reasonable bet to take.
And, essentially, that is what a pairs trade is: a bet on one stock over the other. The simplicity of it makes its enticing; the randomness of it makes it somewhat dangerous. Pairs trades are not suitable for an entire portfolio, but for those people with expertise in a given industry, it allows for a straight-forward, one-on-one wager. Which company will outperform? If you answer that question correctly, a pairs trade will allow you to profit.