Which is the Better Investment? IBM vs BNS Jan 2016

IBM

This week I examined two companies from different contexts in considering investment opportunities (for those who follow in the last week the Dow dropped about 1000 points and presented a lot of great buying opportunities) these were Scotia Bank (ticker symbol BNS) and IBM.  Since there’s a very valuable lesson here it seemed like a good idea to share the analysis.

On the surface according to my typical methodology BNS and IBM seem very comparable.  Both are at 5 year lows.  Both pay relatively high dividends (about 5% for BNS and 4% for IBM depending on which day you bought).  Both have P/E ratios of slightly over 9 (IBM slightly lower than BNS but not meaningfully so).  Both are low by comparable industry standards.  Both are large well established companies.  Both have forward P/E ratios lower than their existing P/E ratio suggesting profits will increase in the next 12 months.

In spite of these factors the two are quite different as investments (both fairly attractive, but quite different).  If you were going to choose which to invest in, which would be the better choice?

There are two key lessons here:

  1. Your time horizon/investment strategy will determine in part what investment is best for you
  2. When you’re investing you are buying companies not stocks

Let’s start with this point about investment strategy and time horizon.

Warren Buffett passes up opportunities every day where stocks go up in relatively short order why?  There are lots of reasons but he has a particular investment philosophy, which is based on long term not short or even mid term results.  This is because he aims to buy a company and reap the rewards resulting in less ongoing work.  This allows him to own a much larger portfolio of companies because he doesn’t have to keep such a close eye on them as if he was investing short or mid term.

Let’s ask the flip side of question if Warren Buffett is turning it down does it mean it’s a bad investment?  Not at all, it might be a great investment for someone who is applying a different strategy or maybe has a different timeframe.  People make money every day investing with a different strategy from Buffett and they consistently beat the market.  There are multiple ways to invest successfully.  You’ve got to decide what’s best for you.

How does this apply to the BNS vs IBM analysis?

According to my analysis BNS is likely to do better than IBM short term.  This is based on two things primarily.  The first is the forward P/E ratio of the company, which is generally pretty accurate for large predictable well established companies like banks especially Canadian banks is MUCH lower than the current P/E ratio and the difference between current and forward is much greater for BNS than IBM.  If BNS earnings rise as predicted it’s highly unlikely the stock will remain down.

Further, because the P/E ratio is lower one would expect a higher midterm return than the P/E ratio of IBM (this is somewhat of a crude analysis but gives a reasonable outlook).  Loosely speaking it works like this.  If you take 100 and divide by the P/E ratio then assuming the earnings remain consistent you should expect over the midterm to earn a simple return that as a rate of return because the profits are ultimately the money of the shareholders (loosely the book value of the company should be growing by that much each year and this can’t continue to grow for long without the value of the stock continuing to grow at a comparable rate).  This of course assumes the P/E ratio is an accurate reflection of the earnings of the company, which it isn’t perfect something like Buffett’s concept of owner’s earnings tends to be more accurate but for the sake of simplicity this will do for preliminary analysis.

I should mention when we’re talking about short term I’m generally referring to a period ranging from a few months to a couple years and when I say midterm I’m referring to a period of typically around 2-5 years with anything more especially in 10-year range being long term (anything much beyond the 15 year range I’d consider extremely long term and is much more difficult to predict).  Long term will typically mean going through at least one business cycle, while mid term will generally involve merely a phase of the business cycle and short term is based more on the buying and selling cycle of a company.  Knowing this allows different insights into probable price behavior.

The second reason I believe BNS is a more probable bet in the short term is because of the nature of the businesses, which is a major Canadian bank is very consistent, the valuation shouldn’t fluctuate much and nor will earnings or the market.  We’re in a rare situation where two factors are simultaneously affecting BNS causing the stock to take more of a tumble than it probably deserves.  IBM is somewhat different because it’s in markets that are rapidly changing hence there’s more opportunity for a company to come into or fall out of favor with the market, which is what’s happening to IBM at the moment in spite of most of the company’s fundamentals not changing.

Understanding this plays into the second point we discussed, which is you’re buying a company not a stock.  If you don’t understand the company, you’re likely to miss a lot in the stock and make many errors long term.  I can make those predictions with some measure of accuracy because I’m not simply looking at the stocks themselves, I’m looking at the companies and the markets they are in.  If you’re ignoring these factors you’re likely to run into a lot of problems.

Continued on part 2

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