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Thursday, November 28, 2013 - 14:30
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Thursday, November 28, 2013 - 14:30

I've Found 2 Stocks That Are Perfect For A Classic 'Pairs Trade'

Thursday, November 28, 2013 - 2:30pm

The life of a Wall Street analyst can be vexing.

Hedge fund managers will take your call only if you have a can't-miss idea to put in front of them. The analysts push their investment committees to help their cause by designating certain stocks as a top pick, or in the case of Goldman Sachs, they get the stock added to the Conviction List.

Yet here's the trouble with this back-and-forth between analysts and fund managers: If a stock pick doesn't work out, they must yank it from the list and admit defeat. As an example, Goldman Sachs just gave up on its Conviction List rating for The Fresh Market (NYSE: TFM), a smaller and less established rival to Whole Foods Market (NYSE: WFM).

Since TFM was first added to Goldman's coveted group of Conviction List stocks in February, it has fallen 15% while the S&P 500 Index has risen 20%. The one-year performance for TFM has been even weaker.

Yet it's the reasoning behind the rating change that should spook any investors that are bullish on Whole Foods. "TFM's expansion into more competitive markets will weigh on results, and rising costs could further pressure (return on invested capital)," note the Goldman analysts.

The key takeaway: TFM is aggressively going into markets where WFM already has a strong presence. And both of these firms are bound to suffer. As Goldman Sachs' analysts add, TFM's "stores opened pre-2013 were in high-income, relatively low-density markets in terms of population and competition. In contrast, more recent openings have been in more densely populated areas that have a higher degree of conventional and specialty competition per square mile, making the battle for traffic even more fierce."

The greatest measure of rising competition: TFM's same-store sales, which consistently rose in the 3% to 4% range in the first nine months of the year, slowed to just 2% in October. Whole Foods' same-store sales growth is more impressive at around 5%, but that has been steadily decelerating from 6% to 7% comps in prior quarters. Again, an increasingly saturated market as The Fresh Market and Sprouts Farmers Market (NYSE: SFM) open more stores is having an impact.

To be sure, Whole Foods has a first-mover advantage, and a long track record of successful operational execution, but a premium valuation is becoming less warranted. Here's how these three firms stack up.

At first glance, you'd suspect that TFM is the better value than WFM, in light of its stronger revenue growth (albeit due to store openings, not comparable-store growth) and more attractive earnings multiple. Whole Foods, trading at around 33 times next year's earnings, appears quite richly valued for any retailer, especially when you consider its decelerating comparable-store growth metrics in an increasingly saturated market.

On second glance, you might realize that Sprouts Farmers market is stunningly overvalued, as it will face the very same competitive pressures. An enterprise value-to-sales ratio over 2.0 is quite unusual for any retailer, let alone one with the 7% to 8% margins on EBITDA (earnings before interest, taxes, depreciation and amortization) that Sprouts generates, according to Goldman Sachs.

To be sure, Sprouts generates some impressive metrics, led by industry-leading sales per square foot. And a faster-growing store count will yield economies of scale that help blunt the impact of the more competitive environment that is emerging. But it's clear that since Sprouts' IPO, which was priced at $18 a share this summer, it opened for trading on an overvalued basis and remains there.

Frankly, I wouldn't want to own this hot stock heading into late January, which is when insiders will be freed up to sell shares as the lockup expiration expires. Shares appear ripe to short, especially in light of the negative turn in competitive dynamics in this space. The current short interest, which is approaching 2 million shares, equates to six days' trading volume.

Even if you fear a direct short position in this ever-rising stock market, you can still profit by pairing it up with a long-oriented position. I'd pair it with The Fresh Market, in light of that grocer's more appealing valuations and still-robust growth profile.

Risks to Consider: These grocers are aiming to tackle the organic/natural end of the market, but traditional grocers such as Kroger's (NYSE: KR) and Safeway (NYSE: SWY) are trying to boost their positioning in this niche as well.

Action to Take --> Whenever you see a major stock price divergence in an industry where the key companies are subject to the same competitive dynamics, an opportunity for a pairs trade emerges. A SFM-TFM pairing is one such example.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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