Washington H. Soul Pattinson (SOL) or Wesfarmers (WES) – Which is the Better Investment?

In this article I will explain why I would buy SOL instead of WES if I had to only own one of the two ASX-listed companies.

Disclaimer:  As of publishing this article on 08/06/20, I own shares in both companies.

Introduction

Few companies listed on the ASX can match the pedigree, scope, or returns of Washington H. Soul Pattinson (SOL) and Wesfarmers (WES).  Both are large, diversified conglomerates with capable management, stable dividends and a long history of outperforming the broader ASX.  SOL was listed on the ASX in 1903 and has roots dating back to 1886 (in Sydney, NSW).  WES was formed in 1914 (in Perth, WA) and was eventually listed on the ASX in 1984.  Ask any Aussie investor and he or she will confidently tell you that these two companies are the very definition of blue-chip stocks.

I am also willing to bet that there isn’t a single person or company in Australia that has not done business with one of WES or SOL’s many subsidiaries.  That’s how vast their economic reach is.  For instance, the construction industry will often purchase supplies from the likes of Bunnings, Blackwoods, and Brickworks.  Consumers like you and I regularly rely on the products sold by Officeworks, K-mart, Priceline Pharmacies, and Coles.  Many industrial and agricultural firms generate their outputs from the coal and fertilisers which are mined and produced by the subsidiaries of SOL and WES.  Long story short, these companies have their fingers in many different pies.

So now you should understand why I call them conglomerates.  Because their whole is made up of the sum of many diversified and independently managed parts.  I also want to briefly discuss why pundits are wrong to label SOL as an LIC (a Listed Investment Company).  While they do have a basis for such an opinion, it just doesn’t stack up when you look at SOL’s structure, its investments, and its overall investing ethos.  On the spectrum of Berkshire Hathaway to a typical Australian LIC, SOL would land more on the Berkshire Hathaway end.  This mainly has to do with the fact that SOL has few and large positions in the companies it invests in – much like Berkshire – while an LIC has numerous and small positions, relatively speaking.

Past Performance

As can be seen in the table below, the 30-year performance of both companies has been excellent, delivering well over the market return.

$1,000 invested in either company on January 1st 1990 would have netted you between $24,480 and $27,540 including dividends.  That is a great result over a 30-year timeframe considering the same $1,000 investment in the ASX would have “only” delivered you $14,095!  This type of analysis clearly demonstrates the kind of return a 35-year-old can expect to achieve by the time he or she is at the retirement age of 65 by simply investing their savings in either SOL or WES (or both…to spread the risk as we’ll see in the next section).

While nowhere near the close-to 20% annualised returns of Berkshire Hathaway, the fact remains that these two blue-chip companies have outperformed the ASX by more than 2% each year.  That demonstrates that their management’s strategies and decisions have worked and continue to do so.  That’s really the core reason why an investor like you or I would consider investing in and holding onto a conglomerate company like SOL or WES for 30 or more years.

Stock Price Volatility

Investors, especially those more reliant on drawing down their capital during retirement, must understand how volatile these companies are.  And I’m not talking about the upside volatility here.  The chart below visually demonstrates that WES has exhibited much greater price volatility to the downside during stressful economic times than SOL (look at 2008-09 and 2020).  These downside plunges from WES are not ideal during retirement or during a time of emergency when a large amount of the stock may need to be divested.

The main reason behind SOL’s and WES’ different price volatilities is due to the significantly different levels of debts these companies carry.  For now, I’ll let you take a guess as to which one is more aggressive and has more debt.

Shares Outstanding

This is an aspect of a company’s history that is often overlooked by investors.  I find that it gives us a fascinating insight into how financially aggressive (WES) or conservative (SOL) a company’s management has been over the past.  The chart below clearly demonstrates this by showing the divergence between WES and SOL over the last 30 years.

Note: I could only find the number of outstanding shares for SOL from 2001 onwards

To interpret this chart, you must first be aware of the methods by which these conglomerates finance their acquisitions.  WES favours the use of what’s called a scrip bid.  As can be seen, they did this back in 2001-02 when acquiring Howard Smith and did it again in 2008-09 (on a much bigger scale) when they acquired Coles Group.  This basically means that the shareholders of Howard Smith and Coles Group were offered a combination of cash and new shares in WES as compensation.  The existing shareholders in WES trust that their management team made the right decision in acquiring these new assets at good prices.

The other way to acquire a company is to either have a large pile of cash or to borrow money.  As can be seen, this is the method by which SOL acquires stakes in companies.  We know this because the number of total shares outstanding have remained practically unchanged over the years.  As we’ll see in the next section, WES have also employed high levels of debt-financing to facilitate their acquisitions (remember, the offers that WES presented to Howard Smith and Coles Group shareholders were new WES shares and cash so they had to get the cash from loan facilities).

Financials

This section will explain why WES exhibits more price volatility to the downside than SOL.  As can be seen from the table below, the debt that WES has been exposed to over the past 10 years is, on average, nearly 3 times their yearly NPAT!  Contrast that to SOL’s 0.5 times their yearly NPAT.

What this translates to, in layman’s terms, is that SOL can easily service their debt from a single years’ retained earnings.  WES cannot do this and they must re-finance their debts (i.e. roll them over) in order to pay them off.  This strategy works well in times of low interest rates but, ultimately, is unsustainable in the long run.  When interest rates rise, WES will prefer to pay off their debts with retained earnings, thus impacting the dividends they pay.  SOL, on the other hand, can continue to pay dividends.  This is another important consideration for an income investor or a retiree.

The next table clearly demonstrates this.  SOL fully pays their dividends from their retained earnings.  This is a sustainable practice.  WES, on the other hand, must finance 43% of their dividends from debts.

Why would a company do this?  Well, it has to do with the management’s confidence in future earnings and their ability to divest profitable investments on an as-need basis to finance debts and dividends.  This was seen over the last quarter when Wesfarmers sold off approximately 10% of their 15% stake in Coles Group.  This locked in a profit for WES and also provided them with liquidity they can now deploy to service debts, pay dividends, or invest in new opportunities.  As we’ve already discussed, SOL takes a more conservative approach and this explains why their stock is more defensive during a down-turn and also explains why their dividends into the future will be much more reliable than Wesfarmers’.

The final column in the table above I looked at out of interest.  I wanted to see which company did a better job at managing their non-core sources of income (such as hedges, currencies, etc.).  It looks as though SOL is doing a better job at this than WES.

Conclusions and Thoughts

While WES returns over the last 30 years have been higher, on average, than SOL, we need to risk-adjust these returns to better appreciate which company is making better investment decisions.  As we’ve seen, WES is far more aggressive in the use of debt than SOL.  This is a great source of risk as a single poor investment can have magnified losses because debt was employed in the acquisition of that asset.  Any risk-adjustment to returns makes SOL out to be a far better investment and long-term prospect than WES (as interest rates will have to go up eventually).  Based on this analysis, I plan to sell my shares in WES, acquire more SOL, and consider adding to my other positions in my portfolio.  Now, this does not exclude me from ever owning WES again, as I believe it to be composed of excellent businesses with excellent prospects.  The issue lies in its current price.  Given the risks, a more appropriate buy-in price for WES is in the $27.5 to $32.5 range.  SOL, on the other hand, I feel is fairly priced at the moment.

As Always,

Invest Sagely (08/06/2020)