A pairs trade on a2 Milk Company Ltd (Australia) (ASX: A2M) and Bellamy's Australia Ltd (ASX: BAL) would have been very lucrative over the past three months.
A pairs trade is when you find two similar investments but you take opposite positions.
For example, three months ago you may have decided Bellamy's shares were expensive and sold them short (remember: short sellers profit from falling share prices). You may also have thought a2 Milk shares were cheap and decided to buy them.
For simplicity, you can see from the chart above that had you made that 'pairs trade' you would have earned almost 18% from your investment in a2 Milk and 63% from your short sale of Bellamy's.
Pretty cool, huh? An 80% return from one idea.
But short selling can be risky since it is akin to having an unlimited interest-bearing loan on shares that you do not own.
Buy: a2 Milk; Sell: Bellamy's?
One strategy investors may be mulling over right now is selling Bellamy's and buying a2 Milk shares. After all, the future of Bellamy's appears uncertain while a2 Milk continues to chug full steam ahead.
Swapping one infant formula maker for another, more diversified, infant formula maker, which both have exposure to China, seems like a smart move.
This is what is known as a relative assessment. And valuing one or more companies against its peers is what we call a relative valuation. These valuations are a quick and convenient way to get a sense of what the market believes is the best expression of an investment idea (e.g. infant formula sales in China).
However, while relative valuation and investment strategies have their benefits, they are not fool proof. In the case of Bellamy's and a2 Milk there is nothing to say Bellamy's shares won't rebound in spectacular fashion next week or that a2 Milk will suffer a setback in China.
Ultimately, to mitigate these risks you have to approach your investment ideas as if you were the CEO of both companies and value them accordingly.
Foolish Takeaway
Bellamy's shares have been heavily sold off in recent months while a2 Milk shares have moved higher. Many investors may indeed be making the switch to a2 Milk.
Now more than ever however I think it is important to do your homework before buying in, and do not let your portfolio become overly exposed to a single theme or idea.
Having said all that, I think a2 Milk is a good company and remains an attractive one to own over the long term. But I would not buy in at today's prices.
