Monday, September 12, 2011

An Example of Portfolio Aggregation - Dell and HP

When you build a portfolio, you are really building your own holding company, with an ownership in the various companies you buy.  Below is an example of how to look at this for investing an equal amount in Dell (DELL) and Hewlett Packard (HPQ).  At a time when tablets are supposed to make PCs obsolete, and with both businesses facing lots of negative news, I thought it would be instructive to see how cheap the combination of these two companies gets.

Both of these companies are in the "Computer Hardware" industry, and in the trailing twelve months (TTM), HPQ has a 33.4% market share of that industry and DELL has 16.1%.  So in total they have about half (five years ago it was more like 60%).  So are they shrinking?  Actually, the industry has grown by about 9% per year over the last 5 years, while HPQ has grown 8% and DELL 2%.  The aggregate investment has grown by 5% per year (vs. 4% for the revenues of the S&P 500).

What else can we say about the HPQ+DELL holding company?  Margins have grown from 5.5% five years ago to 6.6% in the TTM, and ROE has grown from 23.7% to 29.5%.

In contrast, the valuation has dropped from a price-to-sales of 1.1 5 years ago to 0.4 right now.  Price-to-book dropped from 4.7 to 1.7.  The PE ratio went from 20 back then, to 5.9 right now (this doesn't back out the surplus cash that the companies hold, which would lower it a bit more).

Of course, all of this may be because PCs are going to gradually disappear, so if you believe that, this is a classic value trap.  If you think the industry is going to flat-line or do better over the next few years, though, you can buy most of the market share for 0.4x sales, in a business that is easily earning higher than 5% margins.  Even at 5% margins, you're getting an 8% yield on your investment.

Some of that return will no doubt get burned on pricey acquisitions, etc, although the return on retained earnings over 5 years for the aggregate has been 10.9% which isn't bad.

So is this a slam dunk investment?  I'm not sure - I think it's attractive at this price, but I could be wrong.  The main point of this post is to explore the value of aggregating different companies into holding companies to see what the aggregate looks like.

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