Slope of Hope Blog Posts

Slope initially began as a blog, so this is where most of the website’s content resides. Here we have tens of thousands of posts dating back over a decade. These are listed in reverse chronological order. Click on any category icon below to see posts tagged with that particular subject, or click on a word in the category cloud on the right side of the screen for more specific choices.

Market Neutral Investing in China’s Fast Food Industry (by Dave Pinsen)

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Hey Fellow Slopers,

As I've mentioned in the comment threads here on occasion, I've essentially given up trying to predict market direction in the near term. My gut feeling is to lean toward the bearish side, but my gut hasn’t been that good at market timing. So I’ve started putting cash to work in market neutral trades every couple of weeks.

I’m borrowing a page here from a page here from Short Screen member Marc Mayor, who has run a market neutral portfolio with impressive returns for the last ten years: adding a paired long and short position every two weeks, and then eventually closing out old positions as I add new ones, to keep the portfolio capped at 52 positions (26 pairs). I may exit positions before I get up to that cap, but given the number of positions and the small relative size of each one, if I add stops they will be wide ones.

For today’s market neutral trade I shorted CCSC at $22.80 and bought an equivalent amount of YUM at $50.65. As I’ve done with the last few market neutral trades, I shared the trade idea with subscribers of the Market Neutral Notification List the night before I placed the trade.

CCSC is Country Style Cooking Restaurant Chain Co., Ltd., an upstart fast food chain serving Chinese cuisine in China. CCSC went public in the the U.S. at the end of September at $16.50 per share (above its expected offering range of $14-$16) and spiked up 47% on its first day of trading. It peaked at close to $35 per share toward the end of October, and has plummeted since then.

 

 

Even after this steep drop, CCSC looks pricey, trading at about 6x trailing sales, 57x trailing earnings, and 39x analysts’ average earnings estimate of 2011 earnings (58 cents), with a PEG ratio of 2.09.

CCSC may see additional selling pressure when the lock-up period for insiders ends and they can start unloading shares.

Yum! Brands, Inc. (YUM), operator of KFC, Pizza Hut, and other fast food brands, is the dominant fast food restaurant operator in China, and China is YUM’s largest market.

 

 

YUM breaks out its operating results by three divisions — China, U.S., and International, which covers all of its markets excluding the U.S. and Mainland China. In its most recent quarter, 46% of YUM’s operating profits came from its China division. Operating profits also grew the fastest in its China division, on a year-over-year basis: 24% versus 18% in YUM’s international (ex-China) division, and -2% in its U.S. division.

Of the 3,664 restaurants YUM had in China at the end of its Q3, 3,054 were KFCs and 575 were Pizza Huts. The handful of others were a new concept YUM is testing in China, “East Dawning”, which sounds like it would represent direct competition for CCSC’s restaurants. From YUM’s website:

East Dawning, the company’s Chinese quick-service restaurant brand to provide affordable, great-tasting, authentic Chinese food to the Chinese customer. The East Dawning menu is 100% Chinese and offers a wide range of options for all day parts including breakfast, lunch, dinner and snacks.

YUM isn’t exactly cheap here, but trades at a more reasonable valuation relative to its estimated growth and earnings, with a PEG Ratio of 1.63.

Disclosure: Long YUM, Short CCSC

Downside of Using Stops (by Drew)

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Two ways I try to improve as an investor are reviewing past investing decisions and reviewing constructive criticism. I’ll be doing some of both below.

Back in January, I placed an Altman Z”-Score pairs trade, shorting Trico Marine Services (TRMA) and buying an equivalent amount of Oceaneering International (OII). I had found TRMA on Short Screen’s screener, where it was listed at the time as one of the 25 most financially distressed companies among those with a share price above $5.

As we noted in a recent Seeking Alpha article, Short Screen uses the Altman Z”-Score to rank the non-manufacturing stocks in its database, and the original Altman Z-Score to rank the manufacturing stocks; then Short Screen combines the results into one list, ranking stocks according to their distance from their respective distress thresholds. That article stated the original Altman Z-Score Model:

The Altman Z-Score Model: Z = 1.2X1 + 1.4X2 + 3.3X3 + .6X4 + 1X5

Where,

X1 = Working Capital / Total Assets
X2 = Retained Earnings / Total Assets
X3 = Earnings Before Interest and Taxes / Total Assets
X4 = Market Value of Equity / Total Liabilities
X5 = Sales/ Total Assets

Scores below 1.81 indicate risk of bankruptcy within the next two years; scores from 1.81 to 2.99 are a gray area; and scores of 3 or higher indicate an absence of financial distress.

The problem with applying the original Altman Z-Score model to non-manufacturing companies is that the fifth term, Sales/Total assets, tends to vary widely among non-manufacturing companies. Because of this, the Altman Z”-Score model eliminates the fifth term. It also weights the first four terms differently:

Altman Z”-Score Bankruptcy Model:

Z” = 6.56X1 + 3.26X2+ 6.72X3 + 1.05X4

Where,

X1 = Working Capital / Total Assets
X2 = Retained Earnings / Total Assets
X3 = Earnings Before Interest and Taxes / Total Assets
X4 = Market Value of Equity / Total Liabilities

Scores below 1.1 indicate risk of bankruptcy within the next two years; scores from 1.1 to 2.6 are a gray area; and scores greater than 2.6 indicate an absence of financial distress.

On Short Screen’s screener back in January, TRMA showed a distance from distress of -1.23, consistent with its Altman Z”-Score at the time of -0.13. Looking for stronger companies in its industry (offshore oil field services), I found Oceaneering International (OII), which had an impressive Altman Z”-Score of 9. I shorted TRMA at $5.31 per share and bought an equivalent amount of OII at $64.70. I set 9.5% trailing stops on both sides. A couple of weeks later, I was stopped out of OII for a loss of 9.5%. TRMA was down 16% at the time, and I decided to cover it there, closing out the trade for a modest 6.5% gain.

A couple of days ago, I looked at a blog post of mine where I had embedded a chart of TRMA versus OII. I noticed that the chart for TRMA stopped abruptly in September:

The chart ended abruptly in September because the stock symbol for Trico Marine Services is no longer TRMA, but TRAMQ.PK, the “Q” indicating that the company is in bankruptcy. This chart uses the new symbol:

In hindsight, I made two mistakes there. The first was in using stops. The reason I did was that I knew expert short sellers such as Tim Knight and William O’Neil tended to use tight stops. But as short sellers, those investors are driven mainly by technical analysis. I do take basic technical analysis into account when I invest, but the Altman models are primarily based on fundamentals (save for the numerator in the fourth term of both models, market value of equity).

Dr. Paul Price noted that and offered this constructive criticism: since I was shorting companies based primarily on their fundamentals, and since fundamental factors can take several months or to play out, it didn’t make sense to get stopped out of a position based on short-term share price fluctuations. Seeing the gains I left on the table by closing out this Altman Z”-Score pairs trade too soon underlines Paul’s point. Going forward, I won’t be using mechanical stops on these trades.