Credit Suisse’s Top Technology Trading Idea

A pairs trade is one in which an investor is long or buys a stock and simultaneously sells short a stock, most often of the same sector and niche. The idea behind it is, you hedge the long purchase with the short sale, and in a perfect world they both work. The stock that is purchased goes higher, and the short-sale goes lower.

The Credit Suisse team is very negative on one top tech stock, International Business Machines Corp. (NYSE: IBM), and very positive on two others, EMC Corp. (NYSE: EMC) and Hewlett-Packard Co. (NYSE: HPQ). So we have constructed a pairs trade of technology stocks using their ideas. Ideally the purchase amount of stock will equal the amount sold short.

Stocks to Buy

The stocks to buy for the pairs trade, both rated Outperform, are EMC and HP.

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The Credit Suisse team likes EMC very much because it trades at a discount to free-cash-flow on two standards they measure. The company is also cheaper than Cisco Systems and has a superior revenue and earnings per share growth rates to the networking giant. EMC shares rallied this summer on news that Paul Singer’s activist hedge fund Elliott Management had accumulated a stake worth over $1 billion in the storage giant. Many think the activist play is an attempt to spin off and monetize the huge position in cloud software giant VMWare in an attempt to provide additional value for shareholders. While the stake is significant, they certainly at this point haven’t been able to dictate terms to EMC.

EMC shareholders are paid 1.5% dividend. Credit Suisse has a $32 price target for the stock, nearly the same as the Thomson/First call consensus price objective. EMC closed Thursday at $30.39 a share.

With its leading market share of the growing personal computer sales, Hewlett-Packard is another stock that the Credit Suisse analysts like. They feel the stock remains one the cheapest on most metrics, given the high level of free-cash-flow generation. The stock also is trading at a very low 10.5 times 2014 estimated earnings, and HP made big news with the recent announcement it will split the company in two, a course other major Wall Street firms have used successfully. The company has had a remarkable comeback, and by splitting the iconic Silicon Valley giant into an enterprise company selling servers, networking and storage, and a PC and printer maker in a separate outfit, investors may be very well served.

Hewlett Packard investors receive a 1.7% dividend. The Credit Suisse price target is $45. The consensus target is posted at $40.13, and shares closed trading on Tuesday at $37.50.

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Stock to Short

IBM is the stock to sell short for the pairs trade.

IBM is out of favor and still down right at 20% for the year. Investors with a good memory will recall this isn’t the first time the company has been far out of favor. The stock trades at just over 10 times Wall Street 2014 earnings per share projections, or a 35% discount to the S&P 500 Index. All of that sounds very good. However, the Credit Suisse team feels that the stock is very expensive, and the free cash flow generated is penalized because the company has big restructuring costs, receivables, M&A activity and dilution all weighing on it. In fact, the stock trades at a 44% premium to the peers used in the report, which include Cisco Systems and the two stocks to buy.

IBM investors are paid a 2.7% dividend. The Credit Suisse team has an Underperform rating and the price objective is an astonishing $125. The consensus price target is at $169.14. The stock closed Tuesday at $161.89.

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So the trade is for investors to buy one or both of the Outperform rated stocks and sell short an equal amount of IBM. This is only suitable for very aggressive trading accounts, and a stop-loss on the short should be put in, as a short sale that goes awry could have virtually unlimited downside. More cautious traders could put a stop-loss on the long buy as well, if only putting on for a short-term trade.