We look at some fund managers’ quality processes and reveal names that should reward over the long-term
Thursday 12 Mar 2020 Author: Steven Frazer

Given the scale of the global market sell-off, now could prove an opportune time to buy quality stocks or to invest in funds with a quality tilt. We cannot say for certain that they will be good investments in the short-term, yet we’re much more confident they will provide generous rewards in the long-term.

‘Stocks are simple,’ says Warren Buffett. ‘All you do is buy shares in a great business for less than the business is intrinsically worth, with managers of the highest integrity and ability. Then you own those shares forever.’

A ‘great’ business tends to be one capable of managing short-term uncertainties and volatility to prosper in the longer run to deliver what many investors call ‘sustainable growth’.

Take health, safety and environmental technology kit supplier Halma (HLMA), for example. It is often used as an example of a well-run, high quality business and this is evidenced in its impressive share price appreciation over the years.

Yet like any company, it has come in for flack during times of stock market stress. Halma’s shares lost more than a third of their value in the teeth of the dot.com boom/bust, only to bounce back and recover all of those losses and more before the end of 2000.

It was a similar story in the global financial crisis, dropping to the 150p level in early 2009 before more than doubling in price by the end of 2010.

WHAT TO LOOK FOR

There are common measures of profitability, stability and financial health sought by many of the smartest professional investors.

These include gross and operating margins, return on equity (ROE), return on invested capital (ROIC), the volatility of revenue and earnings growth, debt, and the strength of cash generation measured by free cash flow (FCF).

There are also more esoteric factors to consider such as strong brands that can defend profit growth even in the face of increasing competition. For example, this might be Diageo’s (DGE) drinks brand Guinness, or Reckitt Benckiser’s (RB.) disinfectant Dettol.

It could also be intellectual property. For example, Google’s internet search algorithms are so effective that the website has become the de-facto way to find stuff online, which pulls in piles of advertising money.

The network effect enjoyed by Rightmove’s (RMV) property portal is another great example. It has built the scale that make it the first place home buyers look, so no property vender can afford to ignore it, thus drawing even more home buyers to its listings. That’s a network effect.

Generally speaking, high quality firms are consistently profitable, growing, and have solid balance sheets.

This is as true overseas as it is in the UK. ‘We focus on what we regard as higher quality stocks and tend to avoid loss-making companies and are wary of businesses that are over-reliant on debt,’ say Cormac Weldon, manager of Artemis US Select Fund (BMMV510) and Artemis US Smaller Companies Fund (BMMV576).

SEEKING SUSTAINABLE GROWTH

Whether it was stocks like Coca-Cola, American Express or Apple, investor Warren Buffett has always focused on the long-term. He and Berkshire Hathaway partner Charlie Munger have always sought firms with ‘economic moats’ that had durable competitive advantages and the capacity to compound returns over long periods from sustainable growth.

This concept was first outlined in a book called The New Buffettology, written by David Clark and Mary Buffett, a divorced former daughter-in-law of Warren Buffett. It looks for all the classic features that Buffett likes in a ‘consumer monopoly’ type of business.

These include:

–Strong and growing earnings

–Conservatively financed

–Earns high rates of return on shareholders’ equity

–Generates a consistently high return on capital

–Limited requirement for new cash

–Shares offer good value

In this strategy, a key part of assessing whether the stock is good value is to consider the growth rate a company can sustain without having to take on debt or issue new shares.

Retail investor website Stockopedia has a pre-set ‘Buffettology-esque Sustainable Growth Screen’, whose results include Rightmove, promotional products group 4imprint (FOUR) and kitchen seller Howden Joinery (HWDN).


FUNDS WITH A QUALITY TILT

Fundsmith Equity / Smithson Investment Trust

Terry Smith, the former City accountant and founder of fund management company Fundsmith, has his own pocket-sized strategy for buying great companies. This is used in both the Fundsmith Equity Fund (B41YBW7) and Smithson Investment Trust (SSON).

Fundsmith sees a high quality business as one that can sustain a high return on operating capital employed and which generates substantial cash flow, as opposed to only creating accounting earnings.

If a company reinvests some of this cash back into the business at its high returns on capital, Fundsmith believes the cash flow will then compound over time, along with the share price.

