11 High Quality Large Caps

What a great decade it has been to be an investor in quality larger companies. That’s even true for UK-focused investors despite the fact that our home shores are not seen as a natural hunting ground for such stocks. A case in point is my high-quality, large-cap screen. It boasts a 520 per cent cumulative total return since I started to follow it 10 years ago. That compares with 121 per cent from the FTSE All-Share. If I factor in an annual charge of 1.25 per cent the screen’s return drops to 447 per cent.

What’s more, unlike some of the other heavy-hitting screens I run in these pages, it has achieved the knockout record without any major upsets. Indeed, during the 10 years the worst peak-to-trough fall experienced was 26 per cent when markets went into their Covid-induced meltdown in March 2020. That compares with the FTSE All-Share’s 35 per cent decline in the same period.

One well-chronicled feature of investing in quality companies is that while such shares tend not to be hit as badly as the rest of the market during a downturn, they tend to lag during a recovery phase. As celebrated fund manager and quality-investing doyen Terry Smith recently said of his fund’s underperformance during the recent value rally, “our stocks have nothing to recover from”.

So perhaps unsurprisingly the screen’s selection of 12 stocks last year did underperform the wider market. That said, together they managed a solid 23 per cent total return.

While performance overall has been both impressive and steady, in other ways it has not been an entirely seamless 10 years for the screen. Of particular note is the fact that I’ve been forced to abandon some of the original screening criteria over the years. In particular, I’ve now jettisoned any consideration for valuation. Originally the screen looked for shares that were reasonably attractive based on a price/earnings growth (PEG) ratio. However, it has become very hard to find shares in companies that offer genuine credentials as quality plays that also look attractively valued.

A general rerating of shares in the UK’s best companies has also been a factor in the screen’s overall strong performance. Looking at the 11 shares selected by this year’s screen, they have on average rerated by 122 per cent over the past 10 years. No small part of this is to do with the fact that the market was still reeling from the credit crunch 10 years ago. Also many of the names on the list have simply become better companies over the time. But even looking back just five years they’ve rerated by 46 per cent on average. Valuations in this part of the market, especially for quality darlings, are certainly not what they used to be.

That said, the power of compounding means higher valuations can often be justified for a company that can consistently achieve a high return on the money it reinvests into its business and has significant room to grow. The trouble is, such companies can be very hard to spot, even if the human mind’s penchant for “hindsight bias” makes it feel otherwise. 

I have tinkered a bit with the screen’s criteria this year to get around some of the problems created by the big hit many companies have taken due to the pandemic. The criteria based on historical growth and consecutive years of improvement have been softened. All valuation criteria have also been removed. That leaves this year’s criteria as follows:

■ Return on equity (RoE) in the top quarter of all stocks screened in each of the past three years.

■ Operating margin in the top quarter of all stocks screened in each of the past three years.

■ Earnings growth forecast for each of the next two years.

■ Interest cover of five times or more.

■ Positive free cash flow.

■ Market cap over £1bn.

■ RoE growth over the past three years.

■ Operating margin growth over the past three years.

■ Operating profit growth over the past three years.

While it’s always preferable to stick with a hard-and-fast screening criteria, it is my opinion that it makes sense to adapt if it is the only way to keep a screen producing the kind of results one wants. In this case, the list of stocks highlighted from the amended screening criteria looks like a credible list of “quality” names.

Given my comments above about valuation, I’ve decided to look at the cheapest stock on the list. I think it holds lessons about putting too much faith in the numbers when trying to hunt for real quality (I don’t think it really delivers on the quality front). But also illustrates how inconsistency can create opportunities for investors prepared to take on a bit of risk.

Moneysupermarket.com

Moneysupermarket.com (MONY) acts as a price comparison middleman. It points consumers towards the best deals for insurance, loans and utilities. The companies whose products it advertises then pay it fees or commission based on lead generation, which is often linked to sales. 

The online price comparison market is competitive. What’s more, the sector is subject to many external ructions. The experience of Moneysupermarket.com during lockdown provided an unwelcome illustration of this. 

When lockdown got under way in March 2020, investors had hoped that more time at home and a tough economic backdrop would lead to increased price-comparison activity as consumers scrambled to save on bills. Instead, Moneysupermarket.com was hit across the board due to both Covid-related difficulties in end markets and regulatory changes. 

A substantial drop in car insurance premiums resulted in reduced deal hunting. Insurance is the largest market for Moneysupermarket accounting for 48 per cent of pre-pandemic revenue. Within that, car insurance is the biggest source of sales at a bit under half the total.

