Let’s imagine ourselves in a happier time for investors. A time when few had heard of the disease known as Covid-19, and when few who had regarded it as a major threat to either their health or wealth. A time when stocks were moving solidly higher; shares were ‘reassuringly expensive’; monetary policy was accommodative; a post-election fiscal boost was expected in the UK; and largesse looked likely in the US as the incumbent president jockeyed for re-election.
Breathe deeply and focus. Are you in this special place? Readers less traumatised by the recent market crash may even recognise these imagined investment surroundings as being very similar to the start of 2020.
Now let’s undertake one more mental exercise. With our reassuring investment backdrop held firmly in mind, imagine winning a competition that entitled us to buy a portfolio of shares at huge discounts to the prevailing market price – offers of 30 per cent off or even 50 per cent off are commonplace. Surely anyone would jump at that chance – the question is, which shares should we buy?
A plan to play the recovery
The trouble is that it is often hard to appreciate that ‘discounts’ are on offer when wracked by panic from crashing markets. Indeed, while our imagined clement investment backdrop feels far-fetched, tanking markets are causing ‘discounts’ to emerge. At some point a recovery will emerge, too. And while some big fallers will inevitably prove vulnerable to the economic shock caused by Covid-19, other shares are likely to prove fantastic bargains for long-term investors when the good times return.
A watchlist of dream stocks can help focus the mind on taking advantage of opportunities that arise at times of panic. With this in mind, the Investors Chronicle’s companies team has come up with a list of 22 shares in great companies across several sectors. These are shares that at the start of the year would have been top of our list to buy at discount prices; stocks our writers believe offer great buy-and-hold potential when considered with a zen-like calm unencumbered by concerns about the current state of the world. We’ve profiled 10 of these shares here and two more feature in our tips section this week (Diageo and LondonMetric).
This is not a list of straight-up buy recommendations, though. While some of the shares on the list have de-rated substantially already, others have held up relatively well during the sell-off. Rather, this is a watchlist of shares that during good times have often seemed prohibitively expensive, but may become available at bargain prices during the current bear market. In making our list, we’ve ignored defensive sectors such as pharmaceuticals and utilities, where selling is less likely to become indiscriminate.
End of sale?
It would be nice to think we’ve already seen the worst of the market’s fall. If we have, our watch list may be of less use. But, sadly, tough investment conditions may prevail for some time yet and shares may face frequent setbacks. This seems a clear possibility based on both the severity of the shock being dealt to the global economy and also the length of the bull market that preceded the crash.
So, should the bear market endure, we think it will pay for investors to have a clear idea of what buying opportunities will be worth seizing should they emerge. The ‘On the watchlist’ table, above right, is a list of stocks the Investors Chronicle is keeping a close eye on.
On the watch list
|Name||TIDM||Sector||Mkt cap||Price||Net debt (-)/cash inc. leases||EV/Sales||P/TangBV||CAPE||5yr FCF conv.||ROCE||CROCI|
|Auto Trader||LSE:AUTO||Communication Services||£4.0bn||438p||-£305m||12||-||43||116%||64%||57%|
|Central Asia Metals||AIM:CAML||Materials||£228m||132p||-£79m||2.2||-||16||87%||16%||15%|
|Derwent London||LSE:DLN||Real Estate||£3.7bn||3334p||-£985m||-||0.82||-||-||-||-|
|Fevertree Drinks||AIM:FEVR||Consumer Staples||£1.3bn||1155p||£102m||4.7||-||59||68%||47%||27%|
|InterContinental Hotels||LSE:IHG||Consumer Discretionary||£6.9bn||3800p||-£2.0bn||3.2||-||19||100%||27%||21%|
|London Stock Exchange||LSE:LSE||Financials||£26bn||7326p||-£814m||11||-||57||73%||13%||11%|
|LondonMetric Property||LSE:LMP||Real Estate||£1.4bn||165p||-£878m||-||0.96||-||-||-||-|
|Oxford Instruments||LSE:OXIG||Information Technology||£686m||1198p||£5m||1.9||-||22||74%||15%||15%|
Source: S&P CapitalIQ / Sharepad
|Name||Fall from 52wk high||Credit Crunch max drawdown||Crunch low to bull high||Price now||Crunch comparison|
|Central Asia Metals||-50%||-||-||132p||-|
|London Stock Exchange||-19%||-81%||2209%||7326p||1,676p|
Source: S&P CapitalIQ as of 27 Mar 2020
While the main purpose of this exercise is to think about the virtues of stocks away from the current crisis, we cannot entirely escape reality. So each of the write-ups includes a ‘Covid-caveat’ to briefly consider what the current crisis could mean for the company.
