Pairs Trade: Dell Vs. Hewlett Packard

Stock Tickers: DELL, HPQ

After the news of Michael Dell taking full control back from Rollins by re-assuming the CEO role, it wasn’t just a "that’s great for DELL holders" thought that prevailed.

There is a fairly obvious PAIRS TRADE (see Investopedia definition) that can be exploited here at what may be extreme readings.  PAIRS TRADES are when traders go long one company or index and short another.  In that trade you don’t care about the stock market, you just need your Long choice to either perform better or not as bad as the short.  Now that short term rates are much higher and effect borrowing costs and now that so many merger risks are out there, Pairs Trading has seen a decline in the risk appetite from those who would normally look at them.

But why would this case be different?  For starters, these two companies have seen inverse performance to each other and the spread apart is wider than you would guess.  Merger risks do still exist.  It is still possible that a private equity firm could go in with Michael Dell for a premium buyout in a MBO-LBO, but the company is already valued at more than $55 Billion.  H-P is worth more than $115 Billion.  So unless the game truly has changed these companies are probably not going to be targets of a takeover.  That being said: the PAIRS TRADE you could look at if you are a pairs trader and can stomach the inherent risks here would theoretically be LONG DELL and SHORT HPQ.  There is also the immediate post-news reaction risk that has already removed 5% profit compared to anyone that had this trade on yesterday (DELL is up over 4% this morning and HPQ is down 0.6% today).

You can see in the chart here atthe end of this piece about the performance differentials between the two companies, and your premise would hinge on the fact that the best part of a run has been seen in HPQ and most of the worst has been seen in DELL.  So this is not without risk, but it looks much different compared to trying to do this a year ago or 6 months ago.  Because there has not been stabilization yet you wouldn’t dare enter all of the trade at once because you don’t want the immediate risks and the volatility will be higher in these names today and up until earnings.  There is the earnings event risk in FEB when they both report.  So you would start Nibbling and add to the trade up to your normal amount over a few weeks and not finish adding to a full position until after both earnings are out. 
These trades are not without risk, and the horizon on these is often a year or more.  You also have to set strict limits on how much pain you can take on the initial trade because these very rarely work in the trader’s favor right out of the chute.  If you are wrong you score the double loss.  If the Dell turnaround is somehow not able to take hold then it will be painful.  You have the risk that DELL would risk doing a transformational deal where they go make an acquisition to look more like an H-P and get more into services and consulting than they are in now.  There is also the risk that customers just won’t go back.  There is also the risk that H-P’s regained lead in the PC sales is too difficult to unseat and they have much higher retail presence.  But you are reading financial ideas here so you already know about risks and potential losses. 

We need to use a diclaimer here. This isn’t investment advice and we are not making any formal recommendations, so do your own homework and be patient before making any of your own decisions.  The writer of this article does not hold securities in any of the companies mentioned and has not been compensated by any outside parties to portray any company in any given light or with any bias.  Information has been gathered from sources deemed reliable, but no assurances or guarantees can be made regarding the accuracy of any claims or figures.

Jon C. Ogg
January 31, 2007

Below is a chart from BigCharts.com: