A pairs trade in the pub sector

The pub and restaurant sector has seen strong growth in recent years, thanks to a rise in the number of people eating out. However, there are concerns that the fall in sterling is already starting to push up food prices. At the same time, increases to the minimum wage and possible future immigration restrictions could push up staffing costs. Finally, declining beer sales and a possible economic slowdown this year could also hit demand. Still, while the outlook for the overall sector is uncertain, I see an opportunity for a pairs trade (where you go long one stock and short another).

Let's start with the long. Mitchells and Butlers (LSE: MAB) operates several restaurant, pub and bar chains in the UK, including All Bar One, Ember Inns and Harvester, totalling about 1,800 locations, most of which are owned outright. Additional assets include the Innkeeper's Lodge hotel chain and Alex, a group of German bars. The group is trying to boost revenue by increasing the number of upmarket establishments, where it expects most growth to be, and investing in technology that should improve both marketing and customer service.

M&B's share price has declined over the past two years, but now looks attractively valued. It trades at a steep discount of around 28% to the value of its assets (mostly property). Given the demand for additional housing, especially in the southeast, the company shouldn't have any problem selling these sites if it needs to free up cash. It trades on a price/earnings ratio of 11.4, which should fall to seven times forecast 2018 earnings, and offers a solid 3% dividend yield.

Rival pub chain JD Wetherspoon (LSE: JDW) has a very different strategy, targeting the more budget end of the market (although it does have a small hotel chain as well). Its strategy has enabled sales to grow at a rapid rate of about 8% a year, but this part of the market is much more sensitive to any rise in prices. As a result, sales growth is expected to slow substantially in the next few years. Despite that, Wetherspoons is relatively expensive.

Thanks to the share price rising by a third over the past year, it now trades at a price/earnings ratio of 22. Even accounting for projected earnings growth, this means that it will still be trading at over 17 times earnings in 2018. Additional signs that it may be overvalued come from the fact that it has a high price/book value of 5.2 and a low yield of 1.22%.

Since I think Mitchells and Butlers offers more value than Wetherspoons, I recommend buying Mitchells at 249.92p, with a stop loss at 125p. At £4 per 1p movement (though you can of course stake less if you want) this gives you a downside of £499.68. Meanwhile, I'd short JD Wetherspoon at 975.1p, with a stop loss at 1475.1. At IG Index's minimum of £1 per 1p, this gives you a possible downside of £500. The benefit of having one short and one long position is that you are betting on the relative performance of the two shares, not the sector or the market as a whole.

How spread-betting firms deal with dividends

While most spread betters focus solely on share prices, dividends still matter. In theory you should receive a credit from the spread-betting company equivalent to the dividends that you would have been paid multiplied by your stake. So if you are betting on a company at £10 per 1p, and the company pays out a dividend of 5p, the spread-betting firm will pay you £50 (5 10).

Naturally, this works in reverse: if you bet against a company, you will have to pay a sum equivalent to the dividend to the spread-betting firm. Once a firm goes "ex-dividend" the share price is likely to fall by the amount of the dividend, to account for the fact that the owner is no longer entitled to a payment. So a share trading at 105p, should fall to 100p after a 5p dividend is paid. This should cancel out any short-term effects of either receiving or paying a dividend.

One thing to be aware of is that the spread-betting company will deduct part of the dividends that you receive, saying that this is necessary to ensure you don't use spread betting to get around UK taxes on any dividends. While different companies have different policies, a basic rule of thumb is that you will get 90% of any dividend credit, but have to pay 100% of any dividend-related debt. If you want to avoid dividends completely you might want to spread-bet on a futures contract, rather than the current price.

These contracts are based around the price of shares at a specific point in the future, and you don't pay or receive any dividends. However, futures still take expected dividends into account, so the future price of a high-yielding share that pays a dividend soon will be priced slightly below its current price.

An update on our trades so far

At the moment, this page has instigated two open trades: long Brent crude oil (MoneyWeek 828, 20 January) and long gold (MoneyWeek 832, 17 February). Let's take this opportunity to review how they are performing so far.

There is evidence that Opec countries are sticking to their quotas, with Saudi Arabia cutting by more than required to cushion the blow for other member states. As a result, the Brent trade is doing well. The crude oil price has now risen to $56.92, an increase of $1.49 from the original $55.43.

At £1 per $0.01, this means that the trade is now in profit by £149. I'm still confident that the oil price should increase further, with strong global economic growth, and an increase in Chinese consumption, helping to sustain demand. I therefore suggest that you stick with the trade, though you might want to increase the stop-loss from the original $48.50 to $49.50.

The gold trade is also doing well, as the gold price has risen by $20 from the original price of $1,221 to $1,241. At £7 per $1 increase, you should be making a small profit of £140 if you had followed my advice. Although the chances of a rate rise have increased after several Federal Reserve officials dropped hints that the US central bank would adopt a more hawkish stance, I still think that policymakers will be boxed in by the need to keep the American economy growing.

Furthermore, even if the Fed tightens policy, ongoing problems in the eurozone also mean that the ECB is unlikely to follow suit. Global monetary policy is therefore likely to remain loose, which should be beneficial for gold (since the metal does not pay any interest, higher rates make it relatively less attractive, all else being equal). Consequently I'd also therefore stick with the gold trade, only taking profits if it gets to $1,350.