Seth Klarman has made a living buying hated stocks.
Klarman is founder and president of Baupost Group. Baupost is a value-based hedge fund with a focus on buying out-of-favor companies.
The fund has roughly $22 billion in assets under management. Since inception in 1982, Baupost has returned an average 20% a year. That’s more than double the performance of the S&P 500 over the same timeframe. Even more impressive, Klarman has achieved these returns while averaging about a 30% cash position during the life of the fund.
Over the past few months, Klarman has taken a huge stake in one of the world’s most hated tech stocks…
The fund manager bought more than 20 million shares of Hewlett-Packard (HPQ). That amounts to roughly $555 million, or 25% of his equity exposure in his fund. That’s a massive position.
You’ll find HP products in almost any gadget – PCs, cameras, mobile phones, and printers. The company also makes money selling software and providing technology and infrastructure support to individuals, businesses, and governments all over the world.
But the tech giant has recently become one of the most hated stocks on Wall Street.
It started in February. Rumors surfaced of a possible sale of its PC segment. This division accounts for one-third of HP’s sales. But it has dragged down margins as global PC demand has slowed. A few months later, HP warned it would not meet its sales estimates.
On the same day of the earnings warning, management announced a $10 billion acquisition of Autonomy, a large software company headquartered in Europe. This news surprised most analysts covering the stock. Wall Street does not like surprises.
The deteriorating fundamentals and an expensive, ill-timed acquisition resulted in a massive pullback in the stock. Shares have underperformed the S&P 500 by 35% over the past nine months.
Klarman is using the massive pullback as a buying opportunity. I think it would be wise to follow in his footsteps. The company is in the early stages of a massive transformation…
This transformation includes expanding into high-growth areas like software and cloud computing. These growth engines will complement HP’s slower-growing – but cash-generating – hardware segment. Also, new Chief Executive Officer Meg Whitman is focused on building HP’s cash position and finding a better way to integrate its many divisions to improve margins.
In short, Whitman has laid the groundwork for HP to become a successful, cash-generating giant in the years ahead. This should help HP improve its credibility and regain its status as one of the world’s top technology brands.
But right now, HP is trading at just eight times earnings. That’s a 40% discount to the S&P 500. And expectations have never been lower…
After earning $4.88 a share over the past 12 months, the company is expected to earn just $4 a share in 2012. To put this in perspective, back in March, HP was forecasting earnings of $7 a share for 2014.
I don’t see the company coming close to $7 a share in 2014. However, if HP is able to expand its software and cloud exposure, the company could conservatively earn $5 a share by 2014. At the current price of $27, that makes shares super-cheap at four times future earnings.
HP is also expected to generate a massive $10 billion in free cash flow annually in the years ahead. This cash could be used to increase its dividend (currently 2%), buy back shares, or make other (hopefully more popular) acquisitions.
Overall, HP has a long way to go to regain credibility with the Street. Its massive restructuring will take time. But at its current price, the stock looks like a low-risk, high-reward play.