Many value investors scoff at the use of relative valuation techniques. At some basic level, the concept of intrinsic value resists any broader concern for prevailing market values. The sharp investor values only this business—relative to its assets or earnings power—and doesn’t worry about what Mr. Market thinks of it and its competitors. And historical stock market valuations would seem to confirm the intuitions of the saavy value investor. Just look at the NASDAQ bubble—what help would it have been to compare the value of a business to its insanely overpriced competitors?
However, recent research suggests that relative value arbitrage does provide market-beating returns. In addition, both Benjamin Graham and Warren Buffett used relative valuation at various points in their investing careers (though one should note that Buffett gave it up relatively quickly). In fact, in the 1960s, Buffett would borrow shares to short from the Treasurer of Columbia, and when asked which shares he wanted, Buffett said “just give me any of them.”
Most simply, the key to relative valuation, and long-short pair trading, is to find two businesses whose prospects are highly correlated. The standard example is Ford and General Motors. For two highly correlated businesses that are priced differently, the assumption is that business correlation will eventually filter into the businesses’ prices, and the arbitrageur can capture this spread.
For Ebay, many point to Amazon as its most correlated competitor. Both generate a substantial portion of their revenue from internet commerce, via the fixed-price sale of a wide array of consumer goods. As of today (2/12/09), Ebay trades at 7.4x its 2008 free cash flow, 1.55x book value, and 5.16x net tangible asset value. Amazon, on the other hand, trades at 20.15x its 2008 FCF, 10.27x book value, and 12.27x its net tangible asset value.
The best aspect about a paired trade is that it gives the investor multiple ways of being right—not only when Ebay’s value increases, but also when Amazon’s decreases. With multiple ways of being right, a value disparity is likely to fade more quickly. And more quickly realizing returns boosts a portfolio’s internal rate of return. It’s hard not to like that.
Coming up next—Ebay’s “Problems”
Disclosure: I, or persons whose accounts I manage, own shares of Ebay at the time of this writing.