A side-by-side stock comparison should only be done with similar companies if you are going to pick the best investment
Sometimes the best lessons come from the worst mistakes. Even one of the best investment books ever written can have a bad chapter or two but that doesn’t mean you can’t learn something from it.
This article is the 18th in our chapter-by-chapter review of The Intelligent Investor. The book was first published in the early 50s by Benjamin Graham, widely-known as the father of value investing and a mentor to Warren Buffett.
I’m reading through the 2003 edition which includes the 1973 text from Graham and the updated commentary by Jason Zweig. The book is an amazingly concise yet thorough education in investing for both defensive investors and those that want to reach for higher returns.
Check out last week’s chapter review and how to avoid bad stocks and stock market bubbles
Chapter 18 is a side-by-side stock comparison, a grudge-match of eight pairs of stocks. A great idea but Graham picks stocks to compare by alphabetical order.
The result is a completely ridiculous comparison of unrelated companies, for example comparing a public utility with a publishing company just because the company names are alphabetically-close.
It’s one of the biggest mistakes in investing, making investment decisions based on comparisons of unrelated companies. I understand Graham’s reasoning in showing why you can’t compare investments in such a way…but you don’t need eight examples to do it!
To top it off, Zweig’s commentary which is usually very helpful in updating the material carries on the absurdity with eight more similar-sounding pairs.
Fortunately, there is something you can learn from the side-by-side stock comparisons and I’ll work through how to compare stocks the right way.
Lessons Learned in a Side-by-Side Stock Comparison
The lesson of the chapter seems to be chiefly that you can’t compare stocks based simply on their company names. The eight examples lead to all kinds of poor investment decisions on the bad comparisons.
The problem is that industries, a group of companies producing a similar product, can differ greatly on investing measures. Industries in a mature product market are going to see much slower sales and earnings growth versus newer industries.
This is going to affect all kinds of things like,
- The price investors are willing to pay per earnings
- The amount of debt a company is able to safely use
- The amount of dividends returned to shareholders
Graham hits on a few other lessons in the stock comparison chapter.
He points out that price per share is no indication of a good investment. The price per share is a function of the company’s size and number of shares available. Some companies regularly split their shares to increase the count and reduce the share price. The fact that a company’s share price is above or below $100 means absolutely nothing.
A lower price-to-earnings ratio doesn’t necessarily mean one stock is a better investment than another. This is again because of the difference in industries and the average P/E multiple in the industry.
Shares of AT&T trade for just 16.4 times earnings, much less than the 22.6 times P/E multiple for shares of Google parent-company Alphabet. Does that mean AT&T is a relatively better investment than Google?
Maybe but maybe not, the P/E comparison tells us nothing. The story changes when you compare the stocks against the average P/E value in each separate industry. Shares of AT&T are trading at a discount of 21% to the 20.7 average multiple for telecom stocks. Shares of Google are trading at a whopping discount of 47% to the 42.9 average multiple for internet stocks according to Morningstar.
The same caveat to comparing profitability measures like return on equity and operating margin across different industries holds as well.
How to Compare Stocks, the Right Way
Always compare stocks of the same industry when you are doing a side-by-side investment decision. Always!
Let’s look at a better example of two stocks in the automobile industry, high-flying Tesla Motors against 108-year old General Motors.
I highlighted Tesla Motors in our first chapter review of why you should avoid hot stocks in the stock market. The comparison above is pretty basic and you shouldn’t base your entire investing decision on just a few metrics but it does show a wide contrast between the two companies.
Tesla has just become profitable this year after huge losses but is still booking strong sales growth. The earnings losses make it difficult to use a couple of measure but we can still get a sense of how much investors are willing to pay…the answer, a lot! On a book value basis, investors are currently paying more than eight times the valuation for Tesla compared to GM.
There’s another problem to watch out for when doing side-by-side stock comparisons and using measures like price-to-earnings. Comparing stocks like this won’t tell you if a company is a good buy or a cheap stock.
The fact that GM trades for less P/E compared to another stock only tells us it is relatively cheaper. Is paying 5.6 times earnings too much or too little? We also need to compare the company’s P/E ratio with the average ratio it has traded on in the past.
Grab your copy of The Intelligent Investor and follow along with our chapter-by-chapter review.
There is a lot to love about one of the best investment books ever written and even a chapter like this one can teach us quite a bit about investing. Make sure you aren’t making the worst investment mistake when doing side-by-side stock comparisons. Always compare similar companies and make sure growth rates and business models are similar enough to really be able to compare them.