Meanwhile, overseas travel restrictions decimated the group’s travelsupermarket business which followed on from a Brexit-related knock in 2019. Fortunately this division is a relatively small part of the whole.

The company’s money business, which compares loans and credit card deals, accounted for 22 per cent 2019 of sales. It suffered during lockdown as lenders pulled in their horns and tightened lending criteria out of fear of what the pandemic may hold.

And at the company’s utilities-focused home services division (18 per cent of revenue), the introduction of an energy price cap along with a surge in wholesale prices reduced opportunities to find savings. In the first half, the average saving Moneysupermarket.com was able to offer was down by 50 per cent and half of visitors were offered more expensive deals than those they were already on within their top three results. 

Investors also have reason to feel cautious about the regulatory outlook. The insurance industry is due to adopt new rules to prevent new customers being offered better deals than existing customers. This could have negative consequences for switching.

And Moneysupermarket.com also continues to fight a long-term downward trend in gross margins (see chart). This has been caused by the increased cost of attracting visitors to its sites. A key reason for this is the increased use of mobile devices. Generating mobile traffic is more dependent on paid search and mobile users tend to be less committed to transactions when they do visit a site, which means lower sales-conversion rates. 

Reasons to be cheerful

This fairly gloomy picture illustrates why it is hard to cast Moneysupermarket.com as a genuinely high-quality company. Indeed, long-term holders will be familiar with the company suffering due to forces beyond its control, such as the past impact of changes to the Google search algorithm, cyclical downturns in individual end markets (normally not as blanket as last year) and regulatory upsets.

The company nevertheless has its charms. What the stock screen has picked up on is that this is a company that requires very little capital to generate quite a lot of profit, which it is very good at turning into cash. It also hands a lot of that cash back to shareholders.

Over the past 10 years Moneysupermaket.com has returned an amount equivalent to nearly half the current market cap through basic dividends, special dividends and buybacks. It has also had enough money to make several acquisitions along the way. All of this has happened despite the occasional setback. 

The company has also worked to make itself better. To counter the risks associated with the potential for trouble in individual markets it has moved into new product areas. It has also worked on ways of engaging more with customers, such as through its MoneySavingExpert newsletters and by creating repeat business, as it does through autoswitch products. And its users are very enamoured with its offering. The company still boasts a knockout net promoter score of 70 despite its recent struggles to find big savings.

A new chief executive, Peter Duffy, was appointed last September and is hoping to make customer acquisition and data management more efficient. Duffy was formerly chief executive at Just Eat (JET) having been promoted from chief customer officer. The tactics he’s using to boost efficiency have included moving data onto Google cloud and introducing new customer relationship management (CRM) systems. 

There are early signs his action may be having the desired effect with gross margins, following many years of decline, rising from 67.0 to 70.1 per cent in the first half. The majority of the improvement (2 percentage points) was attributed to improved customer acquisition.

While changes in insurance regulation represent a future challenge, more generally end markets appear to be turning up. The home services business should be helped by a rise in the energy price cap. Car insurance premiums are heading back up as drivers get back on the road. And lenders are also loosening the purse strings. Meanwhile, the company’s travelsupermarket business has been merged with an online package holidays comparison site called icelolly.com. This should result in cost savings and could ignite growth when overseas holidays are once again de rigeur.

While brokers have not exactly been scrambling to upgrade their forecasts, some encouragement can be taken from the fact that following a series of downgrades, expectations do at least seem to have stabilised. 

On the money?

Predictability is an important consideration when assessing the quality of a company. Without this, it is hard to be sure about what will result from management’s capital allocation decisions. This poses the risk that the company could achieve worse returns on investment than anticipated and potentially destroy rather than create value. 

Moneysupermarket.com has demonstrated during lockdown that its business is not very predictable. It is not a true master of its own destiny. But over time the company has been able to produce impressive results and lots of cash. It does not have the kind of competitive position that guarantees that will continue, but is good enough at what it does for investors to take some comfort. 

Importantly, the valuation reflects the doubts. It is rated on a forecast free cash flow yield of 6.2 per cent for the next 12 months rising to a tantalising 7.2 per cent based on forecasts for the following 12 months. The forecast next 12 months dividend yield of over 5 per cent is also very attractive. And there are reasons to think the company’s luck could soon start to turn, although regulatory changes are a current concern. 

So while I can’t view the shares as a truly high-quality proposition, at the current price they could prove an attractive proposition nevertheless for those prepared to take on and monitor the risks.