Worth every penny

Many of these questions can be answered by using a simple stock screen to identify “reassuringly expensive” (thank you, Stella Artois) stocks. These shares historically trade at a high price but they have delivered the goods to back it up, and during the crunch years investors gravitated towards them. Now, although the economy is showing modest signs of recovery, some of these stocks have held on to their punchy ratings, reflecting the market’s view that it’s worth paying for quality. We’ve used a stock screen based on the criteria below, which gave us a top-five ‘Stella’ stocks.

Our reassuringly expensive criteria:

■ Total return on equity greater than 15 per cent.

■ Dividend cover of two times earnings before interest, taxes, depreciation, and amortisation (Ebitda) or more.

■ Forecast earnings growth for two years or more.

■ Consistent EPS growth over the past five years.

■ Net debt to Ebitda less than 1.5 times.

■ A cash conversion rate greater than 90 per cent.

■ Ebit margins greater than 15 per cent.

■ Market capitalisation greater than £500m.

This stock screen revealed a neat and tidy top-five stocks that span several sectors and different products and services. Therefore, it’s fair to say that investing in quality can bring diversity to an equity portfolio. Admittedly, it’s not the Warren Buffett-style hunt for value, but it does borrow some of his principles in terms of long-term investing. In each stock analysis, we have pointed to the fact that on just a five-year basis (arguably not long-term for many) several of these stocks have strongly outperformed expectations. Return on equity (RoE) – which demonstrates how efficiently a company is using its balance sheet – is another clear Buffett tactic in sifting out what’s worth buying and this formed the principal basis of this test. Easily manageable debt underpinned by strong cash generation are another good indication of businesses unlikely to run into any serious trouble.

But it should be said that while stock screens offer effective tools to cut through reams of research, it fails to be a complete tool. There are a number of things missed which still – in our opinion – make up a quality stock worth paying for. A prime example, and one highlighted by the Whitbread analysis below, is group management. The reputation of chief executives, finance directors and their past performance cannot be easily analysed by a stock screen but can count for a huge amount in investment decisions. The extent to which the company remains family-owned can also influence investors – a criterion particularly relevant to investing in quality pub operator Fuller, Smith & Turner (FSTA) which trades on 20 times forward earnings. It doesn’t make the cut on the stock screen due to size, but demonstrates many of the characteristics we feel it’s worth paying top dollar for.

Similarly, a stock screen can’t filter out nuanced changes in trading which might spell a period of change. Is the company over-reliant on one customer for the bulk of its earnings? If it is, a change in ordering patterns and thus earnings can destabilise the shares quite quickly. It’s another concern to be aware of when paying out for quality stocks: toppy forward PE ratios aren’t stable and any miss on forecasts can force the stock to de-rate sharply. The earnings growth criteria in our screen should weed out this risk. We’re looking for companies that can keep up with their ratings.

The limits of a stock screen also explain why BT scored a perfect eight while Sky scored a mere five. Regardless, we still rate both stocks as a buy. The latter might not have the balance sheet and track record this test was looking for, but it’s got an undeniable monopoly on the pay-for-TV market in the UK, and continues to attract numerous new customers – factors which help it comfortably pass the margin test.

As ever, stock screens are a valuable starting point for anyone looking to balance portfolios in a certain way, but their limitations should not be underestimated or viewed as a replacement for more thorough research. The results are presented in alphabetical order.

BT (BT.A)

If you wondered whether the telecoms industry would show up in this screen, you might have placed a 50:50 bet on either Sky or BT rising to the top. The two spent much of the last year locked in a battle for broadcasting rights for key Premier League football matches. In the end, Sky paid £4.2bn to show 126 matches per season, including the first ever Friday evening games and both Sunday slots packages, while BT paid £960m for 42 games per season – four more than its present deal. Overall, the combined total hit a new record – in fact it almost doubled what the two groups currently pay between them.

In February BT agreed to acquire mobile operator EE for a staggering £12.5bn, buying all EE shares currently held by Orange and Deutsche Telekom. The stock market clearly supported the move by sending BT’s shares up by 4.5 per cent. There’s good reason: the deal trebles BT’s retail customers adding the 10m it already had to EE’s 24.5m mobile subscribers. Along with newly launched TV and mobile packages, the latest deals make up part of BT’s wider strategy to offer ‘quad-play’ bundles of fixed-line, mobile, TV and broadband services.

The answer to why Sky fared poorly in this screen test seems to be the group’s debt levels. Net debt at Sky represents 227 per cent of net assets, compared with just 26 per cent at BT – interestingly as Sky is the smaller company of the two. That said, the dividend cover at Sky is roughly 2.9 times, compared with 2.3 at BT. However, it appears BT’s track record stacks up better, having beaten Sky on the test for five years of consistent EPS growth.

EE brings 24.5m subscribers to BT

Halma (HLMA)

Industrial technology group Halma has earned its status as an ‘old reliable’ stock – one that investors can rely on for a solid return, consistent growth and steady income. Case in point: at the full-year results in June, the group hiked the dividend by another 7 per cent – for the 35th consecutive year. Even last year’s weaker industry growth and currency headwinds couldn’t hold Halma back and the group reported its 12th consecutive year of underlying growth.

The secret, according to the group’s bosses, is paying attention to long-term social trends and keeping up to date with current health, safety and environmental legislation.

