Wesfarmers vs. Woolworths: Buy, hold or sell?

These two blue chips are key holdings in many portfolios. Should they be?

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Despite a few rocky days thanks to the quarrelling in Washington, DC, over debt ceilings and budget shutdowns, the stock markets in Australia and the US are still cruising along at multi-year highs.

So while blue chips such as Wesfarmers (ASX: WES) and Woolworths (ASX: WOW) certainly aren't 'on sale' just yet, a little of the heat has come out of their stock prices and the next few weeks could potentially create a buying opportunity.

Wesfarmers is a more complicated and diversified company than Woolworths, making the valuation of the company more difficult. With eight reporting segments that span non-discretionary and discretionary retailing, insurance and resources, the Wesfarmers business faces threats and opportunities from many angles.

In contrast, Woolworths is primarily exposed to non-discretionary spending but is increasingly venturing into new areas, such as its recent foray into the home improvement market. From a valuation point of view, the more stable earnings base of Woolworths arguably deserves a premium to the market given its lower risk.

On the other hand the diversified earnings stream of Wesfarmers means it should grow its earnings at a faster rate than Woolworths and hence a reasonable argument can be made that Wesfarmers should trade at a premium to Woolworths.

According to Commsec, the S&P/ASX 300 Index (Index: ^AXKO) (ASX: XKO) is currently trading on a forecast price-to-earnings ratio (PE) of 17.76. In comparison, Wesfarmers, which is forecast to grow its earnings per share (EPS) over the coming year by 11.89%, is trading on a forward PE of 18.66. Meanwhile, Woolworths, whose EPS growth is forecast at 4.5% is trading on a forward PE of 17.47.

Based on these figures the market thinks Wesfarmers deserves a premium due to its forecasted double-digit growth rate while Woolworths deserves to trade at roughly market multiple. On balance, the market would look to have the valuations about right — assuming the market multiple is reasonable.

Foolish takeaway

As wholesaler Metcash (ASX: MTS) and such as Goodman Fielder (ASX: GFF) know, the supermarket giants are powerful and tough competitors. Their strong market shares and wide moats make them enviable businesses to add to a blue chip portfolio — at the right price. With the shares looking about fair value at present, investors might consider waiting for a discount to appear.

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Motley Fool contributor Tim McArthur owns a share in Goodman Fielder.

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