In the digital age, eyeballs can be a very valuable commodity. That’s certainly the case for Auto Trader (AUTO), which operates the UK’s leading website for motor vehicle listings.
The business benefits from a competitive advantage known as ‘the network effect’. Network effects exist when a service becomes more valuable the more it is used. In the case of Auto Trader, the more car buyers that visit its website, the more important and useful it becomes to advertisers, which means more cars are advertised, and the more comprehensive the listings on the website, the more worthwhile visiting the site is for car buyers, and so on and so forth. It’s a virtuous circle where the growing value created flows back to the site owner. After a certain point, there comes little point for buyers to visit other listing sites or sellers to advertise on them, cementing the market leader’s competitive position and pricing power.
As well as capturing eyeballs, Auto Trader has proved adept at providing new and valuable services for both advertisers and car buyers. This includes offering advice to buyers on financing options and insights to sellers on what vehicles are selling best in different parts of the country. This is a great business, and its operations require relatively little investment to grow, which means Auto Trader is very good at generating cash. One rub, though, is that the car market is cyclical.
Covid-caveat: Auto Trader has said that, as a result of Covid-19, it will allow its advertisers to defer March payments for a month and will not charge for April. It has also pulled its share buybacks and its final dividend and is preparing to place shares equivalent to about 5 per cent of those in issue, which could eliminate its debt. Rather than reflecting weakness, the fundraising can be seen as the company moving onto the front foot. There’s little reason to think the group is in danger of breaking its banking covenants, but the improved financial position will allow it to offer more assistance to customers during the crisis and seize opportunities for long-term growth once the crisis is over. The potential long-term rewards from building goodwill with customers during tough times have been reflected in record listings in April. End markets should recover in time and Auto Trader should still be well positioned to profit (significantly) from them. AH
The most profitable end of the retail market is the luxury end. For investors in London-listed shares, there is one clear choice to get exposure to the luxury market: Burberry (BRBY), a fashion house famous for its checked patterns and trenchcoats. The company’s brand has huge caché and stunning pricing power.
As 2020 got under way, there were signs that the company was seeing the fruits of a transformation plan launched in 2017, which has precipitated an avalanche of capital spending on stores and online capability. A new design chief has also reinvigorated ranges and excited fashionistas. New products now make up 75 per cent of the goods sitting in Burberry’s mainline stores.
Covid-caveat: Burberry has already taken a massive hit due to Covid-19. A strong presence in China means it felt the effects of the crisis from the outset. The pain is now spreading into its other markets. Its latest profit warning estimated a deterioration in trading during the six weeks to 19 March, ranging from 40 to 50 per cent against last year. Around 85 per cent of its stores in the Americas are closed. However, the Coronavirus does appear to be receding in mainland China where most of its stores have now reopened.
