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Why GlaxoSmithKline plc Is More Attractive Than HSBC Holdings plc

By traditional valuation ratios HSBC Holdings (LSE: HSBA) looks cheaper than GlaxoSmithKline (LSE: GSK), but there is more to successful long-term investing than buying the cheapest-looking shares.

Businesses have different characteristics

We’d all be investing superstars if looking for ‘cheap’, then buying and holding for a long time, was all it took to outperform on the stock market. The decision to buy HSBC Holdings over GlaxoSmithKline would be easy when presented with these valuation indicators:

 

Share price on 6/5/15

Forward P/E ratio for 2015

Price-to-book ratio

HSBC Holdings

632p

11.5

0.94

GlaxoSmithKline

1518p

17

1.01

By considering only the numbers, we’d conclude that HSBC is cheaper than GlaxoSmithKline. However, businesses have different characteristics, and putting our analysis into a one-size-fits-all valuation model can lead to some serious misjudgements.

Where these firms sit in the investment landscape

US investor Peter Lynch urged us to look at companies according to the characteristics of their underlying businesses before attempting to value them. Lynch’s categories are:

  • slow growers;
  • stalwarts;
  • fast growers;
  • cyclicals;
  • turnarounds;
  • and asset plays.

Lynch’s six categories constitute a powerful investment mind-model, and it could be costly to dismiss them because of their apparent simplicity.

As a bank, HSBC Holdings falls into the category of Cyclical with a little bit of Turnaround potential still present since last decade’s financial crisis. As a defensive pharmaceutical company, GlaxoSmithKline behaves like a Slow Grower with some Turnaround potential present since the firms patent-expiry challenges.

Looking forward GlaxoSmithKline has potential to reap further best-selling, patent-protected drugs from its development pipeline. Such progress could propel the firm into the Stalwart category as its earnings grow. HSBC Holdings, though, will always remain in the Cyclical category.

Different valuation models needed

The value assumptions we make for a cyclical company such as HSBC Holdings need to be different from the assumptions we make for a defensive business with growth potential such as GlaxoSmithKline. That’s why categorising a firm’s business should override any analysis based on valuation alone.

Banks are amongst the most cyclical of all firms listed on the London stock exchange, which means HSBC’s cash flow and profits move up and down in tune with macro economic cycles. Periods of economic stagnation tend to hit the banks’ businesses hard, and we see such fluctuating patterns of business reflected in the banks’ share prices.

Right now, with world economies in apparent mid-cycle, banks ‘deserve’ a moderate rating in terms of their valuation. The stock market is always forward-looking, which means bank valuations are likely to compress gradually in anticipation of the next down-leg, as the current macro-cycle unfolds. When banks hit peak earnings in a macro-cycle, we ‘should’ be seeing the lowest price-to-earnings ratios and the highest dividend yields in the banking sector.

Contrast that valuation situation with that of GlaxoSmithKline’s. Continuous and rising demand drives the pharmaceutical sector as world’s population ages and multiplies. Macro-economic fluctuations have little effect on that demand, which leads to reliable cash flow in the sector.

GlaxoSmithKline’s earnings growth is worth more than HSBC’s

Growth in earnings from GlaxoSmithKline is worth more than that from HSBC Holdings because, over the longer term, Glaxo’s earnings are likely to be more sustainable. Therefore, it seems ‘correct’ that GlaxoSmithKline trades on a higher valuation than HSBC Holdings.

GlaxoSmithKline's defensive growth potential makes the firm more attractive than HSBC Holdings despite the bank's apparent lower valuation. Our top analysts here at the Motley Fool identified GlaxoSmithKline as one of five super-shares listed in the FTSE 100 index capable of making superior long-term investments. You may find out the identity of the other four companies, free of charge, by clicking here.

Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended GlaxoSmithKline and HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.