Wesfarmers Ltd (ASX: WES) is widely regarded as a defensive stock with a solid dividend that performs in all economic cycles. As the chart below shows, Wesfarmers has not only underperformed the S&P/ASX200 (ASX:XJO) (Index:^AXJO) over the last 10 years, but its major rival Woolworths Limited (ASX: WOW) has been a far better investment over that time – and that's even with the 25% share price fall Woolworths has suffered over the last 12 months.
Source: Google Finance
While I wouldn't rush out to buy Woolworths shares just yet, I'm even less enthusiastic about Wesfarmers. Here are five reasons why I'm avoiding Wesfarmers:
1. Return on Equity – Although Wesfarmers' return on equity is expected to increase to around 10% for the next financial year, it is still well behind the 25% return on equity achieved by Woolworths. To put this in simpler terms, Wesfarmers creates $10 of earnings for every $100 of shareholders funds, compared to the $25 of profit Woolworths creates using the same capital.
2. Diworsification – Peter Lynch coined the phrase diworsification in the investing classic One Up On Wall Street. Lynch was referring to companies who attempted to diversify their business, but in doing so dragged down their overall returns. Wesfarmers is a classic example of this and the strategy has proven to be a negative for investors. Its half-year report showed total revenue growth was only 0.4% as weakness in its resources, Target and industrial businesses offset the strong performances in its Coles, Bunnings and Officeworks operations.
3. Supermarkets – Although the Coles business is performing well at the moment, there are a number of potential headwinds. Increased competition from discounters like Aldi is increasing the pressure on both Coles and Woolworths and the effect of this has already been seen in the Woolworths share price. Coles might be forced to lower its margins in order to keep its market share and this will have a negative effect on its bottom line. Investors should also be aware that Woolworths will invest $500 million into lower prices and this could also impact Coles directly.
4. Exposure to the Resources Sector – Earnings before interest and tax (EBIT) from Wesfarmers' coal operations declined by more than 40% in its last result even as coal production increased by 4.4%. This was the result of a sustained fall in the coal price as the global coal market remains over-supplied. The long-term outlook for coal is unclear and pressure will remain on the coal price in the short term as the over supply continues.
5. Valuation – Although many investors may be attracted to the 5% dividend yield on offer by Wesfarmers, it is important to note the current valuation. At the current share price of around $39, the company is valued at 19x FY15's forecast earnings. Considering the lack of revenue growth being forecast for the next two financial years, it is hard to justify the premium to the rest of the market.
Foolish takeaway
There is no doubt Wesfarmers will be operating for many years to come and will remain an important defensive stock for many investors, but I don't think it will be an outperformer in the medium term.