The company may well rethink a planned capital outlay of £180m this year, but net cash of £670m, excluding lease liabilities, as of September 2019 puts it in a good position to deal with the significant trading hit it is experiencing. A permanent change in high-end consumer behaviour and attitudes towards luxury as a result of the crisis is the biggest potential threat to Burberry’s long-term prospects. Yet there remains reason to suspect demand for luxury products and a desire to pay up for them speaks to something very deep in human nature. AJ
Central Asia Metals
Central Asia Metals (CAML) has been on a happy dividend-paying path since 2012, when it started production at the Kounrad reprocessing operation in Kazakhstan. The asset is basically a processing facility near waste dumps that have enough copper left in them to be run through the plant again. It does not deliver major production, and for all the talk around electrification and renewables driving new demand, copper as a material has not proved very compelling. But CAML’s business model does not require high prices to make money. Last year, it produced copper at a cash cost of 51¢ (42p) per pound (lb), or around $1,100 a tonne, against an average price of around $6,000 a tonne.
Away from Kounrad, the company has also just plotted a change in mining technique at Sasa, its zinc and lead mine in North Macedonia bought in 2017. When put in place, this change could increase grades and production, while cutting its sustaining investment by dropping the amount of waste sent to the tailings dam. While this is a technical change with associated costs, it is the kind of work miners should be doing: working out how to make operations run better and more safely. CAML’s record should give investors confidence that it will keep ticking along regardless of metals prices.
Covid-caveat: Copper is in a bad spot as a result of the crisis. The red metal’s price fall is not as bad as oil’s – thankfully there’s no one pumping supply into the market – but it is reliant on government stimulus to climb back above $6,000 a tonne, which is where many producers need it to be for healthy earnings. CAML does not need copper to be at that level for it to make a profit, although it will be some way off its forecast cash profit margin of over 60 per cent this year because of the revenue drop. AH
The real value of Derwent London’s (DLN) £5.5bn portfolio of offices comes down to its location and quality. It owns some of the best offices with some of the most desirable West End addresses going. It is a portfolio that would be very hard to replicate even for an extremely deep-pocketed buyer.
A flashy address and foyer is something businesses have shown an enduring willingness to pay top dollar for. This has been reflected in a steady rise in the rate at which Derwent has been able to agree new leases ahead of estimated rental values (ERV). Last year the group completed new lettings on just under 500,000m sq ft of space, contributing £34m in annual rental income, 7.6 per cent ahead of ERV at the end of December 2018. Meanwhile, the vacancy rate also fell to just 0.8 per cent.
Covid-caveat: There are valid questions to ask about the impact on the office market of a period spent in national lockdown. Specifically, there is uncertainty about the extent to which companies’ experience of working from home will translate into a longer-term reduction in demand for space. However, the nature of Derwent’s offices means tenants are often buying status as much as they are buying somewhere to put bums on seats. This may well prove a valuable defensive characteristic in the years ahead.
Meanwhile, Derwent’s weighted average unexpired lease term was 5.8 years at the end of December, giving the group a degree of security over future income. The tenant base is also well-diversified, with the largest sector – media, TV, marketing and advertising – accounting for 29 per cent of the annual rent roll. The group’s balance sheet is in robust shape too, with a loan-to-value ratio of 16.9 per cent and interest cover of 4.6 times. The nearest debt maturity date is January 2022 and the group has undrawn facilities and cash of £511m. Meanwhile, its development portfolio was72 per cent pre-let at the end of December. EP
Experian (EXPN) is capitalising on the rising importance of data to the global economy. The business-to-business (B2B) division is responsible for the bulk of earnings and provides companies with access to large databases of customer information, as well as other software and analytics. Recent momentum has come from new ‘big data’ platform Ascend, a prime example of how the group develops proprietary technology to be rolled out across industries and geographies. With $270m-worth of Ascend contracts across the US, UK, Brazil and Italy, further sales growth is being driven by adding new modules and cross-selling with other products.
Subscription services in the smaller consumer-focused division have struggled in the face of rivals’ free credit checks. But Experian has adapted, harnessing its own free products to gather more data for the B2B business and earn commissions from pairing customers with loans and credit card offers.
