As the Bull Retreats, Growth Gets Expensive

 | Apr 28, 2014 | 12:30 PM EDT  | Comments
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Stock quotes in this article:

gm

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tsla

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amzn

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wmt

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intc

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csco

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FB

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twtr

The financial media have created a tug of war between small-cap stocks and large-cap stocks. As you would expect, the argument can cut both ways. Small-caps can grow more, so they deserve the higher valuation today. Large-caps are cheap, and if the economy improves, so will their bottom lines. 

My view is simple: Because most stock market participants don't pursue investing on a full-time basis or spend the required time really digging into a company or sector, they should go with the most easy-to-understand approach. To do that requires nothing more than pursuing an old exercise that value investing legend Ben Graham pioneered in his classrooms more than 60 years ago.

Graham's teaching method involved taking a pair of companies and comparing their fundamentals side by side to ascertain the better value. For purposes of his classroom, Graham would simply take two stocks in alphabetical order. So let's look at two similar businesses and see for ourselves which one makes the most sense today.

A good first pair to consider is General Motors (GM) vs. Tesla Motors (TSLA), the old-school automaker vs. the hot, new 21st-century automaker of the future. General Motors has a market cap of $53 billion; Tesla $24 billion. General Motors trades for 7x forward earnings and yields 3.6%. Tesla is valued at 53x forward earnings and offers no dividend. General Motors generates $155 billion in annual revenue, compared with $2 billion for Tesla. In today's very jubilant market, which of two seems to be the sensible, intelligent investment?

How about Wal-Mart (WMT) vs. Amazon (AMZN) today? Wal-Mart trades for 13.5x earnings while Amazon is changing hands for 86x forward earnings. Wal-Mart has operating margins of 5.6% on nearly $500 billion in revenue, while Amazon barely earns 1% margins from $75 billion in revenue. I won't deny that the stronger future growth is likely to come from Amazon in the coming years, but at what price does it make sense to pay for that growth?

Compare Cisco Systems (CSCO) or Intel (INTC) today with the likes of Facebook (FB) or Twitter (TWTR). Two are priced sensibly on the basis of fundamentals, while the other two are priced on the basis of very optimistic, unproven scenarios. As the market shifts from a young bull to a mature bull market, the value of the larger high-quality names begins to resonate more with Mr. Market and with investors. Wal-Mart shares are down less than 1% year to date; Amazon shares are down nearly 25%. While Tesla shares are up 33% this year, compared with a decline of 17% for General Motors, I believe that in the coming year or two, valuation will win, and General Motors will deliver the better return.

In any event, the shift to quality over sexy has begun, and it will continue as long as this bull market continues to age.

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