The risk-reward ratios for General Electric (NYSE:GE) and Honeywell (NYSE:HON) have huge appeal. Both companies have sound strategies through which to deliver upbeat earnings growth over the long run. They are seeking to become more efficient, make acquisitions, and evolve their businesses. In the long run, both stocks offer high return prospects. Where they differ is in terms of their risks, with GE currently being a riskier buy. Here's why.
The key reason for GE's higher risk is its scale of change. While Honeywell has two main means of continuing the growth rate that has seen its bottom line rise at a double-digit rate in each of the last six years (margin improvement and acquisitions), GE is attempting to transform its business in a relatively short space of time.
So, while Honeywell's ability to increase its margins by 220 basis points in 2015 through a restructuring and its $6 billion in acquisitions in 2015 are sound means of growing its bottom line, GE's shift from part-finance/part-industrial company to industrial business with limited finance exposure holds more appeal to less risk-averse investors.
That's because while the endpoint of GE's transition is likely to be higher profitability since the return on capital from its industrial segment has been higher than the return on capital from its finance division, major change at a rapid pace brings increased uncertainty.
Notably, GE is seeking to leverage its diversity on a vast scale through the increased use of the GE Store, where different segments of the business are able to more easily share ideas. While this concept has been around for some time, as a more focused industrial company, GE could leverage it to deliver significant margin improvements and aid R&D in future years. However, the GE Store may also fail to live up to the hype, since much of the company has already been working together for a number of years and has had ample opportunity to generate the desired efficiencies.
While GE has big plans regarding efficiencies, Honeywell has been delivering on this front for the last two years. In fact, it is 40% of the way through a five-year plan whereby it is aiming to record annualized growth in earnings of 10%, driven not by an improving industrial outlook but by rising margins. And with Honeywell investing $160 million in restructuring in 2015 and expected to improve margins over the medium term, it seems highly likely to deliver improved efficiencies over the next three years.
GE has been more ambitious on asset acquisitions and disposals than Honeywell. While Honeywell's $6 billion in acquisitions last year is significant, GE is aiming to generate over half of that figure in annualized cost synergies from just one acquisition, Alstom, with the acquiree likely to aid the company through its complementary technology and a global presence.
While GE is focused on organic growth, it is also considering increasing its leverage by more than $20 billion in order to fund further M&A activity. Meanwhile, Honeywell seems content to rely more on its strong free cash flow (which increased by 11% last year) so as to fund smaller, less risky acquisitions. Increasing leverage could improve profitability, but it may also cause increased risk.
Of course, with greater risk can come greater rewards. GE is targeting 15% annual growth in earnings in the next three years, which, if met, could act as a vastly positive catalyst on its share price. And with Honeywell's core organic sales rising by only 1% last year, its slower pace of change could lead to lower growth over the medium term.
This does not mean Honeywell is without risks. Its performance materials and technologies (PMT) segment is acting as a major drag on its overall sales performance (PMT sales fell by 10% in 2015 but were offset by improved margins), just as GE's oil and gas segment recorded a fall in sales of 13.8% last year. But the key takeaway is that while Honeywell is keen to invest, acquire, and deliver efficiencies, GE is seeking to perform those three functions on a bigger scale, while also moving into and dominating new niches such as the digital industrial space.
GE's higher risk is evident from its P/B ratio of 3 versus 4.8 for Honeywell, while its PEG ratio of 1.5 holds more appeal to growth investors than Honeywell's 2. In other words, the market seems to be more sure of Honeywell's future than that of GE, which is understandable given the scale of change GE is seeking. Although GE is essentially returning to the industrial-focused company it used to be, it is still changing at a rapid rate and its business model is less settled than that of Honeywell. As a result, investors seem to be more certain of Honeywell's near-term performance than GE's.
However, another way to view GE's valuation is that it offers a wider margin of safety since it's cheaper than its industrial peer. And with Honeywell's margin improvements being unsustainable in the long run, and it therefore being under pressure to invest more heavily and to pursue larger and more frequent acquisitions, it could be argued that Honeywell has significant risks, too.
For long-term investors, the greater rewards on offer at GE mark it as the better buy, but for more risk-averse investors, Honeywell remains a sound buy set to continue the run that has seen its shares beat the S&P 500 by 34% in the last five years.
Robert Stephens has no position in any stocks mentioned. 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.