Earning higher returns on capital requires companies to show the ability to continue out‑competing rivals that are trying to take a share of their profits.

This can come in many forms, but Fundsmith looks for companies that rely on ‘intangible assets’ such as strong brands, patents, customer relationships, distribution networks, installed bases of equipment or software which provide a captive market for services, spares and upgrades, or dominant market shares.

Lindsell Train Investment Trust

Lindsell Train Investment Trust (LTI) remains hugely popular among retail investors despite the steep share price decline since July. It has delivered superb returns over years from the high quality stock formula implemented by managers Nick Train and Michael Lindsell.

‘We are guided by four investment beliefs when constructing and managing portfolios for our clients,’ says Train. These are:

–Investors undervalue durable, cash generative business franchises

–Concentration can reduce risk

–Transaction costs are a ‘tax’ on returns

–Dividends matter even more than you think

‘At the heart of the process is our conviction that inefficiencies exist in the valuation of exceptional quoted companies,’ the trust states. This boils down to Lindsell Train’s belief that most investors are typically poor judges of companies with great brand franchises that throw off heaps of free cash flow that will compound over years to create enormous value for shareholders.

It uses various investment metrics and approaches, but admits that the most important is a discounted cash flow calculation. This is one of the more tricky models for retail investors to get their head round because it relies on making fairly accurate assumptions about future cash flows and cost of capital of a business.

The investment team spend most of their time analysing facts and figures and crunching spreadsheet numbers in the hope of identifying potential investments from its stock universe. ‘We find the majority of our candidate investments in a select group of broad industry categories, such as consumer branded goods, internet, media, software, pharmaceuticals and financials,’ they say.

The same process is used in other funds run by Lindsell Train including Finsbury Growth & Income (FGT), Lindsell Train UK Equity (B18B9X7) and Lindsell Train Global Equity (B644PG0).


FOUR QUALITY STOCKS TO BUY AND (PROBABLY) NEVER SELL

Halma (HLMA) £19.49

Halma is a great quality business that operates in secular growth markets with long-term drivers. The designer of health, safety and environmental electronics equipment provides solid, reliable growth, month after month, year after year.

Increasing health and safety regulations, demand for healthcare services in developing economies, and demand for life-critical resources allows Halma to earn strong operating profit margins of around 20%.

Smithson fund manager Simon Barnard calls Halma a ‘very rare breed in the corporate world’ due to its strong acquisition track record, and values the firm for its ‘ability to continually invest incremental capital at very attractive rates of return by adding more small companies to its group each year’.

London Stock Exchange (LSE) £72.18

Whether markets are rising or falling, London Stock Exchange can reliably grow its revenue and profit thanks to transaction volumes both in equity markets and through its London Clearing House operations.

In addition its FTSE Russell index business continues to grow, with revenue up 10% last year, and the newly-acquired Beyond Ratings business has broadened its ESG (environmental, social and governance) appeal to bond investors.

Assuming the regulators approve the $27bn acquisition of analytics and data firm Refinitiv, the deal could transform LSE into the world’s leading financial markets services company and ensure continued growth for many years to come.

Marshalls (MSLH669.5p

This building products firm specialises on landscaping products like bollards and paving slabs. It has a very consistent track record and over the last decade has delivered a total return to shareholders of 775% despite significant uncertainty in the wider construction space.

The company is good at finding the right places to achieve growth and recently refreshed its strategy out to 2023 to focus on areas like housebuilding and transport infrastructure.

The green light for the HS2 rail scheme should boost demand for its paving products. The company also continues to invest in innovation and improvements to its digital platform.

Rentokil (RTO475.6p

Pest control and hygiene services may be unglamorous businesses but that is exactly what makes Rentokil the kind of stock that allows investors to sleep soundly at night.

As the world becomes more urbanised, demand for Rentokil’s services is only going to keep growing, and the coronavirus outbreak is a perfect demonstration of the need for hygiene in work and public places.

The firm reported record revenue growth last year and its leading global position allows it to generate strong operating profit margins – typically 30% higher than the FTSE 100 average – making it a stand-out long-term investment.


Disclaimer: Editor Daniel Coatsworth owns shares in Smithson

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