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Summer Selection: Tobacco, Pharma Or Retail Stocks?

The summer lull is upon us, so the obvious question is: will investors bet on more defensive sectors this summer?

In short, it goes down to fundamentals, rather than seasonality.

Retail, Pharma, Or Tobacco?

Consider GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US), British American Tobacco (LSE: BATS) and Next (LSE: NXT).

Shares of Glaxo and BAT — two of the largest players in the tobacco and pharmaceutical industries, respectively — have been outperformed by Next’s since mid-June. In fact, the shares of the clothing and home products retailer have outperformed those of BAT by almost three percentage points, and those of Glaxo by about seven percentage points at the time of writing. 

Track record, long-term trends and prospects of growth also suggest that: Glaxo is the laggard, and could be bought on the cheap right now; BAT is a relatively stable business whose stock looks undervalued; and Next may continue to outperform the other two, but only if its growth trajectory beats expectations.

NextNext: A Bit Pricey

Next stock has been looking for direction since the end of the first quarter. It is now close to its record highs.

It’s the riskiest bet, but could certainly yield market-beating returns. Next is a solid retailer. Its fundamentals are strong, and its stock is less volatile than those of smaller high-street competitors. Its valuation, however, is demanding.

With a market cap plus net debt (Enterprise Value, or EV) of 11 times forward earnings, before interest, tax, depreciation and amortisation (EBITDA), Next is not a bargain. It needs growth, and lots of it, to continue its formidable run on the stock market.

Efficiency will likely support growth in earnings per share (EPS); market consensus estimates are for EPS growth at about 10% annually  in the next couple of years. Such a growth rate is well below Next’s trailing performance, which points to possible downside for shareholders. It’s a close call, but I would hold Next as part of a diversified portfolio. 

GlaxoSmithKlineGlaxo: A Bargain?

The ongoing bribery saga in China weighs on Glaxo’s valuation, but I’d argue that bad news is already fully priced into Glaxo stock.

At about 11 times forward EV/EBITDA, Glaxo bears the hallmarks of a company whose valuation has been battered well beyond fair value, particularly if its trading multiples are compared to those of other pharmaceutical companies in the UK. Shire stock trades at 18 times forward EV/EBITDA, while AstraZeneca stock is valued at 12 times forward EV/EBITDA.

Several aspects of these three businesses are different, so a straight comparison based on their trading multiples is by no means the only tool a savvy investors should use. It appears clear, however, that the equity values of Shire and AstraZeneca have rallied on the back of takeover talk, rather than in the wake of significant improvements on the business side. The latest £30bn offer from AbbVie, which was announced on Tuesday,  is particularly unappealing for Shire shareholders. 

For its part, with a market cap of £76bn, Glaxo is much bigger than AstraZeneca (£56bn) and Shire (£27bn), and is an unlikely takeover target. If rumours swirling around AstraZeneca and Shire evaporate, Glaxo stock will outperform its smaller rivals, in my view.

british american tobacco / imperial tobaccoBAT: More Upside Than Downside

BAT stock is up 11% this year. Its trading multiples suggest upside could be between 5% and 10% to the end of 2014.

BAT’s long-term prospects, according to market consensus estimates, suggest limited growth for revenue, although EPS growth is forecast in the region of 8% annually to the end of 2016. With a 4% dividend yield, BAT is a less risky bet in the current environment — although I think Glaxo will really surprise investors.

Don't forget to diversify your portfolio at this point in the business cycle. That's sound advice from out team of analysts.

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Alessandro doesn't own shares in any of the companies mentioned. The Motley Fool has recommended shares in GlaxoSmithKline.