TIP OF THE YEAR 2009: Renishaw (RSW)

Last year will be one that most equity investors will want to forget. The FTSE 350 fell 35 per cent over the period, and many will start 2009 sitting on heavy losses. One small consolation could be that shares in some of the better run mid-cap companies - which in normal circumstances attracted premium valuations - have been unable to escape the indiscriminate ravages of the bear market.

That means now might be a good time to buy into high-tech measurement business Renishaw. Since listing over 20 years ago, the company has demonstrated the kind of attributes that would make it the pick of any portfolio. These include uninterrupted year-on-year sales and profit growth, consistently above-average operating margins, steady dividend increases, strong cash generation, and an aversion to taking on debt.

But this kind of quality has always come at a price. Renishaw has often traded on a multiple of more than 20 times earnings, well above the average for both the FTSE 350 and the electronic equipment sector.

Not so now. Renishaw's shares have fallen more than 25 per cent over the past year - including a 40 per cent drop in the last three months, even as earnings have continued to grow. That means they now trade on 11 times forecast earnings for the 12 months to June 2009, even though the company retains all of the qualities that once made it so highly rated. For example, in its last financial year, Renishaw grew sales by 11 per cent to £201m, while underlying operating profit (excluding pension credits which bolstered the 2007 result) climbed at an even faster rate, up 28 per cent to £37.3m, thanks to a massive 2.2 percentage point leap in operating profit margins to a very healthy 18.5 per cent. The company was able to achieve this because of an increased level of new higher-margin products in the sales mix and because the operational gearing of the business.

According to Renishaw's last trading update, in October, demand remains strong despite the mounting effects of the global economic slowdown. Sales in the first three months of the current financial year climbed 24 per cent, while profit before tax jumped a massive 75 per cent to £9.8m. Admittedly, this was boosted by the weakness of sterling - Renishaw pointed out that favourable exchange rate movements added £2.9m to pre-tax profits, and that revenue growth was "only" 14 per cent when the effect of currency moves was removed. Still, that's no mean feat in the current environment.

Renishaw is likely to have benefited further from exchange rate fluctuations in the last few months, too (after taking a currency hit when the pound was strong in 2007). The company does much of its business in continental Europe and Asia Pacific - 38 per cent and 30 per cent of sales, respectively - and sterling's decline against other major currencies has accelerated since the end of September. Moreover, since Renishaw doesn't fully hedge its exposure to foreign currency, much of the effect will flow through to the profit and loss account.

While we wouldn't usually give a company credit for macro events that are beyond its control, Renishaw does deserve recognition for its success in building up a truly international business, which means that weakness in any one market is offset by strength elsewhere. We also like its no-nonsense approach to managing its finances. As well as avoiding complicated and expensive hedging arrangements where possible, it's always resisted the temptation to gear up its balance sheet. The company has also paid close attention to its inventory management and working capital requirements, which meant that operating cash flow more than doubled last year to £46.9m.

Of course, Renishaw isn't completely immune to any wider economic weakness - despite ventures into resilient areas such as dental design and robotically assisted neurosurgery, most of its customers are in the manufacturing sector. And the company doesn't have the luxury of a lengthy order book and high levels of recurring revenue, with contracted sales only accounting for about three months of annual turnover. But Renishaw invests heavily in research and development and fiercely protects its patents, so its niche positioning will help it through the downturn.

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