Three large-cap quality stocks at the right price

The point of changing the screen’s criteria was not so much about performance, but rather the fact that the output of the screen was so contrary to its stated aim.  Indeed, favouring quality stocks over cyclicals will not always be the best move for investors over a given period. That said, over the past 12 months quality stocks have been on a winning streak. It is therefore satisfying to see that the shares selected using the new screening criteria, have substantially outperformed the stocks highlighted using the old criteria as well as the FTSE All-Share index (see table and graph).

2018 performance (old vs new)

While the time had come to change the screening criteria last year, the old screen had performed strongly in earlier legs of our current longrunning bull market. Indeed, the screen has only underperformed the market in one of the eight years that I’ve monitored it. Such consistency should not be expected to continue, but I have no idea when this screen will encounter a noteworthy poor run. 

On a cumulative basis, the total return from the screen now stands at 328 per cent compared with 96 per cent from the FTSE All-Share. While the screens monitored by the column should be regarded as a source of ideas for further research rather than off-the-shelf portfolios, if I attempt to inject a sense of reality into the cumulative performance numbers by applying a 1.5 per cent annual charge to reflect dealing costs, the total returns falls to 288 per cent – still three times that of the index. 

The screen principally looks at two classic quality measures: operating margins and return on equity (RoE). As well as looking for the level of margin and RoE, it looks for improvements in these measures. There are also tests for positive earnings momentum, balance-sheet strength and cash generation. The valuation criteria are focused on a comparison between a company’s value relative to its operating profits (enterprise value to Ebit) compared with its expected growth rate plus dividend yield. This is similar to the price/earnings growth (PEG) ratio. I rather pompously call this a genuine value (GV) ratio. The full screening criteria is:

■ A GV ratio that is higher than the mid-ranking FTSE All-Share constituent (2.0) but lower than top quarter (4.1).

■ PE above bottom fifth and below top fifth of all stocks screened – to avoid anything suspiciously cheap or dangerously expensive.

■ 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.

■ Higher than median average return on equity (RoE) in each of the past three years.

■ Higher than median average operating margin in each of the past three years.

■ RoE growth over the past three years.

■ Operating margin growth over the past three years.

■ Operating profit growth over the past three years.

Only three shares passed all of the screen’s tests this year and I’ve provided a brief write-up of each below. But given three shares makes a rather poor showing for a stock screen, I’ve also provided details in the accompanying table of a further eight shares passing the valuation test but failing one other test. The three stocks passing all the screen's tests can be found at the top of the accompanying table, which also contains details of the tests failed by the other stocks. The shares are also ordered by lowest ('cheapest') to highest GV.

2019 Large-cap Quality Shares

Source: S&P Capital IQ

Spirax-Sarco

The phrase 'priced for perfection' had been closely associated with shares in engineering group Spirax-Sarco Engineering (SPX) this year. The company is much loved for its high returns, steady growth supported by regular acquisitions, and the perceived resilience of demand, despite some cyclicality in its end markets. Unfortunately, first-half results at the start of August proved to be marginally less than perfect.

Sure, investors were treated to organic growth of 8 per cent and lofty margins across many of the company’s divisions. But losses from the European arm of a company Spirax had acquired in 2017 led to some minor disappointment. While management was adamant that full-year expectations were still well within reach, the shares fell as much as 10 per cent over the following days. The accompanying downgrade to the consensus full-year EPS forecast was modest by comparison at 1.5 per cent (see chart 3).

The extent of the earnings upset (very minor) is hardly enough on its own to call into question the company’s credentials as a quality play. However, nervousness about the trading outlook already existed due to signs of a global economic slowdown. More significant, though, is the sky-high valuation. Even after the recent share price drop, the shares trade at a 40 per cent premium to their 10-year average, based on a rolling-12-month forward price/earnings (Fwd NTM P/E) ratio; not exactly 'cheap'.

Spirax is certainly a high-quality play and its shares' forward PE of 29 is more attractive than a few weeks ago when they traded at 34. That said, the trading environment is challenging and there is still significant scope for the shares to derate should there be any further disappointments – even if they are minor ones.

