The current bull market hides many companies flaws. In fact, since 2009, almost all stocks have gone up one way or another. My 11-year-old boy could probably do as well as most investors on the street. This situation makes it even more difficult for investors to differentiate the good picks from the bad seeds. For example, when you look at the Honeywell (HON) and General Electric (GE) stock price graph for the past 5 years, both seem to be a good investment:
Li Lu’s Four Basic Principles of Value Investing
Li Lu is undoubtedly one of the most under-appreciated investors. The founder and Chairman of Himalaya Capital Management established his firm in 1997 based on the principles laid out by Benjamin Graham. Lu is a close friend of Charlie Munger and was once thought to be in-line to succeed Warren Buffett as the chief investment Read More
While Honeywell (HON) clearly outperformed General Electric during this period, most GE shareholders won’t complain about its performance. I know that General Electric is a very popular stock among investors. The company has been around for over 100 years, and has performed quite well for decades. However, I believe the current bull market is hiding many flaw, and Honeywell is a better option for those who look at adding an industrial stock to their portfolio. Ironically, Honeywell failed to merge with General Electric back in 2001.
As a dividend growth investor, my focus when analyzing companies is payouts and potential increase. In order to do so, I have studied 3 components leading to sustainable payment increase as per the 7 dividend growth investing principles:
• Revenue trend
• Earnings trend
• Dividend and payout ratio trend
I will compare both companies using those metrics, and conclude my analysis with a valuation of both stock price.
While Honeywell revenue growth over the past 5 years is far from being spectacular, General Electric is having several problems generating growth. This is obviously caused by the sale of GE Capital, a lucrative but highly volatile segment. The most recent bump in 2016 results in the acquisition of Alstom. Over the past few years, General Electric has focused on restructuring their “GE Store”:
Source: GE China Investor Forum Presentation
In contrast, Honeywell has put additional focus on software engineering with nearly 11,000 engineers working on software instead of more classic industrial goods. The software business is better as it enables more combinations of services, and drives higher margins. Honeywell certainly has some solid growth potential for future investing.
Source: Honeywell Q4 2016 Presentation.
When looking at revenue perspectives, we can see both companies will not burst expectation with soaring numbers in upcoming years. However, when looking at earnings, we can clearly see that Honeywell (HON) is exhibiting success improving their earnings compared to General Electric. Honeywell (HON) management expects to grow EPS by 6% to 10% while GE expects growth of 3-5%.
General Electric will have a hard time replacing GE Capital profit potential through core industrial segments. Additionally, Alstom integration has proven less profitable than expected so far due to speed bumps during the integration process.
Honeywell’s strong position in the aerospace industry, and safety products will help the company benefit from an aircraft upcycle. Did you know that HON won 100% of the jet propulsion engine competitions for medium-to-large business jets since 2001? That’s a very good batting average!
GE’s current payout ratio seems under control with a 75% ratio. However, when we use the cash payout ratio, we can see the company is bleeding cash at the moment (the ratio is at -327%).
Remember, the payout ratio is a reliable indicator of a company’s ability to sustain its dividend, but it remains based on accounting numbers, not real cash. Even then, with slow revenue and earnings growth, a 75% payout ratio doesn’t give you much room for growth.
Honeywell’s (HON) management announced last year that the dividend payout ratio will increase in the upcoming 4 years. They were able to keep it around 40% for the past 5 years, but now they feel it’s the time to reward investors. The dividend payment increase was of 15% and 11.76% in 2016. I’m not putting on my rose-colored glasses, and expecting a 12% dividend growth in the next 10 years, I can appreciate the growth will be significant for several years to come. In comparison, Honeywell clearly has more room than GE to boost their payouts in the upcoming years. v is in good condition to continue its 6-year streak with a dividend increase.
When it’s come to valuation, I use 2 different techniques. The first one will give me a a good idea of what the market value the company. I use the historical PE ratio:
Both companies used to trade at about the same valuation for 3 years in a row until GE posted losses. Now that the company is “back on track”, it seems their stock price is living on “investors hope” that it will get better. On the other hand, Honeywell (HON) trading at a P/E of 20 doesn’t look like an incredible deal either.
I’d like to go deeper in my analysis, and use a double stage dividend discount model (DDM) to determine the company’s value.
GE’s DDM calculations:
I’ve used a discount rate of 10% as I still see various risks attached to GE’s performance in the upcoming years. They recently reported losses in 2015 and 2016, they show difficulty integrating and generating synergy from Alstom acquisition and they struggle to identify growth vectors in the future.
Honeywell’s (HON) DDM calculation:
As you can see, I’ve been a lot more generous with my Honeywell (HON) valuation. This is because the company has increased its EPS strongly in the past 5 years and continue to aim at high single digit growth. Management has already announced payout ratio will rise in the upcoming years, leading to aggressive dividend growth rate. Finally, I’ve used a 9% discount rate as I judge Honeywell’s fundamentals stronger and less volatile than General Electric.
I know Honeywell’s (HON) dividend yield is a lot less attractive than GE’s right now. However, future payout growth should invite additional investors to consider Honeywell over General Electric. In the future, and based on historic performance, it has been clear to me that Honeywell will continue to outperform General Electric.
Disclaimer: I own shares of HON in my Dividend Stocks Rock portfolios.