1 Conglomerate Stock to Buy, 1 to Avoid

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Conglomerates provide an ideal way to diversify. At the same time, they also limit market efficiency by making it harder for investors to allocate risk. If you bundle a package of goods, for example, do you decide to buy the package if there's one really attractive product and four not-so-attractive products? The answer is easy: It depends on the price. Currently, some conglomerates have overall fundamentals that offset weak segments. Other conglomerates, however, do not have the growth capable of offsetting weak segments.

General Electric (NYSE: GE): Buy

From energy to healthcare and finance, GE has its fingers across many different sectors. Fortunately, the company has been largely successful in most of its segments of late. GE Oil & Gas, for example, just recently gained a $165 million contract with Chevron's Lianzi project in the Republic of Congo, wherein GE will supply the necessary technology and equipment for production. Meanwhile, GE Capital recently announced that it would pay a large dividend to shareholders. This suggest that management is confident over future streams of free cash flow, since financial companies are required to hold a large amount of upfront capital lest systemic risk be posed to the wider economy.

In addition to paying out returns to shareholders, the company has been active in reinvesting. Last year, the firm spent $11 billion on just takeover activity in energy. Like many takeover artists, the suitor has been able to create synergistic value through spreading out fixed costs and supplying capital to jumpstart production. While I am not optimistic about the firm's exploits in wind energy, management has now solidly penetrated the market through committing more than $150 million to one of Minnesota's largest wind farms. Still, large utility companies, like Duke (NYSE: DUK), are preferable if you are bullish on wind. Duke has invested over $2.5 billion in wind power over the last half decade. If they are any indication, wind has weak trends--the company will be discontinuing its Gail Windpower Project to focus on rebuilding five existing domestic wind farms. Yet Duke trades high at 19.4x past earnings despite poor growth prospects--should multiples compress, the outlook on GE Energy's wind division will likely depress.

At 12.4x forward earnings and a dividend yield of 3.2% amidst 5-year annual growth forecasts of 11.2%, the stock is well positioned to continue its bull run. The stock is up nearly 50% from its 52-week high, and analysts are still rating it a "buy." The latest report came from Deutsche Bank on Oct. 12 with a "buy" rating and a price target of $26. In fact, no major analyst over the last two years has a price target under the prevailing market assessment. Accordingly, I recommend buying shares now.

3M (NYSE: MMM): Avoid

3M looks decent at 14.1x and 12.8x past and forward earnings, respectively. Yet the stock is only up 18.4% from its 52-week low, and the business "parts" are expensive given the price-to-book ratio of 3.4x. It is currently rated a "hold" on the Street with expectations for 10.8% annual EPS growth over the next five years.

Assuming 3M meets expectations, 2016 EPS will come out to $9.32. At a multiple of 16x, this translates to a future stock value of $149.12. Discounting backwards by 10% yields a present value of $92.59. This provides a nominal margin of safety off of inputs that I already consider to be too bullish. I consider them to be too bullish because 3M only grew EPS by 3.3% annually over the last five years. What major reversal should I expect now?

After all, the third quarter was mostly terrible, with the top-end of guidance lowered from $6.50 in EPS to $6.35 in EPS.  Shares fell 2.7% in aftermarket trading, which I do not believe was enough in anticipation of an investor exodus towards higher growth. Revenues fell 0.4% for the year and even good cost cutting efforts that expanded margins could not offset the weakness from a slow economy. With $5 billion in cash and shares expensive against book value, repurchases won't be too accretive. Instead, management should diversify more into high growth segments and sell off slower growing assets. This will better convince investors to accept diversification while keeping open the opportunity for greater restructuring.

Going forward, 3M is, after all, optimistic about emerging market opportunities. Latin America saw double-digit organic growth despite macro challenges, and Mexico was up 19%. China's transition into a consumer-based economy will also help catalyze business. Until greater penetration is seen in these economies and strategic alternatives are explored, I recommend avoiding the stock and buying GE, the preferable conglomerate, instead.

Dive In, Investors

For GE, the recent financial crisis struck a blow, but management took advantage of the market's dip to make strategic bets in energy. If you're a GE investor, you need to understand how these bets could drive this company to become the world's --infrastructure leader--. At the same time, you need to be aware of the threats to GE's portfolio. To help, The Motley Fool offers comprehensive coverage for investors in a premium report on General Electric, in which their Industrials analyst breaks down GE's multiple businesses. You'll find reasons to buy or sell GE, and you'll receive continuing updates as major events unfold during the year. To get started, click here now.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of General Electric Company. Motley Fool newsletter services recommend 3M Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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