When I first started the `Retire Young` portfolio, my first stock pick was Monster Beverages (NASDAQ:MNST). Many readers commented by saying that I was "playing with fire" by picking highly volatile stocks in order to beat the market and that my portfolio would most likely to be a loser portfolio. Then my other stocks were introduced, such as The Walt Disney Company (NYSE:DIS) which I introduced in my last article. This time, the readers commented that I can't beat the market by investing in a bunch of "low risk" companies. It seems like, while some people think I'll make a portfolio of a bunch of highly volatile and risky stocks, others started to think that I was coming up with a portfolio of low-risk companies.
The fact is far from both of these approaches. I am building a portfolio of companies with solid income that are somewhat under-appreciated by the market. Some of these companies will be high-growth companies; some will be low-growth companies. Some will have higher risk than others. While the amount of risk taken is usually correlated with the amount of possible returns, this is not always the case. The goal here is to find the outliers which present relatively high return potential while relatively low risk. This is the only sure way to beat the market.
Now I am going to introduce a company that may have a higher risk potential than Disney but a lower risk potential than some other "risky plays." Surely this company has its own problems and issues to deal with; however, luckily many of these problems and issues are already baked in the current share price of the company. Let's add this company to our portfolio.
Introducing Hewlett-Packard (NYSE:HPQ)
Hewlett-Packard is a well known company in the technology world that's been suffering from a variety of problems for the last few years. The company made several bad decisions including, but not limited to, bad acquisitions, and it ended up changing its CEOs more often than many companies change their shift managers. Furthermore, the culture of HP was suffering as the company chose to run multiple rounds of lay-offs where thousands of highly skilled employees got punished for the company's bad performance. In addition, the ever-declining PC market isn't looking that great for the HP's future. Then why are we adding this company to our portfolio where the goal is to beat the market by a large margin?
There are two ideas behind my logic of investing in Hewlett Packard. First, most of the company's troubles are already known by the market and they are already baked in the current share price. Second, things seem to be getting better under the current leadership at the company. Unless things get a lot worse at HP, the share price shouldn't fall much lower. On the other hand, if things improve just slightly, the share price can appreciate greatly, which is evidenced by the appreciation we've been seeing in the company's share price since the beginning of the year.
Last year, HP posted a huge loss but the loss was due to write-offs that resulted from some terrible acquisitions of the previous management. When we look at the company's cash flow, HP was highly profitable. In fact, HP currently trades for 3.4 times its cash flow in 2012 and 0.3 times its revenues in the same year. As for 2013, the company is looking at a forward P/E ratio of 5.7. Many people act as if HP derives most of its revenues and profits from selling computers, but the company has many different successful lines of business that make it profitable. HP sells many different technology products and services to businesses and individuals, which means that it is not highly dependent on the revenues that will be generated from selling PCs. The decline we've been seeing in the PC market is surely detrimental for HP, but the blow is not big enough to kill HP like many analysts have been suggesting.
Besides, I don't even think the PC industry will die anytime soon. I understand that people can use tablets to get on the internet, check their e-mail and do other simple tasks, but PCs will be always needed to conduct more serious work. It will be many years before we see companies replacing their PCs with tablets if that ever happens. Some people argue that if we attach a keyboard to a tablet, it could be as effective as a laptop, but then a tablet with a keyboard sticking out wouldn't be that much different than a laptop, would it? At best, tablets can be "thin and pretty laptops" but the PC market will always be around. Even if PC market was to die and it was completely replaced by tablets, HP could just stop building PCs and start building tablets and continue to make money. Of course, it wouldn't make as much money on tablets as Apple, but again not many companies can make that much money on tablets anyways. Companies like Amazon (NASDAQ:AMZN) and Barnes & Noble (NYSE:BKS) are barely breaking even on their tablets.
I first bought HP shares when the company announced that it would spin-off, cancel or sell its PC business and the share price fell from mid 30s to low 20s overnight. After that, I kept adding to my shares whenever the share price fell sharply. In addition, I wrote covered calls and collected dividends. So far, HP has been a great investment for me. If the company was trading at $40-50 per share, I probably would avoid it, but at the current price of $20 per share, it is too cheap to ignore.
In the next 3 years, analysts expect HP's earnings to remain flat at around $3.50-$3.60 per share. Normally, when a company's earnings remain flat, it is considered to be a bad thing, but given HP's current price flat earnings is a good thing. Currently HP is priced to see an earnings decline of as large as 50-60% in the next couple years. As long as HP meets the expectations, it is safe to say that HP is undervalued by a large margin.
HP's dividend rate is 15 cents per share per quarter (annually yielding 2.90% annually), which is easily sustainable compared to the company's current cash flow. I expect HP to not only increase its dividend rate, but also to keep buying back shares to decrease the number of outstanding shares in the following quarters.
We are adding 500 shares of HPQ at $20.63 to our portfolio. Furthermore, we are selling covered calls that expire in July with a strike price of $22.00, which carries a premium of $82 per contract. From 5 contracts, we get a premium of $410. This move effectively reduces our breakeven price to $19.81 which is dirt cheap for a company like HP.
So far, our portfolio consists of 200 pages of Monster, 400 shares of Statoil (NYSE:STO), 100 shares of American Express (NYSE:AXP), 300 shares of Wells Fargo (NYSE:WFC), 200 shares of The Walt Disney Company and 500 shares of Hewlett Packard. Once the portfolio is completed, we'll start tracking the performance of it.