The UK remains a weak spot as B2B customers have deferred spending amid political and economic uncertainty. But North and Latin America boasted double-digit organic revenue growth across the first half of this year and third quarter. North America is the group’s largest operating region and it is tapping into growing demand for information services in the US healthcare system. Add that growth opportunity to a picture of steadily rising underlying operating profit margins and a return on capital employed of 15.9 per cent in 2019, and we think Experian makes for a solid long-term investment.
Covid-caveat: Good cash generation has underpinned a track record of share buybacks – the group intends to buy $400m-worth of shares in the 2020 financial year. As Covid-19 motivates companies across sectors to take scythes to their dividends and share repurchases, Experian has yet to announce any changes. But the pandemic is likely to whack B2B spending this year. We think the long-term data story remains intact, though. And more immediately, businesses and consumers alike could seek more credit information in these uncertain times. NK
Halma (HLMA) is an acquisitive company that bills itself as a specialist in ‘life-saving technology’. It has an enviable track record of consistently churning out growth.
The group is comprised of four business units: process safety, infrastructure safety, environmental & analysis and medical. Demand is underpinned by health and safety regulation, as well as rising standards. The critically important role played by Halma’s products and the close development work it undertakes with customers means its products are judged more on quality than price. Coupled with a focus on specialist niche products, this has helped the company keep margins high over the years.
Halma uses many small bolt-on acquisitions to take the business into new product areas and new geographies and so far in 2020 has spent £227m on 10 acquisitions. The corona crisis means we are likely to see a buyers’ market emerge at some point, but the current levels of uncertainty means dealmaking may need to take a back seat. The balance sheet looks in decent shape, though, with net debt representing less than one times cash profits, and 40 per cent of the company’s £750m borrowing facility is undrawn.
Covid-caveat: Merger and acquisition activity has slowed during the pandemic and the unprecedented level of business shutdowns means demand, even for products as crucial as Halma’s, should be expected to take a hit. As a manufacturer, fixed costs could amplify any strain. However, in the long term, there is little reason to think Covid-19 will undermine the health and safety agenda. In fact, just the opposite. AJ
London Stock Exchange
Although UK banks boast greater influence and larger balance sheets, the London Stock Exchange (LSE) is a strong candidate for being one of the City’s most valuable financial companies, and its best-run business. Its shares are also a sound long-term investment, as they have consistently proved over the past decade.
As the owner-operator of the infrastructure that keeps financial markets running, the LSE has the closest thing to monopoly profits investors are likely to find. This money comes from three primary sources: information services such as real-time price data and benchmarks; clearing services offered to derivatives traders; and capital markets activity – for which it is best known to retail investors.
Because of its scale and dominance, the LSE also exacts enormous pricing power for these services, which in combination with a capital-light business makes for wide profit margins, and high free cash flow margins. What’s more, aggregate demand for these services is only set to grow over the long term.
Covid-caveat: Although LSE’s trading revenues will have been buffeted by extreme market volatility so far this year, those same forces are almost certain to depress fees generated from listing activity. Also, the group’s $27bn acquisition of financial data firm Refinitiv – which the LSE wants to finalise in the second half of this year – could be delayed by European Commission efforts to slow the pace of merger clearance activity. In the grand scheme of things, a regulatory hold-up dims neither the combination’s obvious synergies, nor LSE’s excellent long-term prospects AN
Last year Relx (REL) finally completed its long transition from ink to pixels when it sold its final magazine, Farmers Weekly. A small proportion of sales still comes from print publications and books, but this has dropped by 53 per cent over the course of the past decade. Now the focus is on its extensive digital archive of data and content – a treasure trove of information that helps a range of clients from doctors to lawyers. It has also invested in data analysis tools that offer customers invaluable insights into their industries and customers.
We think this makes it a resilient pick for the long term, especially as over half of its revenues are secured on a very profitable subscription model. The group also has an enviable record for cash conversion and has returned £6.7bn to shareholders over the past five years, split between dividends and share buybacks.
