Recommend Pair Trade of Exelon (Long) and Calpine (Short) 

Pair trade is a new thrust for us even though the McDep Ratio has always been useful for contrasting valuations.  Even Harvard University Endowment gives pair trading respectability.  Listening to the head of money management at the well-known educational institution recently, we conclude that "pair trades", be they in stocks, bonds or commodities, have added billions of dollars to the coffers of higher education.  At the same time it is important to remember that pair trades gone awry contributed to the demise of Long Term Capital Management.   

At a McDep Ratio currently of 0.73, Exelon is quite compelling statistically.  Only two of 30 stocks in our large cap and mega cap coverage appear more undervalued by that measure.  At the other extreme, Calpine's current McDep Ratio of 1.22 is exceeded by only two of 30 stocks.   

Since Exelon is less leveraged than Calpine, one would take a larger position in the equity of Exelon than in Calpine to compensate for financial risk.   

The dynamics that might drive the results of the trade, in addition to valuation, include the relative importance of generation and delivery, the growth rate for electric demand and nuclear versus natural gas.  Generation may be volatile while delivery ought to be more stable.  Exelon is concentrated perhaps one-third on generation while Calpine is all generation.    

Calpine is the aggressive newcomer expanding rapidly.  If growth is slow, Calpine may underperform.   

Existing nuclear is the lowest cost source of electricity.  Our interest in Exelon is the prospect that higher natural gas price will create exceptional profit opportunities for owners of existing nuclear capacity in a less regulated electricity business.   

On the other hand, nuclear has disaster potential as we mention above. Nuclear disaster would also create high demand for Calpine's generation.   

Calpine's new plants generate electricity almost exclusively from natural gas.  As great bulls on natural gas, we should like that and we do.  Calpine's vulnerability is that it does not have gas supplies lined up at a price that assures profitability.   Calpine and others are building huge amounts of new electrical generating plant to be fueled by natural gas.  As a result we expect the natural gas price to be so strong that it dampens the demand for new generation enough to make Calpine's business less profitable than investors anticipate. 

Finally there is no perfect hedge and there is no perfect pair trade.  Yet, we believe that relative valuation is a powerful tool for spotting opportunities.  We hope your "opportunities" are more profitable than unprofitable.