It seems to be a formula that works and Halma’s track record is indisputable. In fact, we summed it up nicely last summer when the group released a set of full-year results: record revenue and profit for the past 11 years; operating margin above

16 per cent for 29 years in a row; dividend increases of at least 5 per cent for 35 years, and rising sales in 38 of the past 40 years. These statistics serve as important reminders why shares in the engineering group deserve to trade at a significant premium compared with its sector peers.

Arguably, from the results of this stock screen, Halma might serve as the best example of an acquisition-led growth strategy. Last year the group spent £100m on new companies to add to the group. But it’s clear it tries to buy quality and never bets too big, preferring so-called ‘bolt on’ deals that can be easily integrated. RohrbackCosasco Systems, on which Halma spent £65m, came with a solid operating margin of 25 per cent.

Essentially, whether Halma is buying up businesses or growing its own, the group invests in making products the world cannot do without. And when the market is volatile, this kind of reliability generally comes at a price.

In focus: Halma might serve as the best example of an acquisition-led growth strategy

Next (NXT)

If you invested in high-street retailer Next five years ago, that investment would have doubled in value – twice. It’s a renowned success story for Britain’s high street during one of the most challenging periods for consumer confidence in recent memory. However, management has done a good job of keeping its own confidence in check. At the last set of results – where numbers came in at the top end of analysts’ guidance – finance director David Keens said the economic recovery and improvement in real wages had not fully filtered down to the way people shop for clothes. Times are still “uncertain”, according to Mr Keens, although he also admits the business is in “good shape”.

The softer outlook might be a concern for some investors, but a good track record should serve Next well in the coming 12 months. Although the business is up against some tough comparatives this year, it remains extremely cash generative and with relatively low gearing, that should lead to consistent growth in profitability.

Although debt levels might be more than 150 per cent of net asset value (NAV), that’s down to a generous handing back of cash to shareholders – another boon for investors willing to shell out for the stock. This year Mr Keens said shareholders could expect a cash windfall of £360m, either through share buybacks or special dividends.

Of course, general retailers – and clothing retailers specifically – are often affected by the same forces, such as weather, which remain at the mercy of fate. So, it’s important to take control where you can, and investors could do worse than put their faith in six years of consistent share price growth – something Next can attest to.

Victrex (VCT)

At first glance, shares in polymer producer Victrex don’t appear to have had the smoothest ride in the last year. Yes, the share price is up overall, but not without some serious dips along the way. However, when seeking out a quality stock the big picture is crucial. Since 2010, shares in Victrex have doubled in value. That largely reflects growing demand for consumer electronics and, specifically, the proliferation of high-spec smartphones which require high-performance polymers in their design.

Victrex’s success also comes down to the fact it’s a very high-margin business. In the first half of the financial year, higher volumes and manufacturing efficiencies drove a 90 basis point increase in gross margins to an impressive 64.9 per cent and an operating margin approaching 41 per cent. But suspicion is mounting that, as manufacturing costs increase, Victrex won’t be able to hold on to these margins. Cost-cutting is paying off for now, but quality outfits like Victrex can find themselves held to an extreme standard by the market. A slight miss on margins, even if they stay relatively high, could be enough to destabilise the share price.

Suitable entry points for new investors have been hard to spot with Victrex, but existing shareholders have been well rewarded, and not just with an increasing share price. Last year, the group announced a special dividend worth 50p a share. At the time, that announcement, along with buoyant sales figures, sent the share price up 7 per cent in one day.

For now, as Victrex starts to pour money into capital investment, the prospect of a special return looks less likely. The group is also tackling currency headwinds and a tail-off in sales from its oil and gas business, which has suffered from depressed investment in global energy markets. But any weakness in the share price could offer up a welcome buying opportunity.

Victrex makes metal-replacement polymers than can withstand the harshest operating conditions

Whitbread (WTB)

What this stock screen might have failed to pick up is the fact it’s all-change at catering and hospitality giant Whitbread. Although the share price has increased nearly fivefold since 2010, recent weakness could be put down to imminent management changes. After five years at the helm, chief executive Andy Harrison will hand the reins over to Alison Brittain next January. Currently the boss of Lloyds Banking’s retail banking arm, she’s been called “one of the most powerful women in the City”.

Management changes aren’t always directly proportional to share price performance. But, in this case, Mr Harrison had a solid track record, having served the same role at easyJet (EZJ) and automotive services group RAC. Whitbread has also performed extremely well under his leadership. So, perhaps it’s valid for the market to have concerns even if his replacement has a great reputation.

Another – more quantitative explanation – could be the group’s near miss in its recent full-year results (the same day Mr Harrison announced his departure). Pre-tax profit of £488.1m came in just 0.9 per cent shy of broker Numis Securities’ forecast for £492.4m and even EPS growth of 19.4 per cent was a little below the top-of-the-range forecast. The problem is companies such as Whitbread are held to rigorous standards by the market and even a slight miss – less than a full percentage point in this case – can be enough to destabilise the share price (good news for those with a long-term mindset, though).

However, in an attempt to buck up market expectations, the group has published new growth targets. These project a compound annual growth rate in Premier Inn UK rooms of 7.5 per cent by 2020 (approximately 85,000 rooms) and a compound annual growth rate of 12.3 per cent in Costa Coffee sales (to £2.5bn). These sizeable targets suggest there might be considerable growth in the Whitbread business model for some time yet.