Use this Trade to Beat a Tricky Market

When the market was in freefall in early August, I suggested intrepid investors could score gains by wading into stocks even as many were pulling out. Sure enough, the market went on to rebound later in August, but we’ve hit a rough patch again in early September. With the market still up from those early August lows, it may be time to adopt a different posture: use hedging strategies to eliminate exposure to an up or down market if you simply lack conviction on how the rest of September — and 2011 — will play out.

This makes it a good time to adopt “pair trades,” which means buying (going “long”) on one stock in a sector while shorting shares (that is, borrowing shares at a certain price in the hopes the price will go down, thus creating a profit) of a less appealing rival.

#-ad_banner-#Here are two pair trades I’m focusing on right now.

Pair Trade No. 1
Long: Exide Technologies (Nasdaq: XIDE)
Short: A123 Systems (Nasdaq: AONE)

In a tough economy, riskier business models always get shunned. This is why these two battery makers may be perceived in a very different light in 2012 and 2013. Exide makes traditional car batteries and should post decent results as auto makers maintain or even boost sales volume from current levels. (Exide also benefits from the increasing number of aging cars on the road, many of which have deteriorating electrical systems that go through batteries more quickly than a new vehicle.)

A123 Systems, in contrast, needs two things in order to be successful: Demand for electric vehicles needs to become quite strong in the next few years to propel orders for the company’s advanced lithium-ion batteries, and it needs to hope rivals don’t flood the market with too many of these state-of-the-art batteries. It’s the latter risk that will likely imperil the business model. Asian manufacturers are bringing on so much capacity that the whole industry may struggle to ever reach profitability as prices drop. Analysts don’t think A123 will turn a profit before 2014, and even that forecast relies on fairly optimistic assumptions about supply and demand. Instead, A123 may never actually move into the black, setting this stock up to fall to new lows in coming quarters as forward-looking assumptions get reduced.

Shares of A123 have rebounded nearly 50% since bottoming out in early August on word that GM (NYSE: GM) may look to use its batteries in future vehicles. What’s left unclear is the size of any actual orders and at what price. A123 may find itself yielding to sharp industry pricing pressures and never make a dime on this contract.

Meanwhile, Exide appears set for a nice rebound. The company has struggled recently as a spike in lead prices (the company’s highest material expense) was slow to be passed on to customers. Exide finally put in those price hikes recently, and quarterly results should start to rebound. After losing money in each of the past two quarters, Exide is expected to move back into the black this quarter and see rising profits from there. Taking a broader view, per share profits are expected to more than double in fiscal (March) 2012 and rise another 50% to around $1.15 in fiscal 2013. Shares trade for less than five times that figure.

Pair Trade No. 2
Long: GT Advanced Technologies (Nasdaq: GTAT)
Short: Rubicon Technologies (Nasdaq: RBCN)

Both of these firms make furnaces used to cure silicon and semiconductor wafers used in the solar and chip industries. A quick review of the order book thus far in 2011 shows two companies moving in very different directions… GT Advanced has been signing-up a raft of new customers, building a $1.5 billion backlog that could take upwards of two years to satisfy. Rubicon has had a much harder time lining up fresh orders, in large part because GT Advanced has come up with more advanced equipment and has been wining on head-to-head bids.

To be sure, both companies are expected to boost sales at a mid-teen percentage clip in 2012. And Rubicon’s lack of recent fresh orders won’t bite for another year as it works through backlog. But analysts increasingly think GT Advanced is poised for strong growth in 2013 and beyond, while Rubicon may be hard-pressed to grow at all due to its lagging technology position. Despite this backdrop, GT Advanced is actually the less expensive stock, both in terms of its price-to-earnings (P/E) ratio and enterprise value-to-sales (EV/sales) ratio.

Shares of GT Advanced had surged from $10 to $17 earlier in the summer, but the recent market swoon has wiped out almost all of that gain. Trading at less than seven times next year’s profits, and with an order book that should help boost sales and profits for the next few years, this stock has become too cheap to ignore and looks like a much better rebound candidate than Rubicon when the market finds its footing.

Why do shares of Rubicon look ripe for short sellers? Because the company’s technology platform is not as strong, forcing it to cut prices to win business. Gross margins, which stood at 63% for the first six months of 2011, should fall to 40% by the end of this year, and close to 30% by the end of 2012, according to analysts at Sterne Agee. As a result, earnings per share (EPS) should drop sequentially for the next six quarters, and the company should exit 2012 with an annualized run rate of roughly $0.40 a share. The stock trades for 30 times that figure.

Risks to consider: The two long plays, Exide and GT Advanced, are dependent on the auto, chip and solar industries. If those industries hit an even deeper slump, then sales and profit forecasts for these firms may need to eventually be lowered. That said, GT Advanced’s strong backlog and Exide’s exposure to the replacement battery market mitigate a lot of that risk.

Action to Take –>
It’s time to stop worrying whether the market will hit an even deeper rough patch. There are great “longs” to be had in this market. But if you’re still a bit uncertain, you might as well pair them with the right shorts and protect yourself while still profiting.