Value Tech Play Could Produce 26% in Income as Riskier Names Sell Off
Technology stocks fall into two very distinct categories. On one hand, you have high-growth tech names, many of which are associated with the social media or cloud computing industries. These names have been extremely popular over the past two years. The problem with these popular stocks such as Twitter (NYSE: TWTR), LinkedIn (NYSE: LNKD) and Salesforce.com (NYSE: CRM) is that valuations have reached extreme levels.
In recent weeks, the speculative tech sector has taken on water, with stocks declining significantly from their highs. This selling could continue as institutional managers lose confidence.
On the other hand, there are “old economy” tech stocks like International Business Machines (NYSE: IBM), Microsoft (NASDAQ: MSFT) and Hewlett-Packard (NYSE: HPQ). These stocks do not trade with the same inflated multiples as the new generation of tech stocks, and their stock prices have been much more stable. Institutional investors appreciate the strong balance sheets, reliable cash flows and healthy dividend yields these companies offer.
As risks mount for high-growth technology stocks, I expect a significant amount of capital to rotate out of the speculative names and into “value” technology stocks.
For many institutional investors, it is impossible to hoard cash during turbulent market periods because their charters require them to be fully invested. Some are even required to have a specific percentage of their capital allocated to specific sectors like technology. For these managers, one of the best ways to manage risk is to shift investment capital from high-beta growth technology to low-beta value technology names.
With this concept in mind, I want to recommend an attractive income trade for Hewlett-Packard today. The stock has been trending higher ever since finding a bottom in late 2012, and shares rallied more than 2.4% on Tuesday following an upgrade from Pacific Crest to “outperform” from “sector perform.” In the report, the analyst noted changing competitive dynamics with IBM and endorsed the “strategic direction of new leadership.”
Increased volatility in newer technology stocks, which appears to be inflating option premiums across the sector, along with a bullish overall trend for HPQ sets up an excellent put selling opportunity for us to generate income from this stable technology company.
With HPQ trading just under $33 and the HPQ June 32 Puts trading near $1.15 per share, we have a chance to sell out-of-the-money contracts at a very lucrative price. By selling these put options, we are taking on the obligation to buy 100 shares of HPQ at the $32 strike price for every contract we sell if HPQ is trading below $32 when the puts expire on June 20.
To cover this obligation, we will need to set capital aside. Since we will be receiving $1.15 per share ($115 per contract) from selling the options, we will only need to allocate an additional $30.85 per share ($3,085 per contract) of our own capital.
If HPQ is above the strike price at expiration, we keep the $115 in income free and clear. This would represent a 3.7% return over the $3,085 set aside. We would earn this in 52 days, so our per-year rate of return would be 26%.
Of course, there is a chance that HPQ will trade back below $32 and we will be assigned shares at a net cost of $30.85. I would be comfortable with this purchase price as it represents a 6.4% discount to the current price.
HPQ has a current yield of 1.8%, so we can expect to be paid while we wait for the stock to continue its bull trend, and we can also sell covered calls against our stock position to generate even more income.
Over the next few months, I expect the trend of capital rotation out of speculative tech stocks and into “safe” value tech stocks to continue. If you like this trade idea for HPQ, you might consider setting up similar positions with Microsoft and IBM. The key is to make sure you are receiving enough income from the put options to justify the risk of the stocks pulling back before expiration.
Note: My colleague Amber Hestla has used this same strategy to “steal” thousands of dollars at a time from Wall Street. By performing these “heists,” as we call them, she’s delivering annual gains of 78.8%… 125.6%… and even 212.2%. Find out how you can do the same.