Why I Bought Puts on Hewlett-Packard

During the rally of the past two months, few areas of the market have generated outperformance like last year’s tech-sector laggards. Almost across the board, the most troubled stocks of 2012 have seen their returns goosed by company-specific news and/or investors’ effort to capitalize on their low valuations.

The numbers speak for themselves:

Company TICKER RETURN, 11/15/12 – 1/25/13
Research in Motion RIMM 99.4%
Nokia NOK 54.4%
Advanced Micro Devices AMD 52.4%
Sony SNE 46.9%
Dell DELL 38.8%
Hewlett-Packard HPQ 31.1%
Xerox XRX 27.1%
Lexmark LXK 22.3%
Yahoo YHOO 13.9%
Technology Select Sector SPDR XLK 6.7%

When it comes to written-off tech stocks, the recipe has been simple: Throw a dart, make money. Heck, even Pitney Bowes (NYSE:PBI) is up 11% in the past two months.

But it’s now time to start looking for opportunities to bet the other way, and Hewlett-Packard (NYSE:HPQ) appears to be one of the best options on this front. Last week, I stepped in front of the speeding train and bought puts on HP. My rationale was this:

The Broader Market Is Due for a Pullback

Key measures of investor sentiment and market performance have reached extreme levels, indicating that the odds of a short-term downturn are rising. Just last week, Bespoke Investment reported the following tidbits on its blog:

  • The American Association of Individual Investors (AAII) weekly sentiment survey is showing bullishness among individual investors at a two-year high.
  • On Wednesday, 79.6% of U.S. stocks were in overbought status (as calculated by Bespoke) — the highest since March 2007.
  • Over 90% of S&P 500 stocks were trading over their 50-day moving averages, only the sixth time this has occurred since 2009.

If these extremes do in fact result in a pullback, the type of lower-quality tech stocks that have come so far in recent weeks are almost certain to underperform.

HP Is Already Starting to Lag — For Good Reason

Betting on market direction through individual stocks is a dangerous game since you often don’t get the move you expect. But HP, in this case, looks like an exception. The stock is up more than 46% from Nov. 20 — the day it reported accounting fraud at Autonomy, the British company it purchased in 2011 — but it has flattened out into a range from $16.95 to $17.25 on declining volume in the last nine sessions. During this time, Hewlett has not just lagged the broader market, but the majority of the downtrodden tech stocks in the table above.

There’s a fundamental justification for this: Unlike Dell (NASDAQ:DELL) or Research In Motion (NASDAQ:RIMM), there hasn’t been any specific news driving HP’s shares higher. Instead, the primary cause of the rally has been the stock’s exceptionally low valuation. Even after its recent run-up, Hewlett still sports a forward P/E of 4.9 and a yield of 3.1%. That’s compelling, but it doesn’t make up for the fact that HP still is seeing negative growth in its PC, printer and server segments, with no clear path back to a recovery.

The slow-to-no growth is visible in earnings estimates: In the past 90 days, Hewlett’s 2013 estimates have come down from $3.58 to $3.32, while the 2014 numbers have fallen from $3.89 to $3.49. The direction of the stock price might have changed, but the trajectory of the company’s earnings estimates remains the same.

The Risk-Reward Profile Favors the Short Side

Put it together, and HPQ appears set to fall further than the rest of the market if the extremely bullish sentiment readings do in fact play out in the form of a short-term pullback. And if the market keeps rising, HP’s fundamental problems should begin to exert a drag on its stock price now that it’s up nearly 50% from its low.

This isn’t a long-term call, but rather a short-term trade. I purchased March 18 puts, which should appreciate about 25% if the stock pulls back 3.5% to 4% in the coming weeks — not an unreasonable expectation.

This isn’t a market that has been rewarding those who fight the tape, but this is a case where the fundamentals and technicals are converging to create an interesting counter-trend trade.

Hewlett reports after the bell on Feb. 21.

As of this writing, Daniel Putnam had bought March puts on HPQ.

Article printed from InvestorPlace Media, https://investorplace.com/2013/01/why-i-bought-puts-on-hewlett-packard-hpq/.

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