For Value Investors: 2 Conglomerates 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.

Editor's Note: The original post omits Tyco's spinoff of many of their business units. This post has been corrected and Motley Fool apologizes for the error.

In my view, conglomerates are one of the best ways to diversify in an economy with tax efficiency. If you just "buy and hold" the stock, you should theoretically track the broader macro trends with no taxable turnover. However, sometimes companies that look like conglomerates are more heavily concentrated in one segment than what many investors may recognize. This is not necessarily problematic. Below, I consider several conglomerates with a bias towards the long position.

Why I Like General Electric (NYSE: GE)

In the 4Q of 2012, Iberdrola SA, Spain’s biggest electric utility company, announced it will sell its French wind energy company to General Electric. GE’s decision to acquire the wind company reflects bullishness on what is forecast to be the third largest renewable energy sector in 2015. The deal was valued at $400 million, and it is complemented by GE Oil & Gas's $500 million contract to supply equipment and services to Petrobras. The latter will be used in offshore oil production, which is expected to experience considerable growth. Thus, the contract will pay dividends not just now but well into the future by improving GE's "resumé," if you will.

The most recent quarter also saw an uptick in the underlying momentum. The most recent quarter saw industrials organically grow 8% y-o-y and backlog peak at $210 billet. Revenue of $39.3 billion came in $590 million ahead of consensus and was complemented by management's brightened outlook on China.

In a recent evaluation of GE’s assets and revenues, it was seen that 20% of its $699 billion in value is going towards the operation of its businesses, while the rest, 80%, goes to their hedge fund GECC (GE Capital) for various forms of investments (debt, equity, loans, VC etc.). This ratio actively under management has been said to make GE more of a fund pool rather than an industrial company. In times of financial weakness, such as now, capital companies see worsened ROIs and make their parent company’s shares go down. GE is expected to see a decline in their shares in 2013, from $1.73 to $1.68.

Being largely a financial, however, isn't always bad. The firm's decision to acquire MetLife's bank deposits will add $6.4 billion to lower borrowing dependence. As a whole, GECC provides 84% of the firm's liabilities and all but 10% of cash control. The stock trades reasonably at 15.9x past earnings, offers a 3.5% dividend yield, and carries a 11.1% forecasted growth rate. Combined together, these variables make GE a strong investment

3M (NYSE: MMM): the Good, the Bad, & the Alternative

If you are looking more for a real "tech conglomerate," you may be tempted to consider 3M. 3M’s dividend yield is at 2.5%, and the company holds a 96 year history of paying dividends and more than 50 years worth of increases. In the year 2011, 3M paid over $1.5 billion to its shareholders and re-purchased $1.8 billion. This represents 77% of past earnings being returned to shareholders. The stock is also 12% less volatile than the broader market. So, in terms of low risk investments, 3M fits the bill.

But the stock looks relatively expensive at a respective 15.8x and 14.4x past and forward earnings. 3M grew EPS by only a rate of 3.3% over the past five years, yet a rate of 10.6% is expected over the next five. In my view, this puts downside pressure on the firm. Even assuming the company meets expectations, the stock would be worth $139.05 at a multiple of 15x. Discounting backwards by 10% yields a present value of $86.34, which is 13% below the current price. Accordingly, I would recommend avoiding 3M if you want to make a value investment.

Instead, I would consider a firm like Tyco (NYSE: TYC). In my view, it is trading at an unrecognized discount. While many investors look only at the trailing and forward earnings multiples, free cash flow is ultimately what shareholders see at the end of the day. And Tyco has a strong free cash flow yield of 8.6% that comes on top of a 1.9% dividend yield. Investors have started to pick up on this value story, as evidenced by the 13.7% gain over the last three months, a near quadrupling of the return on the S&P 500 over the same time period.

TakeoverAnalyst has no position in any stocks mentioned. The Motley Fool recommends 3M. The Motley Fool owns shares of General Electric 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. Is this post wrong? Click here. This article was written by the staff of TakeoverAnalyst, which does not intend on opening a position in the next 48 hours.

blog comments powered by Disqus