Investing in quality companies can be a wonderful thing. Businesses that can make large returns on the investments they make and also have the growth potential to plough that cash into similarly lucrative opportunities can generate incredible value for shareholders. Such companies harness the magic of compounding. Each year, they grow from a larger base, meaning they have progressively more money to invest the following year.
The incredible maths of compounding means we all struggle to get our heads around how powerful it is as a means of wealth creation. As a highly simplified example, let’s take a company that does not use debt and has no maintenance spending needs. If it starts life with £1m of shareholder equity, consistently returns 20p on each £1 invested in the business (ie, a 20 per cent return on capital) and ploughs all its profits back into a limitless growth opportunity, the value of shareholder equity would hit £1bn in 38 years. That’s a mind-blowing 1,000-fold return! No wonder Albert Einstein is said to have called compound interest “the eighth wonder of the world”.
However, another consequence of the maths of compounding is that businesses that are exemplars of the phenomenon are few and far between. The global economy simply isn’t big enough for many of them.
What’s more, while it is easy to describe what investors should be looking for, it is much harder to find the real thing. And those companies that look the most reliable bets tend to have sky-high ratings attached to their shares. The danger of overpaying for stocks that appear to fit the bill is amplified by the fact that the human brain is hardwired to be gullible when presented with impressive-but-shaky growth stories.
Still, there are ways of increasing our chances of coming across one of these much-cherished investment plays. We can start by looking for 'quality compounders' in the right place. Historically, this has unfortunately not been on home shores. Rather, it is the US where world-beating quality companies emerge in relative abundance. This makes sense based simply on the size of the country’s domestic market, which provides huge scope for growth. Less tangibly, a culture that promotes entrepreneurship and technological innovation may also be a factor. Whatever the case, history suggests the US is a land of opportunity for investors looking for quality compounders.
But it is not only where we look for quality stocks that matters but also how we look for them. On the 'how to' front, we are exporting a bit of British know-how. In this article, we are going to scour the US market using one of Investors’ Chronicle’s favourite quality screens: the High-Quality Large-Cap screen.
In this magazine’s weekly stock screening column, based on annual portfolio reshuffles, this strategy has racked up a cumulative total return of 508 per cent over the 10 years from inception in August 2011. That compares with 120 per cent from the FTSE All-Share over the same period. In other words, the screen appears to be doing something right.
No screen does nuance very well, though. There are a number of things the screen’s criteria can overlook. Two in particular stand out. Firstly, this screen is obsessed with high margins. The reason for this is because when companies make large profits from their sales, it suggests they are doing something that is special and hard to copy. Something their customers are willing to pay up for because they can’t get it elsewhere.
However, some quality companies generate high returns on investment by selling a lot of stuff for each dollar invested in the business but at low margins. Discount retailer Costco (US:COST), which uses a membership system as a competitive moat, is an example of such a business. Our screening criteria misses out on the Costcos of this world.
The other big caveat to be aware of with our screen is that many of the most successful compounders in the world owe their fortunes to their investment in intangible assets. In a weird twist of accounting rules, these types of investments are generally treated as day-to-day costs rather than being logged as assets on the balance sheet. For intangible-intensive companies investing heavily in growth, this can substantially depress reported profits and margins. It also leads to an under-reporting of assets on the balance sheet. That makes such companies appear as though they have required much less investment to get to where they are than is actually the case.
The biggest danger comes for the screen with intangible-intensive companies that have run out of growth options and consequently reduced their level of investment. This will cause reported profits to surge because costs associated with intangible spending will drop. At the same time, a diminutive balance sheet that has failed to log past spending on intangible assets will make the company appear to be making returns on the assets that have been recorded.
So some opportunities will be missed by the screen. And some that the screen highlights may be false. That’s why we’re rolling up our sleeves and getting stuck into the screen results so we can tell you what’s what.
Read our in depth analysis of the top four companies from the screen:
|Name||Ticker||Sector||Mkt Cap||Price||Fwd PE||DY||PEG||GV Ratio||FY EPS gr+1||FY EPS gr+2||3M Fwd EPS||3-mth Momentum||EBIT Margin||RoE||Cash Conv.||ND/EBITDA||Test failed|
|S&P Global||SPGI||Financial Publishing||$111bn||$460.97||32||0.6%||2.25||1.53||16.7%||7.6%||9.1%||6.6%||51.9%||473.5%||91%||0.16||-|
|Hershey||HSY||Food||$26bn||$176.69||23||1.8%||1.98||1.39||12.4%||7.2%||7.8%||3.1%||22.1%||64.4%||103%||1.77||RoE and margin up|
|Paychex||PAYX||Data Processing||$44bn||$120.65||34||2.1%||2.58||1.60||13.9%||6.8%||8.5%||10.3%||38.4%||38.3%||89%||-0.10||RoE and margin up|
|Zoetis||ZTS||Pharmaceuticals||$106bn||$223.19||43||0.4%||2.52||1.89||20.7%||11.7%||8.1%||10.9%||35.7%||50.6%||83%||1.40||RoE and margin up|
|Moody's||MCO||Financial Publishing||$72bn||$389.15||31||0.6%||1.68||1.26||21.3%||3.7%||8.1%||4.9%||47.0%||163.0%||85%||1.59||RoE and margin up|
|CDW||CDW||IT Services||$26bn||$193.62||23||0.8%||1.47||1.12||18.5%||7.4%||6.1%||-1.0%||7.0%||69.9%||86%||2.01||Margin test|
|Jack Henry||JKHY||IT Services||$11bn||$152.15||31||1.2%||2.47||1.71||14.3%||9.4%||8.8%||-10.2%||23.1%||21.7%||110%||0.16||RoE test|
|Kansas City Southern||KSU||Railroads||$27bn||$290.71||30||0.7%||2.43||1.51||16.8%||20.7%||1.4%||2.1%||38.9%||14.6%||97%||2.62||RoE test|
|Source: FactSet, accurate as of 2 Dec 2021. Some prices may differ to those quoted in individual articles. £1=$1.33.|