The Alcoa, Alcan Relative Value Play
One way for investors to
eliminate
some of the current volatility and uncertainty associated with
making directional bets on individual stocks is to employ relative value
strategies, also known as pairs trades. The strategy essentially isolates the
position risk down to the relationship between two companies–as opposed to
assuming the risk of absolute returns when trading a single stock.
The approach is pretty straightforward and works
like this:
- First, find two companies that are direct
competitors in the same sector or industry. - Second, find characteristics, fundamental or
technical or both, that would favor one company’s performance over the other.
- Third, buy the company that looks stronger and
simultaneously short sell the company that looks weaker. - Fourth, for risk averse investors–consider
buying a put option on the long stock position and call option on the short
position. Once the position is in place, investors will profit if the long
stock moves by a greater amount on the upside or if the short stock moves by a
greater amount on the downside.
Now that I have covered the basics, consider this
relative value play….
Industry:
Aluminum–metals &
mining
Competing companies:
Alcoa
(
AA |
Quote |
Chart |
News |
PowerRating) and Alcan
(
AL |
Quote |
Chart |
News |
PowerRating)
Scenario:
Aluminum is considered an industrial metal since
it is used to produce a wide array of industrial goods, such as aircraft,
automobiles, beverage cans, buildings, chemicals, etc. As a result, the price of
aluminum is well correlated with economic cycles. Current demand for aluminum,
however, remains subdued due to a lack of global demand for industrial
goods–with the exception of China.
China
China is one of the world’s fastest-growing
economies and requires substantial amounts of aluminum to facilitate this
expansion. Although China is a huge consumer of aluminum, it produces the
metal domestically, as its government has been reluctant to rely too heavily on
foreign imports. However, China does not have access to alumina, which is a key
ingredient in finished aluminum. And as a result, it is heavily dependent on
foreign providers for this key material. Moreover, exporters are currently
having a hard time meeting China’s demand for alumina, and prices have started
to increase.
Alcoa
Alcoa is the world’s leading producer of alumina
and is expected to be the main beneficiary of the demand shortfall. And, the
company is expected to significantly increase its alumina production over the
next few years in order to meet Chinese demand and not lose market share;
Chinese demand for alumina is expected to continue for the next few years, as it
continues to build its infrastructure.
Alcan
Alcan’s business is much less dependent on the
sales of alumina and more dependent on demand for finished aluminum
products–which isn’t expected to pick up for the time being.