It is important to understand the difference between a company and the stock of that company. Great companies are not always great long-term investments.
Xerox (XRX) may be among the best example of this idea. Over many years, the stock price has enjoyed a few bull markets but spent most of its time confined to a relatively narrow range between $6 and $10 a share.
But, after decades of disappointing investors, if management can now meet the low expectations of analysts, this trade could deliver a gain of more than 50%.
The history of Xerox is well known. This is the company that invented the copier and whose name became synonymous with copies and the act of making copies. Later, engineers at Xerox would develop the graphical user interface that Apple (AAPL) and Microsoft (MSFT) rely on for their computer operating systems. Xerox engineers also developed the technologies that allow computers to communicate with each other.
While ideas generated by Xerox have changed the world, investors in the company have not really prospered over the long term. The stock ended 1977 at $7.79 a share (split adjusted) and is now just above $8. Considering the impact of dividends and splits, the stock has appreciated 220% over the past 35 years, or about 3.4% a year.
Given the small rate of appreciation in the stock, it is not surprising to see that XRX has grown earnings slowly, averaging growth of 4.3% a year in the past five years. Analysts expect that to pick up to 6.6% a year in the next five years. In 2013, analysts are expecting to see earnings per share (EPS) of $1.12.
Given its slow rate of earnings growth, the stock probably deserves a below-average price-to-earnings (P/E) ratio. Fair value might be around 8 to 10 times earnings, well under the long-term average of about 15 for large-cap stocks. Based on the estimates for 2013, this would make XRX worth $8.96 to $11.20 a share.
At the low end of the valuation range, XRX would deliver a gain of about 8.7%. With a dividend yield of 2.1%, the total return on XRX could be almost 11% in the next 12 months, assuming the dividend remains unchanged.
The chart confirms that XRX could deliver a double-digit gain to traders.
XRX has just broken out of a double-bottom on the weekly chart. The price target for any price pattern is based on the idea that price moves are symmetrical. This pattern was about $1.70 deep with the top of the range at $7.80 and the bottom near $6.10. A $1.70 gain from the breakout level of $7.80 gives us a target of $9.50.
Relative strength (RS) is also shown in the chart, and with an RS rank of 94, XRX is among the strongest stocks in the market. This indicator confirms the buy signal given by the price pattern.
If XRX falls back into the pattern area, the breakout will be considered a failure. The midpoint of the pattern is around $6.95, or about $1.30 a share below the current price level, which represents a risk of about 16%. Because of the low volatility of the stock, options prices are low and that offers a trade that carries only a little more risk than buying the stock, in dollar terms.
January 2014 call options with a strike price of $7 are trading at about $1.55. If XRX reaches $9.50, the call will be worth at least $2.50. The loss is limited to the amount paid for the call option, although a stop-loss can be used to limit losses further.
With options, traders will not get the dividends from XRX, but the large potential gains make that a small price to pay. Because calls cost less, traders could also use the capital that would otherwise be tied up in owning XRX to invest in an income fund.
Recommended Trade Setup:
-- Buy XRX Jan 2014 7 Calls at $1.65 or less
-- Set stop-loss at $0.70
-- Set initial price target at $2.50 for a potential 52% gain in 10 months