Why we’re bullish on Hewlett-Packard

Author: Jean-Luc Nouzille, Bristlecone Value Partners LLC

Covestor model: Large Cap Value

Disclosure: Long all stocks mentioned

The best thing about September is that it is finally over. The S&P 500 index declined by 7.2%, and the Large Cap Value model portfolio dropped even further during the same period. Investors appeared to have a split personality throughout the month, alternatively showing signs of extreme pessimism and optimism, with the market registering frequent and large daily swings.

At the time of this writing, there does not appear to be any resolution yet of the situation in Europe. It seems that politicians across the pond are making the economic situation worse by prescribing a medicine, austerity, which keeps pushing the sickest patient, Greece, further into recession and fiscal deficits.

During the month, stocks that contributed positively to our portfolio’s performance were Intel (INTC), Maxim Integrated (MXIM), and Motorola Solutions (MSI). The top detractors were Cemex (CX), Vulcan Materials (VMC), and Apollo (APOL).

The biggest decline by far during September was experienced by Cemex (-41%), due to a combination of increased recession fears driving down cyclical stocks and concerns that the company will not meet its debt covenants at the end of the year. As we commented last month, we continue to feel that the company has some flexibility in addressing this issue. On the most recent conference call, management outlined a $1bn divesture plan to ensure compliance. We’ll keep monitoring the situation.

The well-documented missteps at Hewlett Packard provided us with what we feel is an opportunity to buy shares in a company that remains competitive in most of its business lines, generates a lot of free cash flow, and has a sterling balance sheet. The reasons for the stock price being cheap are mostly related to the clearly dysfunctional management team and board of directors. Just a few days after our September 16 purchase, a new CEO was announced. Although we reserve our judgment for now, the selection process was again less than satisfactory. However, with the stock trading at close to 6 times next year’s estimated earnings, we feel that we are more than adequately compensated for the risk that we are taking.

To make room for this new position, we decided to sell our investment in Motorola Mobility’s stock, as its price-to-value discount had almost disappeared following the acquisition offer from Google.

As of September 30th, the US market is down almost 9% for the year. Depending on whether you adjust or not for the economic cycle, stocks today are either cheap or fairly valued on average. However, we feel that the stocks we own in the Large Cap Value portfolio are very cheap. We believe that this is a great time to own them, and we anticipate that a combination of rising earnings and valuation multiple expansion will provide us with very satisfactory returns over the next 3 to 5 years, but there is no question that the ride will be bumpy and test our conviction at times.