The 'Retire Young' Portfolio: Which Gun Company To Add?

| About: Sturm, Ruger (RGR)

Now is a good time to add a gun company to the `Retire Young` portfolio. Currently, guns are selling like hot cakes in the US and the strong demand is expected to continue for the foreseeable future. Most gun companies report backlogs that will take several years to deplete and the business is doing really well for them. Yet, many gun companies are undervalued because investors are worried that laws will change and many guns will get banned, which may hurt gun companies in the long run.

First, I don't see guns getting banned altogether in the US. Gun ownership is part of American culture and it is protected by the Second Amendment to the US constitution. Currently, there are talks about making certain background checks mandatory for gun buyers, and even this proposal has little chance of passing in the House of Representatives where conservatives have the majority. Without getting too much into politics, it is safe to say that there isn't anything in the horizon (at least in the legal horizon) that would hurt gun sales in the short or medium term.

There are 2 gun companies that are rather popular with the investors. These companies are Sturm, Ruger & Company (NYSE:RGR) and Smith & Wesson Holding Corporation (SWHC). Both of these companies are great and they both have posted impressive results in the recent past. For example, in the last quarter Sturm Ruger (I will refer to the company as Sturm Ruger for the rest of the article because it is easier to read) reported revenue of $156 million, which represents a growth rate of 40% compared to the $112 million generated by the same company in the same quarter a year ago. As for profits, the growth rate was 52% as the company increased its EPS from 79 cents to $1.20. Similarly, Smith & Wesson reported a revenue growth of 39% and income growth of 225% in the last quarter compared to the same quarter a year ago. Both companies are doing really well.

As for valuation, Sturm Ruger is trading for 12.6 times past earnings, 8.7 times book value, 1.9 times annual revenues, 10.4 times annual cash flow and 9.1 times forward earnings with a dividend rate of 3.3% (keep in mind that Sturm Ruger's dividend rate tends to be very volatile from quarter to quarter and there the fluctuations may continue in the future quarters as well). Smith & Wesson is trading for 8.6 times past earnings, 3.7 times book value, 1.1 times annual revenues, 7.9 times annual cash flow and 7.6 times forward earnings. The company doesn't have a dividend but it has an impressive PEG value of 0.5. If you value dividends, Sturm Ruger is the option to go with; however, if you are looking at fundamentals, Smith & Wesson seems to be cheaper. Again, I believe that both companies are great for investment.

Smith & Wesson has $59 million of cash versus its market value of $568 million (representing 10.38%); whereas, Sturm Ruger has $46 million of cash versus its market value of $973 million (representing 4.72%). Smith & Wesson has a total debt of $44 million; whereas, Sturm Ruger doesn't have any debt.

Currently, Sturm Ruger trades 16% below its 52-week high ($60.11); whereas, Smith & Wesson trades for 21% below its 52-week high ($11.25). Currently, the market is at all-time high and it is unfair for both of these companies that they are trading significantly below their 52-week high values. Once investors start getting confident in gun companies, these companies both should see a lot of upside.

Currently analysts have a target price of $12 for Smith & Wesson, indicating a potential upside of 35%; whereas, they have a target price of $48.5 for Sturm Ruger which actually indicates downside to the current price of $50. Keep in mind that there are only 2 analysts covering Sturm Ruger and 5 analysts covering Smith & Wesson.

In the face of increased demand, these companies could have done a better of job of increasing the production, but they didn't do much of this. Many investors are upset that the two companies left some money at the table by not ramping up the production. Maybe the companies didn't think that the demand would continue to be this strong, but it is time for them to increase their production rate so that they can maximize their earnings when the demand is hot. I like the fact that both of the companies have a diverse portfolio of products though. This allows the companies to continue making money if demand for a certain type of product gets lower. Furthermore, these companies sell a lot of guns to members of law enforcement around the world, which means that even the consumer demand for guns decreases over time, these companies will still continue to generate revenues from police and military members around the world.

If we look at the past performance of the two companies, we see that both companies had impressive returns in the medium term. In the last 10 years, SWHC is up by 532% and RGR is up by 414%. In the last 3 years, SWHC is up by 98% and RGR is up by 192%. In the last year, the stock prices of both companies have been underperforming the overall market despite great performances from these companies. This is why I expect a lot of upside potential from both companies. Many times, the worst performer of a year can be the best performer of the next year (examples: Ford (NYSE:F) in 2008-09, Bank of America (NYSE:BAC) in 2011-2012, Hewlett Packard (NYSE:HPQ) and AMD in 2012-2013).

Now, out of the two companies, which one do we add to our portfolio? While I like both companies, I will pick Smith & Wesson because it has more upside potential. When we look at ratios like price to sales, price to earnings, price to book value and price to cash, Smith & Wesson seems to perform better. Therefore, we are adding 1,100 shares of Smith & Wesson at $8.77. Furthermore, we are selling covered calls that expire in September with a strike price of $10. This move pays us $0.50 per share, effectively reducing our breakeven price to $8.27.

So far, we have 7 stocks in our portfolio, namely: Monster Beverage (NASDAQ:MNST), Statoil (NYSE:STO), American Express (NYSE:AXP), Wells Fargo (NYSE:WFC), The Walt Disney Company (NYSE:DIS), Hewlett Packard and Smith & Wesson. We will add 3 or 4 more stocks and we'll be ready to go.

Disclosure: I am long SWHC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.