Hewlett-Packard's Silver Linings

| About: HP Inc. (HPQ)

By now, it’s well known that Hewlett-Packard (NYSE:HPQ) laid an egg Tuesday afternoon when it reported second-quarter numbers. It was bad enough to see EPS fall from $0.80 in the year-earlier period to $0.70 in the latest quarter. But adding to the gloom were the eye-catching declines in some key product categories (19% for PCs, 23% for printer supplies and sales, and 28% for the server and storage division) and management’s gloomy guidance for upcoming quarters. In response, the stock fell about 5 percent Wednesday and underperformed an already-weak market Thursday morning.

I don’t mean to minimize the difficulties being faced by HP, which are considerable, but I do think it’s important to put them in perspective.

Figure 1 shows how HP fares under the P123 Balanced stock ranking system I created on Portfolio123.com, as well as how it scored under this system at three month intervals over the past year. (An explanation of this ranking system, as well as performance results demonstrating its effectiveness can be found in the Appendix at the bottom of this article.)

Figure 1

EPS growth is an important component of the model, and not surprisingly, HP took a hit here. Notice especially the poor Acceleration score, which reflects the wall HP’s earnings trend hit in the latest quarter.

But the most interesting number may well be the Recent Growth score, which, although not great, still remains in the upper half of the range. That’s crucial. It reminds us that HP is not the only company out there reporting bad numbers. That should surprise nobody. After all, we are in a recession. But all too often, when a company reports, interested observers put on the blinders and forget about everyone else out there. That’s all well and good for story writers, but for investors, who are constantly on the prowl for better opportunities, “bad but not as bad as most others” can be a respectable answer.

Even under this criteria, I still find HP’s EPS Growth score too low to excite me right now. However, it’s not so low as to raise long-term doubts about the company. I assume HP won’t be the only one reporting bad numbers in upcoming quarters so I have no reason to expect more than a modest shift in this rank in the near future. And combined with other criteria, I note how easily HP’s overall rank could recover toward the upper echelon.

In the largest component of the model, Company Quality, HP still fares reasonably well. The financial strength sub-component lags because HP is carrying a degree of leverage that, while quite reasonable for manufacturing firms as a whole is above what we often see in this particular industry, which includes quite a few firms with little debt or none at all). But to one degree or another, that seems to be a fact of life for HP. Even so, its strong scores for Returns on Capital and Earnings Quality can often predominate.

The Industry Strength category measures the halo effect, so to speak; the extent to which a stock can be helped or hindered not by any trait inherent in itself but by characteristics of and sentiment toward the industry to which it belongs.

This industry’s financial fundamentals actually look pretty good relative to most others. (Before shedding to many tears for the declines in computer-related markets, consider what you might prefer instead. Homebuilding? Airlines? Autos?)

The Price Trends component, however, is a basket case. In recent months, Wall Street has been lukewarm at best toward the group, more so than fundamentals would seem to warrant. Right now, however, the attitude seems to be out-and-out hate. That may be a bit much and could easily be corrected in the near term. If that happens, it could make for a nice upward jolt in HP’s overall rank.

As to Stock Valuation, HP really isn’t on the radar of the cigar-butt crowd. But for what it’s worth, the score here is less mediocre than it’s been in the recent past and seems unlikely to prevent the stock from being buyable when other components line up more favorably.

Disclosure: No position in HPQ

APPENDIX –The P123 Balanced Ranking System

Multi-factor ranking uses factors similar to what many are familiar with when they use stock screeners: growth rates, valuation metrics, balance sheet ratios, margins, share-price performance measures, and so forth. The differences are in how they are used.

  1. Screeners compare factors to specific thresholds, in order to create pass-fail tests, and are designed to identify a limited number of companies that pass all of the tests used. Ranks, on the other hand, seek to classify all companies with respect to all factors based on a set of best-to-worst scales.
  2. Screening, by its very nature, must treat all factors equally. Ranking, on the other hand, can assign different weightings (degrees of importance) to different factors.

Because ranking can provide analytic perspective on all stocks in a universe (as opposed to screening, which provides strong answers for a few stocks but remains silent for most others), it is more commonly used by those seeking to assess a full universe of stocks (e.g. Value Line, S&P, Morningstar, Money Central, Zacks, TheStreet.com, Investors Business Daily, Schwab, and so forth).

Given the fact that most investors usually encounter stock ranking systems that are associated with major organizations, such as those mentioned above, it is easy to assume that the creation of such a system is beyond the individual capabilities of the typical investor. Actually, however, that is not the case. All one needs is access to an appropriate tool capable of doing this sort of number crunching. I create and backtest my ranking systems on Portfolio123.com.

Ranking systems can be specific (based on a narrow group of factors) or general (based on many different kinds of factors. I’ve used both but I usually prefer to use of many factors. That’s because there are countless different ways a stock can demonstrate merit (and attract above-average investor interest). I prefer not to pre-judge which of the particular way a specific stock can “strut its stuff.”

This particular ranking system, which I refer to as P123 Balanced, is based on the following groups of factors (except where otherwise noted, each company factor is ranked relative to all other companies in the investment universe):

  • EPS Growth (25%)
    • Recent EPS Growth rates
    • Recent EPS Acceleration
    • Long-term EPS Growth history
  • Company Quality (30%)
    • Returns on Invested Capital
    • Earnings Quality
    • Financial Strength – company factors are ranked relative to those of other companies in the same industry.
  • Industry Strength (20%) – each industry factor is ranked relative to those of other industries
    • Industry Price Trends
    • Industry Fundamentals
  • Stock Valuation (25%)

Figure A-1 shows the result of a Portfolio123 performance test of this ranking system from 3/31/01 through the present. It assumes 4-week rebalancing and excludes OTC stocks and others with market capitalizations below $250 million or share prices below $5.

Figure A-1

The leftmost vertical red bar represents the average annualized rate of change for the S&P 500. The dark blue bar next to it depicts the average annualized rate of change for the worst ranked stocks (those in the bottom five percent). The rightmost dark green bar represents stocks ranked in the top five percent.

While this is by no means the only way to evaluate equity performance potential, it does seem like one pretty good approach for using objective fundamental criteria to identify potential market winners.

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