Five reliable stocks with pricing power

So what’s the point in continuing to hunt for ‘inflation beaters’? The aim of the inflation beaters screening criteria was to highlight companies capable of paying reliable and growing dividends that would be able to keep pace with price rises. In particular, the hope was that dividend history could act as a decent proxy for a company’s ‘pricing power’. And while it is handy to own shares in companies that raise prices when inflation raises its ugly head, it is also often handy to own shares in companies that can raise prices full stop. In fact, the kind of high-quality companies that can set prices have become increasingly prized since 2012 due to the low bond yields that have persisted thanks to – irony of ironies – low and stable inflation. The popular reasoning behind this is that scant returns from safe bonds have made the reliable income streams from high-quality ‘bond proxy’ equities more attractive, which has caused such stocks to re-rate upwards.

The screen’s criteria are as follows:

■ A rising dividend in each of the past 10 years.

■ 10-year and five-year compound average dividend growth of 5 per cent or more and growth in the past year of 5 per cent or more.

■ Dividend cover of two times or more.

■ Net debt of less than 2.5 times cash profits.

■ A return on equity of 15 per cent or more.

■ A dividend yield of 2 per cent or more.

■ Forecast earnings growth both this year and next.

There are fears that, with bond yields now rising, especially in the US, the high ratings commanded by these stocks will start to unwind – to some extent this has already happened. But the counterpoint is that the high returns from these companies compound to such an extent over time that paying up can prove the smart option for buy-and-hold investors. What’s more, when high-quality stocks de-rate during wider market sell-offs, the resilience of their earnings (the key fundamental they de-rate against) can make the downside less severe than lower-rated but less-resilient ‘value’ stocks. There’s no getting around the fact, though, that the price paid compared with ‘fair value’ is always going to be a significant determinant of investment outcomes.

Last year, despite the backdrop of tightening monetary policy, the screen put in a good performance (see table, below); since I started running the screen it has delivered a 114 per cent cumulative total return compared with 66 per cent from the FTSE 350, which is the index the screen is conducted on. If I factor in a 1 per cent charge to account for dealing costs, the total return drops to 99 per cent. This screen tends to highlight many of the same shares year in year out, so the costs in reality may be lower than my 1 per cent proxy. That said, the screens covered by this column are considered to be of interest to highlight ideas for further research rather than as suggestions for off-the-shelf portfolios.

2018's Inflation Beaters

Three stocks passed the screen’s tests this year. A further two passed on the weakened criteria of only needing positive forecast earnings growth on average over the next two years, as opposed to in each of the next two years. I’ve provided a write-up of the most expensive of these, which is soft drinks company AG Barr. 

Five companies with pricing power

Source: S&P CapitalIQ

AG Barr

Glasgow-based soft drinks company AG Barr (BAG) has many fans thanks to its impressive record of producing high margins and high returns on capital backed up by strong cash conversion. At its heart, the company’s success is all about managing its brands, and in particular its core IRN-BRU brand.

While the company has an efficient manufacturing and distribution operation, brand is arguably the key factor that differentiates one sweet-tasting fizzy liquid from another – most of Barr’s drinks are fizzy, with carbonates last year accounting for 74 per cent of sales and 79 per cent of gross profit. As well as producing "Scotland's other national drink", IRN-BRU, the company owns brands such as tropical drink Rubicon, Tizer and Funkin cocktail mixers. It also has several manufacturing and distribution partnerships with third-party brands such as Snapple and recently signed up premium brands San Benedetto and Bundaberg. Sales are concentrated in the UK, which accounted for 96 per cent of revenue last year.

The group’s historic financial performance provides solid evidence that Barr has a very good business. To borrow an old IRN-BRU strapline, the consistently high returns of the past decade suggests a company “made in Scotland from girders” (see chart).

But high returns are coupled with rather pedestrian, albeit decent, growth rates. Earnings per share (EPS) growth is forecast to be around 3 per cent in the recently completed financial year, and 5 per cent in the following year. This is slightly lower, but more or less on a par, with the five-year historical compound annual growth rate (based on S&P CapitalIQ data). Meanwhile, there’s no noteworthy trend in broker forecast revisions over the past 12 months.

There’s encouragement to be taken from recent trading based on how Barr coped with a particularly tricky period during the first half of last year: it had to contend with the introduction of the UK sugar tax; crazy weather including The Beast from the East; and a carbon dioxide shortage. Having reformulated most of its drinks to reduce sugar levels, Barr has successfully focused on increasing sales volumes and winning market share. True, the strategy has weighed slightly on margins as the company has absorbed input cost rises and increased marketing spend. But having focused on volumes during a turbulent period for its rivals as well as itself, Barr now plans to boost the value of sales.

Given the strategy, all things being equal, investors are likely to be closely watching how margins progress over the next 12 months. The strain in the retail sector means investors are also likely to want to check that receivables (yet to be paid invoices) are under control when full-year results are announced next month given an uptick in the measure at the half-year stage.

While growth may be nothing to shout about, the company has used its strong balance sheet and cash generation to enhance EPS through share buybacks and is currently part-way through a £30m buyback programme. But the multiple of earnings the company has to pay for its own shares means the returns from this spending are not amazing. Indeed, it is the high multiples investors are expected to pay for AG Barr’s shares that are likely to be the key consideration for any new investor.

The consistency of Barr’s returns has not been matched by the consistency of the rating attached to its shares over the past decade. The multiple valuation has climbed and currently sits comfortably in the top tenth of the 10-year range based on some key metrics. As can be seen in the accompanying table, if the past decade’s valuation range is taken as a reliable guide to the future, one would bet that the contribution to shareholder returns from valuation will be negative (ie the shares look more likely to de-rate than re-rate based on the 10-year history).

AG Barr vs its 10-year history

Source: Bloomberg  

However, compared with other highly regarded consumer-staple stocks, AG Barr’s rating does not look overly stretched, even if it is still on the expensive side.

AG Barr vs peers

Source: S&P CapitalIQ

This begs the question of whether investors would be better off looking for cheaper lower-quality shares. There may be a case for this for anyone that thinks it is likely the market will re-price AG Barr et al independent of a wider sell-off and economic downturn. This is a view that has been popular for several years based on the potential for rising interest rates to impact negatively on reliable 'bond proxy' stocks such as Barr. There is a logic to the argument, but so far it has been mainly bark rather than bite. And in the case of a more broad-based bear market, Barr’s earnings resilience would be likely to offer welcome protection. Still, the shares are no bargain.