Barriers to entry in the field are formidable; it would be a long undertaking to create a database that matched Relx’s comprehensive collections. Meanwhile, the company publishes many of the top peer-reviewed academic journals. All in all, we view the publisher’s digital transformation, sticky clients and consistent growth as highly attractive for the long term.
Covid-caveat: We think Relx should deliver a relatively stable performance over the course of this crisis, given its online nature. But not all of its operations are digital – its Reed Exhibitions division, which represented 13 per cent of group profit in 2019, will see a major hit from mass social distancing. The company is also locked in dispute with many customers in the academic world who believe they are charged too much for access to research. Changing attitudes towards the importance of access to this information could add to threats to the wide margins from these activities. LA
Investors’ perception of Rentokil (RTO) may be clouded by its history. After expanding too quickly and taking on more business lines than it could handle, its overambitious growth strategy came crashing down – along with its share price. But having returned to its roots as a pest control provider, we think it deserves a place on our watchlist.
As we pointed out in our recent tip, Rentokil is a fund manager favourite. It was the third-largest holding of the Royal London Sustainable Leaders Trust in February and the fund’s manager, Mike Fox, calls the $20bn global pest control industry “exceptional”. Long-term structural drivers of demand include increasing urbanisation, rising food and workplace regulations and climate change. And as the top player in 50 of its 80 markets, Rentokil is well-positioned to benefit. The group is targeting expansion in North America – the world’s largest pest control market – as well as emerging markets.
With an estimated 80,000 pest control companies around the world, the group has been boosting growth by buying up smaller outfits, which helps improve productivity by increasing the density of its local branch networks. In terms of organic growth, broker JPMorgan estimates average organic revenue growth in pest control outperformed that of number one US player Rollins (US:ROL) between 2015 and 2018.
Covid-caveat: But what about the dreaded ‘c-word’ – coronavirus? In a recent update, Rentokil projected that the pandemic would drive “a difficult second quarter and potentially beyond” as lockdown measures dampen activity in sectors such as leisure. Aiming to conserve over £500m in cash, the final 3.64p declared for 2019 is being withdrawn, acquisitions activity is suspended, and 2020 capital expenditure reduced by at least £75m. But it’s worth noting that demand for hygiene services is building and could be sustained post-coronavirus as businesses focus more on cleanliness. We don’t think the near-term disruption should detract from the long-term, defensive growth on offer. NK
Sage (SGE) sceptics are quick to point to management’s lethargy in offering a software subscription service. But the company is now playing catch-up with its US peers, which made the switch from a lumpy licensing model years ago. The benefits of selling software subscriptions – higher recurring revenue, wider margins, stronger return on capital employed – are therefore still to come.
In the three months to December 2019, Sage reported its eighth consecutive quarterly increase in recurring revenue. Subscription sales accounted for 70 per cent of the top line, up from 53 per cent in the comparable quarter of the previous year. And there is further to go – management is targeting subscriptions at between 85 per cent and 90 per cent of total revenue.
The transition to a subscription model has meant some short-term hits to revenue, especially in its software-related services division. But considering this legacy business now only contributes 12 per cent of group revenue, its decline shouldn’t matter much.
More important for long-term investors is Sage’s ability to turn profits into cash, which it can then reinvest in further growth or return to investors. In the past five years, operating cash conversion and free cash conversion have averaged 91 per cent and 122 per cent, respectively. In 2019, free cash flow of £443m easily covered dividend payments of £181m, meaning Sage’s dividend may survive the coronavirus crisis intact.
Covid-caveat: Disruption caused by the current crisis will stall sales activity and the potential for customers to go to the wall during a recession is a threat. However, the timely sale of the Sage Pay business for £250m at the start of 2020 has boosted the balance sheet, although the company is still likely to be sitting on debt. Management has therefore taken the sensible decision to preserve its cash for now and has suspended its share buyback programme. MB