Case 070Pairs and relative valueHard

In quick delivery, Swiftora's share is heading from 45% to 55% with contribution margin up 3 points, while Kartlo's falls from 30% to 20% with margin down 5 points. Build the long Swiftora, short Kartlo pair: sizing, what it earns if the thesis plays out, and what happens if the whole sector falls 20%.

Coatue ManagementNew York · 2014

The situation

Quick delivery of groceries in Indian cities is a three-player market. Your work on app downloads, dark-store openings and order data says Swiftora's share of order value will rise from 45% to 55% over the next year, with its contribution margin improving 3 points, while Kartlo's share falls from 30% to 20% and its margin worsens 5 points.

Both are listed. Swiftora has a beta to the consumer-internet sector of 1.2; Kartlo, smaller and more leveraged, 1.6. Your PM wants the share view, not a view on the sector, and asks you to size the long leg at Rs 10 crore.

Your task

Size the short leg, estimate what the pair earns if the share shift happens, show what a 20% sector fall does to a beta-matched and a rupee-matched pair, and name the risks.

Quick check

To make the pair neutral to the sector, how large should the Kartlo short be against Rs 10 crore of Swiftora?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Go long Rs 10 crore of Swiftora and short Rs 7.5 crore of Kartlo, matching Rs 12 crore of sector exposure on each side. If the market keeps paying the same for each rupee of order value, the share shift moves Swiftora up 22.2% and Kartlo down 33.3%, earning about Rs 4.72 crore. A 20% sector fall costs the beta-matched pair nothing; a rupee-matched pair would gain Rs 0.8 crore on it, and lose the same in a rally.

Step 1What is the pair actually betting on?

On share moving from one company to the other, not on quick delivery as a whole. Two tea stalls outside the same station both suffer if the station closes; the bet here is that commuters are switching from one stall to the other. If each rupee of order value keeps the same worth, Swiftora's slice grows by 55 / 45, +22.2%, and Kartlo's shrinks by 20 / 30, -33.3%. The margin moves, up 3 points at Swiftora and down 5 at Kartlo, would widen the gap further; leaving them out keeps the estimate conservative and gives you something to say when the PM asks where the extra upside is.

Your view of the share shift, and what it does to each company's sliceSwiftora today45%Swiftora, your view55%Kartlo today30%Kartlo, your view20%+22.2% of its slicemargin +3 points-33.3% of its slicemargin -5 points
Your view takes Swiftora's share of order value from 45% to 55%, +22.2% on its slice, and Kartlo's from 30% to 20%, -33.3%, before counting the 3-point and 5-point margin moves.
Step 2How do you size the short so the sector cancels?

Match beta-adjusted exposurePosition size multiplied by the stock's beta to the sector or market: how many rupees of sector movement the position really carries., not rupees. Rs 10 crore of Swiftora at a beta of 1.2 carries Rs 12 crore of sector exposure, and Rs 7.5 crore of Kartlo at 1.6 carries the same Rs 12 crore on the other side. If the sector falls 20%, Swiftora should fall 24% and Kartlo 32%: the long loses Rs 2.4 crore, the short gains Rs 2.4 crore, and the pair is flat. What is left is the share shift.

The pair: sector exposure netted, the share shift keptRs croreLong Swiftora10.0 cashx 1.2 = 12Short Kartlo7.5 cashx 1.6 = 12Money in each legSector exposure (cash x beta)12 long - 12 short = 0 net sector+2.2+2.5net +4.72Share shift, sector flat-2.4+2.4net 0.00Sector -20%, no shift-0.2+4.9net +4.72Both togetherlongshort
Rs 10 crore of Swiftora at beta 1.2 and Rs 7.5 crore of Kartlo short at beta 1.6 each carry Rs 12 crore of sector exposure, so a 20% sector fall nets to zero and the pair earns about Rs 4.72 crore from the share shift with or without it.
Rs croreBeta-matched: 10 long, 7.5 shortRupee-matched: 10 long, 10 short
Share shift, sector flat+4.72+5.56
Sector -20%, no shift+0.00+0.80
Sector +20%, no shift+0.00-0.80
Share shift and sector -20%+4.72+6.36
The beta-matched pair earns Rs 4.72 crore from the share shift whatever the sector does, while the rupee-matched pair adds a hidden sector bet, gaining Rs 0.8 crore in a 20% fall and losing the same in a 20% rally.
Step 3What can go wrong?

Four things, in order of how often they hurt pairs. First, the short squeeze: a weak, heavily shorted company is a takeover candidate, and a 40% jump in Kartlo costs the short Rs 3.0 crore, most of the thesis gain. Second, betas are estimates, and in a sell-off leveraged names often fall more than their beta says, which helps this pair but hurts it in a rally. Third, borrow on Kartlo may be expensive and can be recalled. Fourth, share data may be wrong. Size the pair so a squeeze is survivable, set a stop on the short leg and recheck the beta ratio monthly.

Where candidates lose it

The frequent mistake is equal rupees on each side and calling it market neutral. Kartlo moves more than Swiftora, so a rupee-matched pair is net short the sector and will make or lose money on sector moves the PM said not to take.

The second is presenting the share view without a valuation link. The pair earns money only if prices move; saying how share maps to value, here a constant worth per rupee of order value, is what turns an industry opinion into a trade.

What the interviewer asks next

  • Kartlo announces a fundraise from a large conglomerate. What do you do with the short?
  • How would you add the margin moves to the thesis return?
  • The platform limits you to 2% of NAV of risk on the pair. How big can it be?

Asked at Coatue Management, Equity Research, New York, 2014 (Wall Street Oasis): eventually that led to the question of who's poised to win and who's doomed to fail within the industry

Company names and figures are illustrative.