Diageo

Diageo’s (DGE) status as a quality stalwart is based  on an unrivalled portfolio of upmarket spirits brands. Its strong presence across spirit categories means when the fortunes of one type of drink wanes (such as recent falls in rum sales), the rising popularity of other tipples (tequila and gin a current case in point) tends to take up the slack. It also has broad international exposure, including a strong presence in emerging markets, which has helped drive recent growth.

Over the long term these characteristics show up in key financial ratios used by investors to assess quality, two of which are chronicled by the graph below. For example, while there have been some fluctuations, over the last 15 years the company has produced a consistently high return on the money it has invested in its operations – the return on capital employed (ROCE). Meanwhile, gross margin, which is commonly regarded as being a good indicator of a company’s pricing power and market strength, has been both high and consistent (as measured against the right axis of chart 5). 

Nb ROCE data is from a different source to that used in the table of screen results

Often the kind of competitive advantage that allows companies to sustain high returns and gross margins is referred to as an economic moat; Diageo’s moat being its top-notch portfolio of brands, which includes Johnie Walker, Smirnoff, Tanqueray and, in the world of beer, Guinness. Such moats become of truly outstanding value to shareholders when they are coupled with an opportunity for significant, high-return, high-margin growth. 

In Diageo’s case, growth can be regarded as decent rather than great. Over the next two years, the company has guided to mid-single digit organic annual sales growth and 5 to 7 per cent organic operating profit growth. Encouragingly, unlike Spirax, the recent trend in EPS forecasts has been upwards.

Solid cash generation coupled with the relatively limited opportunity to invest in organic growth means the company often has money to spare. Some of this is funnelled into acquisitions, such as last month’s purchase of non-alcoholic premium 'spirit' company Seedlip. The company also has a record of returning excess cash to shareholders, often through share buybacks. That said, the relatively high valuation of the shares means a recently announced £4.5bn shareholder return over the next two years could come by way of special dividends.

Games Workshop

Games Workshop (GAW) is in the process of going from being considered a recovery-growth play to a quality-growth play. As such, it could turn out to be that dream stock that boasts both high returns and high growth. The catch is that its high returns are based on its dominance of a niche market and it is nigh on impossible to predict how large and valuable that niche could become. 

The potted history is that following a five-year period of cost-cutting and reorganisation, Games Workshop made a big push towards customer engagement starting in 2015. This made very good use of digital media, and its highly-engaged and loyal fan base. Turnover and profit growth have been knockout since then (see chart 6). Not only has the company been selling more of its traditional miniature figurines and games products through both its own shops and third parties, but it has also seen a take off in royalty revenues, such as licensing intellectual property for computer games. Royalty revenue is almost pure profit.

The company  has historically been regarded as not having too much regard for the wants of the stock market, which in itself is no bad thing. In fact, recently the relatively limited coverage of Games Workshop's shares by brokers has been a boon for shareholders as its profits have surprised on the upside time and again, driving the share price higher. EPS for both the current and next financial year have been upgraded by 38 per cent over the last 24 months (see chart 7). The company’s relatively new, but internally promoted, top brass has sought to make the cycle of product launches a bit more stock market friendly, though. 

Returns on capital are extremely high but are expected to drop in coming years. The expected fall is because the company needs to invest to keep up with demand. As well as increasing capacity in its Nottingham facility it plans a 50 per cent expansion of its Memphis warehouse. The margin the company achieves on sales and recent growth rates means the investment has the potential to pay off handsomely. 

The UK market for Games Workshop’s products is relatively mature, but based on sales in its domestic market, there could be significant growth potential in Europe and North America if hobbyist enthusiasm proves a match. What’s more, new ways to extract value from the company’s intellectual property are under consideration, with recent results revealing a television series is a possibility. 

When returns and growth are high, valuation is rarely a stumbling block to shareholder gains, and for believer, Games Workshop’s valuation should look a bargain. But the potential of the market for Games Workshop’s lovingly developed intellectual property is still the big unknown.